The recent housing bubble, from an economic perspective, came about as a result of the convergence of several economic factors that have been observed to be present in most, if not all, economic bubbles that have occurred over history. While these factors would probably have gone unnoticed by most home buyers, their presence in the marketplace was certainly noted and warnings were issued, and left unheeded as the housing market, normally a haven for long-term investments, suddenly became highly speculative over a span of a few years.
In his book, TrendWatching (HarperCollins, 2002) Ron Insana, a familiar television personality, takes an in-depth look at economic bubbles and provides interesting and rational explanations for these economic phenomena from a historical perspective. Beginning with the well-know tulip-bulb bubble that occurred in Holland between 1634 and 1637, Insana reveals, step-by-step the number of market factors and the governing principles that are present for the creation of a bubble, why the bubble will rise until it reaches critical mass, and the ensuing economic collapse that occurs in aftermath. Investors and students of economic history will find the insights and explanations highly relevant to today's economic collapse and the forthcoming deep economic recession.
So what are the mysterious economic factors that caused the recent housing bubble to collapse, and why weren't we prepared to head it off before the housing market shattered the financial dreams of millions of Americans, and consequentially, the entire global market place?
One way to look at it is consider the housing market, or any other market for that matter, as a house of cards that is built up gradually over a short period of time, and then collapses under its own weight and inherent instability. The builder knows that the house will collapse eventually, but goes on building anyway, only stopping until it does.
In the housing market, there are thousands of such builders, and although they take many different forms, they are still building houses made from flimsy playing cards. They are home buyers and sellers, real estate investors, institutional lenders, market speculators, government regulators, Wall Street traders, quasi-government agencies, and many more all being cheered on by the media and opportunistic, self-serving speculators. If you've paid any attention to the number of television shows dedicated to buying and "flipping" a home, or buying and selling a repossessed or foreclosed home as a way to get rich quick, you've encountered them and their appearance in the marketplace is one significant factor that fueled the rise of the bubble.
Irrational exuberance or the tendency to speculate wildly in the market place in an attempt to get rich quick is only one factor, although in 2002, irrational exuberance was the missing factor from the mix necessary to declare a state of "bubble madness" was present in the housing market. Yet it was indeed present, and the bubble expanded rapidly over the four years that followed, until its collapse became noticeable in 2007. By then, unfortunately for millions of new homeowners, it was too late to get out of the market and foreclosures and bankruptcies began to eat up the wealth of the nation at an alarming rate.
While irrational exuberance appears as the final component necessary for the creation of a housing bubble, what are the other factors required for a bubble to form in the marketplace? In TrendWatching, Insana provides five fundamental market forces which have been present when similar bubbles have appeared. In order to apply these fundamentals to the housing bubble, one must examine each of them in light of evolving market, regulatory and financial conditions over a period of time. This will establish the context of the bubble and, notably, the presence of these factors will certainly have an influence on a wide variety of markets.
For the purpose of understanding the housing bubble, it is important to study each in the context of the time period, 2002 through 2008. As presented in TrendWatching, these factors are:
The development or discovery of a transformational technology that captures the attention of investors.
A watershed event that sparks a change in monetary policy.
A watershed event that sparks a change in fiscal policy.
An opportunity for investors to speculate in a hot, new asset class.
Investors believe that this asset class will provide above-average return without interruption for the foreseeable future.
An in-depth exploration of these factors is beyond the scope of this article, and is left to the reader to pursue. It is important, however, to point out that the economic stability of the nation was categorically impacted by the terrorist attack of September 11, 2001. Subsequent events, like Hurricane Katrina and other natural disasters, occurring over a relatively short period of time following September 11, have also contributed to a period of financial uncertainty and insecurity.
Real estate, long regarded as a safe haven for investors and a hedge against inflation, became the "hard asset" for investors. As the government responded with sweeping changes in leadership and economic (monetary and fiscal) policy, investors became speculators and Wall Street, encouraged by an regulatory attitude of de-regulation and disregard, quickly took advantage by inventing new, and now nefarious, financial instruments. In the presence of these conditions, the mix was just right for a bubble in the real estate market to rise exponentially, and collapse at nearly the speed of light.
The recession ahead is projected to be deep and severe. Currently, the government has demonstrated that it is best at fumbling the ball, over and over again, by intervening in the financial market at the expense of trillions of taxpayer dollars. The rationale seems to be one of "Our Team is too big to fail", so let's throw money at it and we will be sure to win the game. Many a fallen emperor has believed the same, while the barbarians gathered outside the gate. In the short term, investors are left wondering where their money will be safe and when will the next bubble appear?
Reference: Insana, Ron. TrendWatching: Don't be Fooled by the Next Investment Fad, Mania, or Bubble (2002). HarperCollins. New York