The anatomy of a financial bubble’s boom and bust: Part I
Before we get into the heart of our problem at hand, I think the definitions of microeconomics and macroeconomics should be addressed.
Microeconomics is directed at us as individuals where our primary concerns center around prices and wages: how much things cost, and how much money we make to purchase things we need or want.
Macroeconomics is directed at the nation as a whole and in particular to the government’s fiscal policy with its annual budget, and the monetary policy of the Federal Reserve’s control of interest rates and other responsibilities.
The basic laws of supply and demand apply to both divisions of economics.
Nouriel Roubini and Stephen Mihm authored the book, Crisis Economics – A Crash Course In the Future Of Finance. Roubini, an economics professor with New York University, has extensive senior policy experience, having worked in the White House and the U.S. Department Of Treasury during 1998 – 2000.
Mihm’s, an economics history professor with the University Of Georgia, writes for the New York Times Magazine, the Boston Globe, and other publications. Mihm was also the Newcomen Postdoctoral Fellow in Business History at Harvard 2003 – 2004. Theirs is the most detailed explanation about our financial system’s crash that I found.
Roubini and Mihm state that the 2007-2008 crash was no freak event.
It was probable and predictable because financial crises generally follow the same script every time.
Economic and financial vulnerabilities build up and eventually reach a tipping point. For all the chaos they create, crises are creatures of habit.
Most crises begin with a “bubble”, in which the price of a particular asset rises far above its underlying fundamental value.
This kind of “bubble” often goes hand in hand with excessive accumulation of debt, as investors borrow money to buy into the boom.
Asset bubbles are often associated with an excessive growth in the supply of credit.
This could be a consequence of lax supervision and regulation of the financial system of banks and other lenders, or even the loose monetary policies of a central bank.
In America, our central bank is the Federal Reserve Bank, and later we will look at it in more detail.
Regardless of how the boom begins, or the sources by which investors join it, some assets becomes the focus of intense speculative interest.
The desired asset could be anything; however, stocks, housing, and real estate are the most common.
Even though there have been other booms that led to a bust, optimistic investors attempt to justify the overvaluation of the asset in question and claim : “This time is different”, the economy has entered a new phase where the rules of the past no longer apply.
The above description of a bubble’s anatomy was prevalent in bubbles of the past, with minor variations in some cases.
We will note its presence in America’s recent crises, and from which, we are still reeling some six years later.
The column for part 2 will pick up with our real estate bubble bust of 2007-2008.
Take heed of 2 Chronicles 7:14.
By Aaron Russell, Sr.