BUBBLES Forever Blowing

May 23, 2010

BUBBLES
Government policy is the fundamental cause of asset bubbles, such as the recent housing bubble, and the 1929 stock market crash. The basic driving force is price inflation caused by the ever-increasing money supply. The Federal Reserve System provides the increasing money supply but in the long run, government policy drives the Fed. (The independence of the Fed is a convenient myth).
The consequence of inflation is a draining away of the value of each dollar. If you have cash in your wallet, under your mattress, or in a savings account in the bank, it is losing value every day.
What to do? The solution is to buy some asset which will grow in value to compensate for price inflation. Better yet, borrow money to invest in some asset. Live your life on credit. Your cash balance will be negative, so in reality you can’t lose anything to the depreciation of the value of cash.
In fact, you will gain by inflation if your loan (mortgage) is on a fixed interest basis. In time, inflation will affect your dollar income. You’ll get more dollars (of less value per dollar) to pay off your mortgage. You pay your mortgage with cheaper money.
Government policy gave us further motivation to buy homes. The Fed influences all interest rates by setting the interest rates at which it lends to banks. When this rate is low, mortgage rates are low. Currently, the Fed rate of interest to banks is essentially 0%. You can’t go much lower than that.
The Federal agencies, Freddie Mae and Freddy Mac were created in the 1930s to encourage home buying, by guaranteeing home loans. This reduced risk to lending agencies, so they charged lower interest rates. Freddie Mae and Freddy Mac didn’t have a fraction of the reserves that would be needed if there were a spate of mortgage defaults.
Income tax encourages debt. With a tax deduction on interest paid, the effective interest you pay on a mortgage is much reduced.
Finally, in recent years, the government has actively “encouraged” lending institutions to relax qualifications for home loans. Many people ended up buying homes that they couldn’t really afford.
When many of these people defaulted, the system collapsed. The government bailout of some major banks, and Fannie Mae and Freddie Mac, saved them at a cost of trillions of (counterfeit) dollars, but the housing bubble was burst.
PSYCHOLOGY
There is a big psychological factor in any bubble. With all the encouragement by government, it seemed like a “can’t lose” opportunity. And there were enough winners to make it look tempting to take out a mortgage. I was a winner in the mortgage game, many years ago at a time and place where home prices were rising rapidly.
Inflation alone gives us an incentive to spend dollars of diminishing value to buy assets which will retain value. Easy credit makes it possible to do this with borrowed money. The Stock Market Crash of 1929 was caused by this same combination: inflation and easy credit.
Stock prices were climbing rapidly. People were making fortunes, if they pulled out in time. People who had never bought stocks plunged hysterically into the market with all they had, and more. The stock market is always speculative. In the short term, it’s very risky. When the bubble burst, many people lost a fortune – of borrowed money.
The crash in the housing market was really less painful than the Stock Market crash. As long as homeowners had the income to pay their mortgage, their “losses” weren’t really losses. They saw house prices rise and then fall, but they still had the same house with the same mortgage payments to meet. Only if they sold the house did they sustain a real loss.
When a bubble bursts, the government points an accusing finger at supposed culprits. The finger is pointing the wrong way. Government policy builds bubbles. Any random event can burst the bubble.

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