Chapter Fifteen: Bubbles
”There’s a bunch of pops and clicks on the sound track that I couldn’t eliminate…if anybody has any suggestions or ideas as to why this happened or how to fix it, I am all ears”.
We have been hearing bits and pieces of the crisis starting to unfold and this REALLY puts it together....and we have not even reached the peak oil section yet!
Thanks Chris. Very well done. You should consider teaching :).
David
According to the numbers quoted by Chris, house prices increased on average by a factor of 2. In comparison to the tulip mania (price increases by a factor of 30), this is a low multiple and for that reason, I think calling that price increase a "bubble" is an exaggeration. Exuberance is perhaps a more appropriate notion. I also doubt that house prices will return to the pre - bubble levels. Given the tremendous increase in the price of many commodities (copper. oil, wood), the increase in house prices is to a certain extent justified. After all, inflation is real. Inflation is not only a monetary phenomenon. With oil and other resources depleting, the purchasing power of money decreases steadily even if no new money is being printed.
Housing is an important capital stock in the US economy. Since our manufacturing sector shrinks steadily, the only source of income for our banks are mortgages, that is, loans backed up by houses. Houses are the only remaining sourse of capital in the US. For that reason, a crash in the housing markets can not be allowed.
sczech - I don't think the multiple increase is important. Surely the multiple achieved all depends on the starting value.
Houses are the single largest, most highly geared investment that people make in their lifetimes. Prices are starting from a base of say $100,000, not $1 or so as in the Tulip example. This is why penny stocks can 10-bag whereas blue-chip companies would find it much harder.
An increase of 30-fold from say $1 to $30 means nothing in isolation - what is important is how affordable the asset is (price:income).
The cost of raw materials for housing may have increased somewhat (add 10-20% onto build costs), but this in no way can explain a 2-fold rise. Also, productivity should have improved and labour costs fallen over this time, negating some of the raw material costs.
The argument that housing 'is important' is precisely the problem. With the move away from manufacturing toward a service economy the only way of increasing GDP is by inflating asset prices (thus increasing debt). This is what Chris shows with the increase from $21trn to $48trn in debt over 7 years!
The problem with this is unsustainability. The Fed has blown these bubbles (by way of low real interest rates) to cushion us from economic shocks, but all this has done is delay (and increase) the eventual pain when the bubble bursts.
It is now no longer a question of whether a housing crash 'can be allowed', it is happening right now. The only relevant point is whether we allow a painful and long overdue correction to happen naturally as it should, or try to intervene and prop up the market which will cause wide-scale monetary problems over a much longer period, as Von Mises mentioned.
I appreciate Chris's explanation of 'bubble' psychology, but the chart showing U.S. inflation as a flat horizontal line relative to real estate appreciation is economically misleading. Home price appreciation should be compared with the loss in value of the currency--i.e. 'inflated dollars'. His following chart which shows real estate values vs. income support is more informative, in my opinion.
Consequently, sczech makes a valid point. Single-family residences ("SFR" serves a fundamental human need...shelter) and thus serve as a vital physical commodity. Commodities are a good investment when a currency is being debauched. Yes, prices will substantially decline for the NEAR TERM. Those who get really burned here are RE flippers and those who looked to get rich quick--i.e. no-down RE nonsense. Those who made purchases for the long term will survive.
As the Fed and Treasury bail out Freddie and Fannie, new money will be created and infused which will result in shoring up real estate values. All political parties are committed to having SFRs, and the industry that creates them, remain American's core investment and major manufacturing sector, respectively.
The Fed, Treasury, and politicians with their heads screwed on straight are starring at a potential "debt deflation." Read Ambrose Evans-Pritchard's most recent gaze into his economic crystal ball--Monetarists warn of crunch across Atlantic economies at: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/07/11/cnmone...
hello doctor,
first thanks for educating us.
can you explain, what happens when someone defaults, what happens to the money? it is still in the system correct?
so with all this housing bubble and people not being able to pay their mortgages, where did all this money disappear and why are banks facing credit crunch?
for example,
builder sells a house for 100k
partyA borrows money from the bank, bank creates 100k and gives it to the builder. partyA defaults, bank doesn't get the money but gets a level3 (illiquid) asset. but 100k is still in the system with the builder. so where is all this money going?
Submitted by jetgraphics on Tue, 07/08/2008 - 18:51.
Usury, and usury based investing, is mathematically impossible in a finite money token system. Over time, the aggregate debt (principle and interest) exceeds the sum total of all money tokens. Thus a portion of debtors must default, and suffer the loss of pledged collateral. This is why usury has been condemned from time immemorial. Yet each generation convinces itself that usury is reasonable, and embraces it.
In America's situation, it has gone far beyond sanity.
