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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  1. #1 by Fabio Sekoff on March 26, 2011 - 11:44 pm

    Hey Carmen you got some 20-20 hindsight and definitely know your history…and we are bound to repeat government intervention more often because of the progressive mind setting until we crumble just like it happened to ancient Rome of course if We The People stir this baby right!
    I totally agree Bob all recessions have produced abundant wealth for those that position themselves under the right spout per say!
    Economies are like roller coasters sans government intervention what trumps healthy and normal recoveries prolonging the pain for those who get affected by it, working/middle class!

  2. #3 by Stephen on March 23, 2011 - 9:19 pm

    The article does cover accurately the basics of why we had a real estate bubble.
    Of course, it does not explain the Why? the FED created the real estate bubble.
    Keynesian economics itself never admits clearly that it IS the philosophy of preventing
    immediate pain with later more serious pain from bubble bursting. Their essential
    assumption is that recessions are bad and must be avoided. They have been good at
    selling this to the general public because our leaders like the “having your cake and
    eating it too” approach. Every politician wants to get re-elected and this is far more
    important than the long term economic benefit of the people and the nation.
    Austrian economics could not rule easily in this political leadership mindset because it does not allow you to “kick the can down the road”. The concept of recessions as good and healthy like a fever that helps the body fight germs is a hard sale and does not fit with our pain avoidance pill popping soft society. Deficit spending is the politician’s magic pills that never cure but relieve the immediate pain while allowing the underlying cancer to grow. The dot com crash was suppose to be a time of recession. This would have cleaned house of bad investments and business. I see the 911 event being like the Japan tidal wave. It just provides cover for the real economic re-adjustment required. The cure for the dot com bubble burst was to cut taxes and government spending. We only got the tax cut. Unfortunately, Keynesian economic advisers in government knew this would cause the recession to last a few years of pain. Instead, we got increased spending both in guns to invade Afghanistan and butter(senior drug benefits) just like President Johnson or President Hoovers excess spending years. Jobs were created for military and government while our loss of investment directed toward increased efficiency in the private sector was stolen. Although individual tax rates were lower, there were fewer deductions(closing loopholes) and Corporate taxes became the highest in the world. Because the federal government gets larger due to all this increased stimulated income being taxed and is always looking to tax domestic corporations, manufacturing was encouraged to ship jobs overseas to avoid these taxes since only US based business is taxed so much. This was threatening to create high unemployment and another recession. Unfortunately or fortunately(depending on your view), the government got us into Iraq which pulled a lot of individuals in the military reserves out of their private sector jobs. Of course, with even more jobs shipped overseas, the FED reduced interest rates to stimulate the real estate industry. This created so many jobs in building, finance and real estate sales that we needed to import millions of illegal workers to fill all the labor requirements. Even though wages were flat in manufacturing, people could maintain their lifestyles by getting low interest loans on their houses and it became their income supplement source. The result of all this was to create a new more massive bubble in real estate. People knew inflation would come and chose real estate because it always goes up(or had up to that point). At this time the economy was composed of real estate, finance, military and its subcontractors, farming, retail for consumers and the government itself. Real estate bubble breaking killed a major employer and outside of farming and a smaller manufacturing export business due to weak dollar left other employers as the weak hollow economic base. This is why Obama will not end the wars to the chagrin of his followers because returning unemployed troops are not kind to its leader historically when they come home. So all this pain is the result of avoiding the short term pain ten years ago and trying to prevent recessions. So basically, you can sum up simply that bubbles are caused by government and FED recession prevention policies. Therefore, since Austrians do not see recessions as bad and to be avoided, large bubbles never get big enough to cause widespread economic damage. This is unlikely to be a very low probability of being corrected. Whether we are past the tipping point is not important as realizing that nothing will change in how we run our politics and economics. It continues to be a polarized battle of destroyers from both the Democrats and Republicans. If you want to blame a President, blame them all, since they have all been following the same policy since 1913 with major destruction in 1933, 1971, and the last decade. Before the FED, recessions were short term events that efficiently restructured the economy. Now they are held back by a DAM until it breaks but now it is so big with global currencies the flood will be global. Anybody seen Noah? Next stop without a doubt is a global currency crisis and hyper-inflation followed by a massive global Depression and creation of a single world currency as the fix. If you want freedom to still exist, fight like hell to keep the internet Free and uncontrolled since it is the only hope to create a decentralized modern economic system that could bring a bright future.

    • #4 by carmenalexe on March 24, 2011 - 3:58 am

      Stephen, excellent input describing the past and current economic affairs. I, too, think a lot about inflation which if it turns into hyper inflation could be catastrophic to our nation. Do you see any way that such an event could be avoided? I read not long ago an interesting article about the Fed having the ability to issue QE into perpetuity. Apparently the interest payments our country makes are being turned around and issued in new QE’s. Have you heard or read about it?

