Economic Bubbles 101

The all too common phrase of “Learning from History” has been the rhetoric amongst governments and central banks for decades. And because we’ve heard this most of our lives we may think that today’s economic events will not have the dire consequences of past mistakes. So is the case with the infamous Asset Bubbles that our economy had experienced just about every decade during our lifetimes. What puzzles me is the fact that academic macro-economists always debate whether the central banks should prick bubbles or just let them run out of steam on their own instead of focusing on how to avoid them.

Just as many of the diseases are the result of individual lifestyles – and in many cases they can be prevented – the Law of Cause and Effect applies to the economic bubble events. For example, the Real Estate Bubble that we experienced during the early 2000s did not “just happen.” Something did cause the bubble that eventually brought upon us the current financial crises. From an Austrian School perspective there is a logical explanation of how man-made economics (Keynesian-ism) bubbles form and why allowing the market to act freely would prevent them from happening.

Demand for Credit

When an economy experiences a high demand for credit it is due to a high demand for scarce resources. As a result of the scarcity in the market Businessmen engage in the production of such resources thus creating an investment boom. Without central bank intervention – in a truly free market – the high demand for credit would be reflected in a raise in the interest rates. This is part of the economic law of supply and demand. When a commodity, for example, is in short supply with a high demand the price of the commodity goes up. The same law applies to the demand for credit, whereas when credit is limited – due to limited savings – and the demand is high, the cost of credit would normally have to go up.

The Cost of Credit expressed in the Rate of Interest

So, what happens then if the cost of credit is suppressed by the central banks? Clearly, investment boom does not stop. First of all, it gives wrong signals to the business men, as in the previous example, the builders will over build. It brings in the arena other players/participants that may not necessarily be equipped to handle the credit and/or business requirements – the new builder and the marginal home buyer. In Austrian Economics terms these are called “malinvestments.” Malinvestments are investments that in a free market – one without government and central bank intervention – would not occur. The origin of the word “mal” comes from the Latin word “malus”. Its meaning is “bad” or “inadequate.”

If the central bank would not fix the pricing of interest rates – such as Alan Greenspan did during the Real Estate Boom – the market would adjust by allowing the rates to go up. As a result of a rate increase at least two events would have occurred. 1) Malinvestments would have been prevented, and 2) Asset prices would have not been inflated. In our example, the prices of real estate would have not gone up so fast and so much. The price of the asset – real estate – would have been kept in check by the market. Of course, things didn’t occur this way. The central bank applied the man-made economic principle so by keeping rates at such low levels it led to malinvestments and artificially inflated real estate values. Therefore, without the natural rise in the interest rates, the interest rate suppression caused inflation to be channeled into the asset itself.

Credit expansion exercised by the central banks prior to and during all events of the so called “Economic Booms” can temporarily create the illusion that there is more real funding available than actually exists. In addition, it makes many people feel rich when they review their net worth in terms of asset evaluation. In reality, the effects of a Bubble are, without a doubt, a painful Burst. There is no such thing as a soft landing when it comes to economic bubbles; they must be prevented by the government and the central bank by allowing the market to adjust itself freely without their intervention.

Lessons from the Great Depression

The Great Depression of the 1930’s was the effect of a couple of primary events that occurred. First, it was the 1929 Stock Market crash that was fueled by a credit expansion that led to artificially inflated values of stocks. Credit expansion is always triggered by the joint effort of the central banks and governments. If rates were allowed to adjust freely – without central bank’s intervention – malinvestments would have been prevented and stock values would have been maintained at values dictated by the free market. Many Americans were exuberant of their new-found riches in the stock market. Just as (many) young people act as if they’re invincible so were many “new wealthy” individuals and businesses. Secondly, when the stock Bubble burst, instead of allowing the “too big to fail” entities to fail politicians made the decision to save them. Thus, more government intervention in form of regulations, taxation, and bailouts. People lost their stock investments and their bank savings. Bank runs occurred because the banks only kept a fraction of their deposits in their vaults – fractional reserve banking system that is applied today – while the rest had been lost due to loans secured by stocks. I see plenty of similarities in events between yesterday and today. In a nutshell here they are:

1.  Credit Expansion promoted by the central banks;
2.  Occurrence of Malinvestments;
3.  Asset Bubbles;
4.  Bubble Burst;
5.  “Too big to fail” corporations saved through bailouts;
6.  Asset deflation;
7.  Government implementation of new regulations;
8.  Keynesian principles applied causing more money to be printed;
9.  Stagflation – our current economic stage – in which prices of commodities go up while asset values – such as real estate – continue to deflate.

And finally if the central banks, governments, politicians, and modern economists would really stand by the slogan of “learning from history so that it does not repeat itself” they would do well to pick up a few books of Austrian Economists such as Mises, Rothbard, Hayek, or Hazlitt.


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