Housing Bubble

Housing Bubble

Do stable economies lead to instability and bubbles?
Adrian Adrian

Throughout economic history there have been numerous debates regarding the relative instability of economic systems.  One view was that while economies will always have disturbances that create booms and busts, ultimately it will always be driven towards a stability.  

The Great Depression in 1929 led people to question this and in particular John Maynard Keynes questioned whether an economy can be self-righting and also how much role financial markets play in a functioning economy.  Of course, part of the reason for the change of thinking is the fact that modern economies are very different from economies of the 19th century which was described by Jean-Baptiste Say as an refined barter system (people produce goods and they exchange them for money).

The works by Keynes and Irving Fisher (Regarding, how debt can cause depressions) proved to be vital in the understanding of the instability of modern economies and was the basis for a paper by Hyman Minsky who revisted this problem in his work "The Financial Instability Hypothesis".   Minsky went on to suggest that current capitalist economies actually plant the seeds for it's own destruction. During the financial crisis of 2007, also now referred to by some as the "Minsky Moment".  

This particular Minsky Moment occurred when speculation reached unsustainable levels and caused the collapse in the housing market, leaving enormous 'toxic' debts, which ultimate led to a halt in interbank lending and the failure of banks such as the Lehmann Brothers.

So, why does this occur?

Housing is a great example of why this happens.  At first it starts with prices being reasonable, it's a low risk investment, it's affordable and sold in a way in which the payments cover both interest and capital.  As confidence in the market improves and asset prices start to rise and people start to take on more risk, to a point at which they can only really afford the interest of the loan.  Speculation continues and the financial system begins a "Ponzi" style loan system to encourage as many borrowers to take out loans even though they can't really afford the repayments of the interest, let alone repaying the capital.  Welcome the "subprime" mortgage.  This all seems fine, as long as prices keep rising and new people keep entering the market, the increase in the price will always be worth more than the debt.   The finance industry started to bundle up the debts (mixing high risk with lower risk to make them look more attractive) and sold them to other banks with the promise they would deliver a solid income stream for 20-30 years.

Of course, once the bubble has inflated to such a point, small shocks can have a major impact and when the economies started to stall, incomes dropped and demand for new homes also dropped, suddenly the debt is outpacing the asset valuation and borrowers see their debts grow.  Then people start defaulting, reposssions happen and prices tumble.

Minsky has described the third and final type of investor as the 'Ponzi' Borrower.  Like all ponzi schemes, they offer high returns and the new investors' money is effectively used to pay the prior investors their dividends giving the illusion of profitability (with the hope of attracting new investors).  Unfortunately, schemes like this always collapse as the high levels of returns promised fail to be met and the ponzi borrowers stand to lose a large proportion of their money.

Minsky already told of the financial crisis and the nearly catastrophic collapse caused by the extended period of financial stability.  This led to huge levels of debt and ultimately an extremely unstable economy.  The seeds have been sown.

There were three possible solutions.

  1. Central Banks could  bail out the failing banks.  This, as Minsky saw it, could lead to further instability as the banks might be tempted to take greater risks in the understanding they would be saved.

  2. Governments could increase debts to stimulate the economy (and demand) but ultimately this could cause further problems as they could then be subjected to financing difficulties (Also, this appears to just push the problem slightly further down the road).

  3. The final solution, is create stricter regulation in the financial markets, which, in the long run is probably the only solution and completely necessary, unfortunately there seems to be a lack of understanding on the part of the regulators as the financial markets can move very quickly.

While the debate may still be open, Minsky's work has become increasingly relevant and his work and predictions were definitely proved to have weight during the crash in 2007-08. 

Based on what we have learnt you might think that actions would be put in place to stop this occuring again, tougher regulations and working towards more stability as it's apparent the markets will not achieve this on their own. Unfortunately it seems that many governments/central banks, especially in the UK have opted for a strategy that can only lead to further instability, by increasing funding a housing bubble that is clearly in the 'Ponzi' borrower stage and introducing more schemes (Help to Buy, Funding for Lending Scheme, Stamp duty cuts, Home buyer ISAs, etc) creating more debt and offering banks protection from failure.

You may have thought the financial crisis ended in 2008 with the bailouts and emergency interest rates, but confidence has clearly grown and the perceived stability is paving the way for far more instability moving forward.  In the UK, they can at least place the blame on Brexit, which is going to become an convenient scapegoat.