Fernando MonteiroThe Nature of Economic Bubbles
March 8th 2010 15:05
Economic bubbles have, in the last decade, become synonymous with real estate booms which popped-up everywhere in the western world and which at some stage were pricked by central banks. In the USA, the last real estate bubble burst generated the global financial crisis with vast and dire consequences to the world at large. What are, though, economic bubbles?
When you go to economic school, if you dear reader do go, they teach you that when demand and supply for a good or service in an economy meet at a certain point and rest, that is their equilibrium. Then they tell you that, if demand for a good or service increases, its price first increases, then supply also increases since producing to sell at higher prices is attractive. And so the equilibrium of prices moves to a higher point.
According to conservative economists this always happens and, more interestingly, markets when left to themselves naturally tend to some sort of equilibrium. So, they say, markets should be allowed to function freely and unrestricted by legislation. Other less conservative economists defend that it’s only in tightly regulated markets that equilibrium verifies and as a consequence of the special circumstances that that regulation creates. Elsewhere, they defend, once market forces are left to themselves, markets depart from all equilibrium and behave aberrantly.
In any case, whichever inclination the reader picks, the question imposing itself now is what are economic bubbles? A bubble is an anomaly in a market. It happens because either demand or supply or any other external factor is not working as in the scheme of equilibrium described above. In the latest housing boom, both in America and in Australia, the supply of new homes was negligible and so an initial increase in demand caused prices to increase.
Then, as mentioned, not there being any increase in supply, this increase in price brought an extra increase in demand. This, though, was strange because an increase in price should bring a decrease in demand, since paying for it becomes harder and less attractive. But that’s how a bubble works: an increase in demand brings an increase in price which then brings an increase in demand, and so on. It works as a self-reinforcing system.
What motivates people to demand more housing when their prices go up, though? In a nutshell, it’s their expectancy that other people will be prepared to pay more for it. So, speculation becomes the name of the game. People put up for sale homes for a greater price than they bought them for; other people buy them and do the same. And this crazy spiral where there is never any equilibrium or limit, as it seem to be believed by the feverish speculators in that market, keeps going on forever.
That is, though, until they burst with a bang. But, why do bubbles burst and when, the reader might ask. Without an increase in the supply of homes, the increases in prices go too high and, at some stage, people realise they can’t keep on paying more. Costs, both principal amounts borrowed and interest, become just too high and also inaccessible. With decreased margins due to higher costs, buying homes to sell becomes less attractive, and demand wanes. Suddenly, as most other players realise this and retract, the game virtually ends by crashing.
In Australia, the last housing bubble was pricked by the Reserve Bank of Australia hiking interest rates in a determined way. It was meritorious that the amount of monetary policy used was just enough to burst the bubble without much impacting on home prices and also without depressing the general economy. It was also handy that inflation rates were also high at the time.
Initially and as a result of these interest rate increases and consequent bubble bursting, home prices came off their peaks a little bit, but then with the federal government’s incentives to buy first homes they went up also a little bit. Home values in Australia, though, in terms of number of times the average income are highest, and many people who would otherwise be able to buy home cannot now afford it. On the other hand, many home owners are faced now with the bitter reality of their mortgage debt being greater than the market value of their houses/apartments, which gets known by the term “negative equity”.
As a note to end this article, it is worth mentioning that the RBA’s interest rate tool to control some economic variables is a rather crude one. You just have to consider that in our economy, one third of the people rent; another third owns their homes outright. It’s only a minority of one third that pays a mortgage loan and they are the ones who get pushed around by the RBA when, by changing interest rates, it affects their disposable incomes and demand.
When you go to economic school, if you dear reader do go, they teach you that when demand and supply for a good or service in an economy meet at a certain point and rest, that is their equilibrium. Then they tell you that, if demand for a good or service increases, its price first increases, then supply also increases since producing to sell at higher prices is attractive. And so the equilibrium of prices moves to a higher point.
According to conservative economists this always happens and, more interestingly, markets when left to themselves naturally tend to some sort of equilibrium. So, they say, markets should be allowed to function freely and unrestricted by legislation. Other less conservative economists defend that it’s only in tightly regulated markets that equilibrium verifies and as a consequence of the special circumstances that that regulation creates. Elsewhere, they defend, once market forces are left to themselves, markets depart from all equilibrium and behave aberrantly.
In any case, whichever inclination the reader picks, the question imposing itself now is what are economic bubbles? A bubble is an anomaly in a market. It happens because either demand or supply or any other external factor is not working as in the scheme of equilibrium described above. In the latest housing boom, both in America and in Australia, the supply of new homes was negligible and so an initial increase in demand caused prices to increase.
Then, as mentioned, not there being any increase in supply, this increase in price brought an extra increase in demand. This, though, was strange because an increase in price should bring a decrease in demand, since paying for it becomes harder and less attractive. But that’s how a bubble works: an increase in demand brings an increase in price which then brings an increase in demand, and so on. It works as a self-reinforcing system.
What motivates people to demand more housing when their prices go up, though? In a nutshell, it’s their expectancy that other people will be prepared to pay more for it. So, speculation becomes the name of the game. People put up for sale homes for a greater price than they bought them for; other people buy them and do the same. And this crazy spiral where there is never any equilibrium or limit, as it seem to be believed by the feverish speculators in that market, keeps going on forever.
That is, though, until they burst with a bang. But, why do bubbles burst and when, the reader might ask. Without an increase in the supply of homes, the increases in prices go too high and, at some stage, people realise they can’t keep on paying more. Costs, both principal amounts borrowed and interest, become just too high and also inaccessible. With decreased margins due to higher costs, buying homes to sell becomes less attractive, and demand wanes. Suddenly, as most other players realise this and retract, the game virtually ends by crashing.
In Australia, the last housing bubble was pricked by the Reserve Bank of Australia hiking interest rates in a determined way. It was meritorious that the amount of monetary policy used was just enough to burst the bubble without much impacting on home prices and also without depressing the general economy. It was also handy that inflation rates were also high at the time.
Initially and as a result of these interest rate increases and consequent bubble bursting, home prices came off their peaks a little bit, but then with the federal government’s incentives to buy first homes they went up also a little bit. Home values in Australia, though, in terms of number of times the average income are highest, and many people who would otherwise be able to buy home cannot now afford it. On the other hand, many home owners are faced now with the bitter reality of their mortgage debt being greater than the market value of their houses/apartments, which gets known by the term “negative equity”.
As a note to end this article, it is worth mentioning that the RBA’s interest rate tool to control some economic variables is a rather crude one. You just have to consider that in our economy, one third of the people rent; another third owns their homes outright. It’s only a minority of one third that pays a mortgage loan and they are the ones who get pushed around by the RBA when, by changing interest rates, it affects their disposable incomes and demand.
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