      • #5 by Stephen on March 29, 2011 - 2:00 am

        I would love to be optimistic. If there was an easy solution I think this path would have been taken.
        I have looked hard and long of how the worst could be avoided. I know the direction we would have to take but it would require a strong recession. I am not sure this junkie economy would volunteer for the withdraw and/or rehab. Many still think just another high is the way but this will lead to an economic overdose of the stimulus. No country in history has ever been able to reverse the course we are on before their money was worthless. What makes this so bad is we have hooked most of the rest of the world on the same drug. Nobody exists to help us all rehab from this economic insanity of electron created currency on all the world’s government and banking computers. Yes, certain countries will be in better shape than us, but they won’t be able to help us. The paper printing is only a fraction of the story. I am convinced that we will not see double digit inflation this time as a warning. Because of computers the short latency of economic decisions globally through the internet, I believe individuals thinking they can take advantage of the next bubble will have a greater risk than they can imagine. One moment we are talking 5-9% inflation and then suddenly it will be panic and hyper-inflation. It will happen too quick for the FED, banks or government to control it and the cumulative speculation by individuals will make this more risking than putting your life savings on a single bet in Las Vegas. Yes, you get rich or totally wiped out. I just want to survive. This will be a one time only event for the human race. I just want to be in a position to help the rebuilding on sound economic concepts.

      • #6 by carmenalexe on March 29, 2011 - 6:56 pm

        Stephen, I think that the steroids pumped into the economy have been of short nature, but the economy has been abused to the point where….additional steroids may not work anymore? OK, stock market crash, we know it’s coming soon. But my thoughts are that people will still fill up their car gas tanks, smoke cigarettes, drink alcohol, and eat junk food. Wouldn’t the companies that produce these bounce back fast after the crash? I don’t trust ANY Wall Street manufactured assets but still what’s your view on these type of stock?

  3. #7 by Thomas Walker, Jr. on March 23, 2011 - 8:36 pm

    Great post Carmen. Austrian monetary theory is my lodestar, although I have to say that the slide presentations on this site ( really unlocked my understanding.
    I entirely agree with Bob, we can look for bubbles to be ongoing & recurrent, though perhaps not always sequentially in the same sector. I also agree that bubbles should be exploited. In fact, in the small business milieu, failing to do so can mean macro factors will cyclically undo years, decades, of hard work & effective management.

    • #8 by carmenalexe on March 24, 2011 - 4:15 am

      Thomas, awesome site to review the differences between Keynesian and Austrian theories. Growing up with the philosophy of saving and not incur debt made it easier for me to relate to the Austrian theory.

      I agree with finding solutions to benefit from an event such as this (as long as it’s moral and ethical). Yet few of the people will care to do it and many that would like to do it don’t know what could be the best way. Since you’re in the field I wonder where do you think economically we, as a nation, will be in 10 years from now.

      • #9 by Thomas Walker, Jr. on March 25, 2011 - 6:01 pm

        How to exploit the credit cycle…there is no grand theory that I can articulate, and of course Austrians look askance at aggregations. On a micro-level, on the firm level, though, the process of strategic planning with strong links to relevant external data can show price mismatches that indicate bubbles or their aftermath, and therefore indicate clear buy/sell/hold signals as to capital expansion, acquisitions, or contraction. Return on assets applied differentially can really highlight those signals. As to the future; not rosy, we carry tremendous regulatory & tax overhead, and yet, entrepreneurship can carry a lot. I think growth will resume.

      • #10 by carmenalexe on March 29, 2011 - 6:59 pm

        Thomas, when do you foresee growth resuming? 2012, 2013 or…..? How about the dollar collapse? Wouldn’t this prevent a growth?

      • #11 by Thomas Walker, Jr. on March 31, 2011 - 2:57 pm

        There’s no easy prediction. When people purpose to stop waiting for the State to help them/get out of their way (depending on ideological bent), growth will return. We are seeing signs in manufacturing, so I’m told. Even with an intrusive & irresponsible government (but I repeat myself, three times) action beats inaction. As to whether there’s hope that the US retreats from the high-debt hyperinflationary brink…Europe is belatedly addressing their problems. With sufficient pressure which only crushing reality can deliver, I think we will too. Oh, here’s an article:

  4. #12 by Greg Parrish on March 23, 2011 - 1:24 am

    Going beyond the economics of it all, our human nature dictates how we as individuals and as a society, behave. We want more and we want it easy and cheap. People don’t view their actions as part of the problem. They just know that they want “it”. consequences be damned. Quite a different attitude compared to our country’s previous generation.

  5. #13 by roncents on March 22, 2011 - 10:18 pm

    ‘If it ain’t broke don’t fix it’ goes for our economy as well. That is another lesson from history. Good article Carmen.

    • #14 by carmenalexe on March 23, 2011 - 5:37 am

      Greg, you’re talking about the instant gratification that our society has been accustomed to. Have you read the book Dumbing Down: Essays on the Strip-Mining of American Culture, by John F. Thornton & Katharine Washburn? It’ll explain how and why…

    • #15 by carmenalexe on March 23, 2011 - 5:39 am

      Ron, It’s not broke for them but certainly for us it is. Thanks for reading and I appreciate your comments.

  6. #16 by carmenalexe on March 22, 2011 - 8:00 pm

    Paul, makes sense, indeed. If the majority of the middle class disappears it’s probably impossible to exploit the powerful rich class.

  7. #17 by Paul Lewis on March 22, 2011 - 7:55 pm

    Thats all very well Bob, and people should try and protect themselves as best they can. But if humanity is heading for disaster due to the concentration of wealth caused by the central banking cartel fixing the price and quantity of currency then we are all in for a tough time. The system needs to change and the time is now.

    Salt March anyone

  8. #18 by carmenalexe on March 22, 2011 - 7:50 pm

    Smart man you are, Bob!

  9. #19 by Bobf on March 22, 2011 - 7:26 pm

    In many respects, the healing process will be spurred on by a refilling of the bubble, and I’m counting on it, banking on it, and preparing for it. The lesson to be learned is not that the bubble can be avoided, but rather that it should be exploited.

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