A unit dollar, by constitutional law, is a silver coin (3/4 ounce). A one ounce gold coin was equivalent to 20 unit dollars. In 1872, the Federal government demonetized silver (alleged gold standard), creating a huge money shortage. The following economic chaos "softened" up public opinion to accept the "solution" - an elastic money supply (debt credit).
With the institution of the Federal Reserve Act (1913), debt credit (Notes issued at usury) was substituted for hard money. By 1933, the aggregate debt bankrupted Congress. In House Joint Resolution 192, they repudiated their promise (Title 12 USC Sec.411) to redeem Federal Reserve Notes (FRNs) with lawful money (gold and silver coin). After that point, ALL FRNs BECAME WORTHLESS. (No par value).
What Americans call "dollars" *(paper currency) are NOT dollars. Ask a judge to rule that a FRN is a dollar, and he will demur. So if you think you are dealing with dollars, at law, you are not. (Now you know why fractional metallic coin is becoming more and more expensive. The "paper" is worth less and less.)
For generations, people have been buying and selling with a money token that is devoid of any value or standing at law. Which might explain the insanity that comes from Congress and the courts.
M1 (2008) = 1.4 T (available cash and travelers checks)
National debt = 9.4 T
Private housing debt = 27 to 48 T
Does anyone notice the discrepancy, yet?
That which is owed is far greater than the sum of available money tokens. How did we get 'inflation' when the obligation far outstrips the sum of money tokens? Where's the "too much money chasing too few goods"?
Last year, Congress borrowed MORE than the interest it paid on the national debt. That's right - Congress is paying its interest bills with borrowed money! And you thought that Congress just "printed up new money." (No, it doesn't. Congress has the constitutional power to coin money (stamp bullion) or borrow money. If it DID have the power to create new money, it wouldn't need to BORROW it.)
Worse, the national debt (9.4 T) is denominated in lawful money, and FRNs cannot pay it. If computed in terms of ounces of gold, America's national debt is roughly 99 times greater than the whole world's stock of above ground bullion. At current mining rates, it would only take 87 thousand years to dig up enough - if the debt was frozen right now. And thanks to the 14th amendment, you cannot question the validity of the national debt. (!)
Ludwig Von Mises and any other economist who fails to condemn usury (charging a fee for the use of money - not just excessive interest), will mislead you every time.
The logical result is an utter collapse of the American money token system, and financial ruin for anyone holding "paper" as an asset. If you are a creditor owed money, you will be ruined. If you are a debtor owing money, you will be ruined. There's not enough gold and silver to operate a hard money economy, and the current system based on usury is insane.
To put it into perspective, in the dim past (1900s), a Sears Catalog mail order house would set you back $500 to $1400. That's when money was still money, and not "bubbles".
(500,000 FRNs for a dinky apartment in LA or NYC? Beyond insane!)
When correcting for inflation to display the real change in housing prices, do these charts (following Schiller) use government inflation figures? The most alarming period corresponds with the most understated government inflation figures (compared to Williams' Shadow Government Statistics at shadowstats.com).
Using Williams' inflation estimates, the bubble price increase in real terms might be 70% of that produced using government figures for 2000 - 2008, hence the evidence of an historic bubble would be less dramatic (though evidence of inflation would be more alarming.) Another way of looking at the cost would be price / cost to produce the house, adjusting, in effect, for house price inflation only.
Thanks for an unnervingly cogent series of lectures.
so, this article explains what is a bubble.
but how does one identify the top? what are the signs to look out for?
for example, some people say gold/silver might be in a bubble, how do we know we have reached the top?
i know gold is money, but in dollar terms how do i know gold has reached its top?
thanks!
To have hyperinflation, does it matter what the distribution of wealth is like to get too hyperinflation or is it just the presence of the excess fiat currency enough to trigger the inflation?
For example, if you have 101 people in a closed system where there is 1 billion and 1 million dollars circulating. In scenario A 1 person has a billion and the other 100 split 1 million dollars. In scenario B the 101 people equally have a share of the 1 billion and 1 million. Intuitively I see scenario B as a more inflationary scenario where as scenario A is dependent on how B acts. Sort of like DeBeers. Supposedly they have enough diamonds to fit every female with a 1 karat ring, but by controlling the flow of diamonds into the public and using a sophisticated marketing scheme, they have been able to maintain the value of the diamond despite their seemingly infinite supply. Can't that happen with money?
Submitted by superchase on Tue, 07/15/2008 - 03:48.
Maybe the real culprit is none other than the Bush Administration. Perhaps the Fed's measures had a lot to be desired, but maybe they were only reacting to a very poor set of fiscal policies by that administration. Bush primed pumped the American economy with debt, lax lending policies, unrealistic tax cuts and budget projections. So really, what was the Fed supposed to do? Just do its best to react to whatever those controlling the finances and treasury were doing. In that case, it was Bush and his cronies. Not even John McCain initially backed the Bush tax cuts. As well, Alan Greenspan warned about what he called 'irrational exhuberance'. It's quite apparent he knew what was going on, but with a bad leader like Bush, what could Greenspan, a Republican himself, do about it?
