Crash Course Chapter 15: Bubbles

Throughout the long sweep of history, the bursting of asset bubbles has nearly always been traumatic. Social, political and economic upheavals have a bad habit of following asset bubbles, while wealth destruction is a guaranteed feature.

Along the continuum of irrational financial behavior, it can be tricky to tell the difference between a bubble, a mania, and mere touch of exuberance. A bubble is reserved for the height of folly, and history is rich with folly.

So how would we know that we’re in an ‘asset bubble’? What do they look like and what can we expect when one bursts? The Fed famously likes to claim that you can’t spot one until it bursts. But actually you can, and the definition is pretty simple:  “A bubble exists when asset price inflation rises beyond what incomes can sustain.”

Bubbles used to happen once every generation or so, because it took time to forget the pain from the damage. Today we are facing the bursting of a second major asset bubble, housing, spaced less than ten years from the bursting of the dot-com bubble. This is simply astounding and thoroughly unprecedented. It is the largest bubble in all of history and will probably be the most destructive. And it is happening right now.

This housing bubble has no historical precedent and is massively out of proportion to anything we’ve ever experienced before. There is nothing even remotely close to it in magnitude, so we are left without any history to guide us as to what the impacts are likely to be.

So, what can we expect from a collapsing bubble? Simply put, everything that fed upon and grew as a consequence of the bubble will collapse. Unfortunately, this time it’s probably NOT any different.