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Milton J. Madison - An American Refugee Now Living in China, Where Liberty is Ascending

Federalism, Free Markets and the Liberty To Let One's Mind Wander. I Am Very Worried About the Fate of Liberty in the USA, Where Government is Taking people's Lives ____________________________________________________________________________________________ "Extremism in defense of liberty is no vice. Tolerance in the face of tyranny is no virtue." -Barry Goldwater-

Wednesday, December 24, 2008

The Function of a Bubble.....

There has probably been asset bubbles as long as there have been people. It is human nature to try to benefit from various opportunities and sometimes over extend themselves that eventually cause a collapse in the price of these things. What happens in a bubble is that the price of an asset rises well above its real productive value and reaches prices on emotion and not rationality.

So, many rue the the collapse in housing. despite this having been a government mandated bubble, it is a bubble all the same. Prices of housing rose way above its real productive value and we can argue that housing can only rise to a price that can be supported by the income that the people produce in the region. Since real estate cannot be transported it is fundamentally regional in nature and limited in price to a regional economy. What we have observed is that during the bubble, prices rose way above what could be reasonably supported. Since the US Government promoted home ownership through various programs and supports, such as interest tax benefits for mortgages leading to higher prices and greater leverage, loosening of credit standards for mortgage lending forced upon banks, the creation of Federally chartered mortgage guarantee and lending organizations Fannie Mae and Freddie Mac that were required to hold greater and greater portfolios of risky loans, the mandated support of Sub-prime and Alt-A substandard mortgage lending under the guise of support for disadvantaged minorities and a host of other misguided supports and schemes, people reacted rationally within the environment that the government created.

So, now, post-bubble, there is a greater supply of housing at a higher price than can be absorbed given the economy and regional factors. So what will happen? PRICES WILL FALL and probably dramatically. In many cases, prices will actually fall well below the value that would be determined in a normal market. Some people will be in a position to take advantage of that and they are the lucky ones.

But, its important to recognize that bubbles are both human nature and part of capitalism as markets determine market clearing prices for everything. Human nature and a humans self interest can never be eliminated since this is part of what we are.

As written by 'evil' Wall Streeter Henry Blodget, a 1990's era internet-tech analyst writes....
First, bubbles are to free-market capitalism as hurricanes are to weather: regular, natural, and unavoidable. They have happened since the dawn of economic history, and they’ll keep happening for as long as humans walk the Earth, no matter how we try to stop them. We can’t legislate away the business cycle, just as we can’t eliminate the self-interest that makes the whole capitalist system work. We would do ourselves a favor if we stopped pretending we can.

Second, bubbles and their aftermaths aren’t all bad: the tech and Internet bubble, for example, helped fund the development of a global medium that will eventually be as central to society as electricity. Likewise, the latest bust will almost certainly lead to a smaller, poorer financial industry, meaning that many talented workers will go instead into other careers—that’s probably a healthy rebalancing for the economy as a whole. The current bust will also lead to at least some regulatory improvements that endure; the carnage of 1933, for example, gave rise to many of our securities laws and to the SEC, without which this bust would have been worse.

Lastly, we who have had the misfortune of learning firsthand from this experience—and in a bust this big, that group includes just about everyone—can take pains to make sure that we, personally, never make similar mistakes again. Specifically, we can save more, spend less, diversify our investments, and avoid buying things we can’t afford. Most of all, a few decades down the road, we can raise an eyebrow when our children explain that we really should get in on the new new new thing because, yes, it’s different this time.
So, what I think will be the result of all of this? I think:
1. People will save more and consume less. Household consumption as a percent of GDP has risen from 60% to 70% over the past 25 years-or-so and it appears as if we a going to quickly return to more savings and less consumption.
2. Housing prices will fall relative to everything else. People will spend less for housing than they have in the past as it now has to make rational sense relative to regional GDP. Housing will be plentiful and more affordable than we will ever to be able to remember.
3. Less costly housing will free up capital for investment in more productive areas of the economy. Housing absorbed a disproportionate amount of savings and this will flow back to the productive economy.
4. Financial engineering and Wall Street income relative to GDP will permanently fall. In other words, the fees that financial institutions gain from everyday transactions will decrease relative to the economy as a whole making it more productive.
5. Over-investment in assets during a bubble have positive benefits as these assets are moved towards more productive uses. The internet bubble created a foundation to fundamentally change how people live and work. We do our everyday activities much differently than we did before Al Gore invented the internet. This will also prove to be true as housing will not be the burden that it was in the past and productive in ways that we cannot imagine now.

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