Submitted by scallywag on Tue, 07/15/2008 - 05:44.
Thank you for putting it all together so lucidily.
connecting all the dots as you have done is an eye opener.
waiting for the final chapters..
keep on Keepin on
"Maybe the real culprit is none other than the Bush Administration. Perhaps the Fed's measures had a lot to be desired, but maybe they were only reacting to a very poor set of fiscal policies by that administration. Bush primed pumped the American economy with debt, lax lending policies, unrealistic tax cuts and budget projections. So really, what was the Fed supposed to do?"
Under the leadership of Paul Volcker, the Fed killed inflation by raising interest rates until inflation expectations were destroyed. Needless to say the Volcker took an incredible amount of political heat for that. So much so that, despite his success, Reagan did NOT renew his tenure.
You can bet your last n'gwee that Volcker's successors got the message loud and clear: "Do not displease your political masters...or else!"
The result is obvious for all to see; Greenspan and Bernanke were/are keenly aware of who hold the keys to THEIR personal well-being. Do you think the 300,000 dollars PER LECTURE that Greenspan pockets now has escaped being noticed? Hmmmm! Let me think about that for a nanosecond.
SO, the short answer to what the Fed should have done is: The Right Thing a.k.a. acknowledge the bubble and puncture it at its roots without any mercy. But that would have gone opposite to the wishes of their true masters, the banking elites and an Administration desperate to hide how bad their econ management has been. What better than create false wealth as an easy fix to this politically irritating problem, while allowing the banking industry to capture ever-increasing fees at every level of the housing bubble??
Chris,
You leave out the role of compounding, that you so nicely introduced the talk with. That's the whole difference between the savings rate of the productive people and those irrationally multiplying (financial) assets that are 'unearned'. The extreme (hockey stick type) difference is entirely due to the means used. One demographic uses service, the other uses compounding. Please factor that in when blaming the whole God awful mess on the mismanagement of greedy bureaucrats and a financial structure prone to abuse...
check my physics if you want more
best, Phil
Submitted by charlespm on Wed, 08/13/2008 - 15:34.
What an amazing time of hope and paradigm change we are living in. More and more economists realize the evilness of (k)eynesian economics and begin to embrace the Austrian Theory of the Business Cycle (ATBC). I'm a college professor of economics, in Peru, and let me tell you, all those college textbooks that were required reading (e.g. Samuelson, Dornbusch to name just a few) are in a place they should always have been—the waste basket. By the way, one of the most respected American economists, Paul Kasriel, has just embraced the ATBC and has nothing good to say about the hideous FED. Best to you, Chris. God bless Ludwig von Mises, the greatest economist of the 20th century.
Chris will be launching
Chris will be launching this wonderful chapter too.
Bubbles... Maybe one of the most interesting chapters .
I am sure the FED will be mentioned in this chapter :)
Keep it superb, chris.
Great Stuff! Keep up the excellent work.
Great Stuff! Keep up the excellent work of keeping us informed.
Jake
Wow!
Anxiously awaiting
ETA
Not a buble
looks like a bubble to me
Houses are the single largest, most highly geared investment that people make in their lifetimes. Prices are starting from a base of say $100,000, not $1 or so as in the Tulip example. This is why penny stocks can 10-bag whereas blue-chip companies would find it much harder.
An increase of 30-fold from say $1 to $30 means nothing in isolation - what is important is how affordable the asset is (price:income).
The cost of raw materials for housing may have increased somewhat (add 10-20% onto build costs), but this in no way can explain a 2-fold rise. Also, productivity should have improved and labour costs fallen over this time, negating some of the raw material costs.
The argument that housing 'is important' is precisely the problem. With the move away from manufacturing toward a service economy the only way of increasing GDP is by inflating asset prices (thus increasing debt). This is what Chris shows with the increase from $21trn to $48trn in debt over 7 years!
The problem with this is unsustainability. The Fed has blown these bubbles (by way of low real interest rates) to cushion us from economic shocks, but all this has done is delay (and increase) the eventual pain when the bubble bursts.
It is now no longer a question of whether a housing crash 'can be allowed', it is happening right now. The only relevant point is whether we allow a painful and long overdue correction to happen naturally as it should, or try to intervene and prop up the market which will cause wide-scale monetary problems over a much longer period, as Von Mises mentioned.
Great chapter Chris. Keep up the good work.
Apples vs. Oranges
can you explain what if someone defaults?
Sigh - no clue
Usury, and usury based investing, is mathematically impossible in a finite money token system. Over time, the aggregate debt (principle and interest) exceeds the sum total of all money tokens. Thus a portion of debtors must default, and suffer the loss of pledged collateral. This is why usury has been condemned from time immemorial. Yet each generation convinces itself that usury is reasonable, and embraces it.
In America's situation, it has gone far beyond sanity.
A unit dollar, by constitutional law, is a silver coin (3/4 ounce). A one ounce gold coin was equivalent to 20 unit dollars. In 1872, the Federal government demonetized silver (alleged gold standard), creating a huge money shortage. The following economic chaos "softened" up public opinion to accept the "solution" - an elastic money supply (debt credit).
With the institution of the Federal Reserve Act (1913), debt credit (Notes issued at usury) was substituted for hard money. By 1933, the aggregate debt bankrupted Congress. In House Joint Resolution 192, they repudiated their promise (Title 12 USC Sec.411) to redeem Federal Reserve Notes (FRNs) with lawful money (gold and silver coin). After that point, ALL FRNs BECAME WORTHLESS. (No par value).
What Americans call "dollars" *(paper currency) are NOT dollars. Ask a judge to rule that a FRN is a dollar, and he will demur. So if you think you are dealing with dollars, at law, you are not. (Now you know why fractional metallic coin is becoming more and more expensive. The "paper" is worth less and less.)
For generations, people have been buying and selling with a money token that is devoid of any value or standing at law. Which might explain the insanity that comes from Congress and the courts.
M1 (2008) = 1.4 T (available cash and travelers checks)
National debt = 9.4 T
Private housing debt = 27 to 48 T
Does anyone notice the discrepancy, yet? That which is owed is far greater than the sum of available money tokens. How did we get 'inflation' when the obligation far outstrips the sum of money tokens? Where's the "too much money chasing too few goods"?
Last year, Congress borrowed MORE than the interest it paid on the national debt. That's right - Congress is paying its interest bills with borrowed money! And you thought that Congress just "printed up new money."
(No, it doesn't. Congress has the constitutional power to coin money (stamp bullion) or borrow money. If it DID have the power to create new money, it wouldn't need to BORROW it.)
Worse, the national debt (9.4 T) is denominated in lawful money, and FRNs cannot pay it. If computed in terms of ounces of gold, America's national debt is roughly 99 times greater than the whole world's stock of above ground bullion. At current mining rates, it would only take 87 thousand years to dig up enough - if the debt was frozen right now. And thanks to the 14th amendment, you cannot question the validity of the national debt. (!)
Ludwig Von Mises and any other economist who fails to condemn usury (charging a fee for the use of money - not just excessive interest), will mislead you every time.
The logical result is an utter collapse of the American money token system, and financial ruin for anyone holding "paper" as an asset. If you are a creditor owed money, you will be ruined. If you are a debtor owing money, you will be ruined. There's not enough gold and silver to operate a hard money economy, and the current system based on usury is insane.
To put it into perspective, in the dim past (1900s), a Sears Catalog mail order house would set you back $500 to $1400. That's when money was still money, and not "bubbles". (500,000 FRNs for a dinky apartment in LA or NYC? Beyond insane!)
Inflation Adjustment
is gold/silver a bubble?
Control the money supply like DeBeers controls diamonds
But is the Fed to blame?
Thank you for putting it all
Clicking and Popping noises on soundtrack...
Fed's role
superchase wrote:
"Maybe the real culprit is none other than the Bush Administration. Perhaps the Fed's measures had a lot to be desired, but maybe they were only reacting to a very poor set of fiscal policies by that administration. Bush primed pumped the American economy with debt, lax lending policies, unrealistic tax cuts and budget projections. So really, what was the Fed supposed to do?"
Under the leadership of Paul Volcker, the Fed killed inflation by raising interest rates until inflation expectations were destroyed. Needless to say the Volcker took an incredible amount of political heat for that. So much so that, despite his success, Reagan did NOT renew his tenure.
You can bet your last n'gwee that Volcker's successors got the message loud and clear: "Do not displease your political masters...or else!"
The result is obvious for all to see; Greenspan and Bernanke were/are keenly aware of who hold the keys to THEIR personal well-being. Do you think the 300,000 dollars PER LECTURE that Greenspan pockets now has escaped being noticed? Hmmmm! Let me think about that for a nanosecond.
SO, the short answer to what the Fed should have done is: The Right Thing a.k.a. acknowledge the bubble and puncture it at its roots without any mercy. But that would have gone opposite to the wishes of their true masters, the banking elites and an Administration desperate to hide how bad their econ management has been. What better than create false wealth as an easy fix to this politically irritating problem, while allowing the banking industry to capture ever-increasing fees at every level of the housing bubble??
compounding
What an amazing time of hope