11/13/2008 05:12 am ET Updated May 25, 2011

Depression Economics Explained, Part 1: Speculative Bubbles

People are desperate for an explanation of the economy that actually makes sense. They're not getting it from the experts. My talks with "Norm" are a composite of recent conversations I've had with friends, family and neighbors about what's going on with the economy. This first installment deals with the concept of speculation and the long "speculative bubble" that led to the current crisis.

Norm: Isn't this crash in stocks and housing prices just psychological? If people stopped selling and started buying, prices would go up—so why don't we all just start buying? It sounds too easy, but it sounds like common sense too, doesn't it?

Zack: Yeah it rings true. But it rings true in the same way as the promise of a chain letter or pyramid scheme—you know: "Let's each get ten friends to give us ten dollars...and then they'll each get ten friends...and soon we'll all be rich!" It can work for a little while, but only a little while. The financial equivalent of a chain letter is what economists call a "speculative bubble." We just had one that lasted about 20 years, it encompassed all sorts of assets. And that bubble is bursting now.

Norm: But it wasn't a chain letter—it was people investing in stocks and bonds and homes, in other words: real things with real values.

Zack: It's true that real assets are involved. But those assets become mere excuses for speculation in a bubble and are left behind in the dust of wildly increasing prices. One of the first financial bubbles was around tulip bulbs in the 1500s. It got so crazy that one rich lord traded his castle for a single bulb. He did it because he knew that the next day he'd be able to sell the bulb for enough to buy two castles. Speculative bubbles have happened over and over through the whole history of capitalism. Some say they are unavoidable.

Norm: But we're not talking about tulips, we're talking about houses. Supply and demand set prices: demand for housing was high and so housing prices went up!

Zack: It's not true that prices in this bubble were set only by "supply and demand." In the case of home prices, people were borrowing to pay way beyond what their income could "demand" in the market. They did that because they believed they'd be able to turn around and sell and retire on the surplus.

Norm: Yes, because demand was pushing prices up! My parents did exactly what you said just a few years ago when house prices were still shooting up. They got $500,000 for a house they bought in 1969 for $30,000 and paid off in 1989. Don't tell them their house wasn't really worth that much—they have the cash in the bank to prove it was.

Zack: In every bubble, there are always a lucky few who cash out at the right time and exchange their bubble assets for hard cash. As long as it's only a few people doing that at any given time, the bubble can keep inflating.

This stuff is counter-intuitive because our individual experiences in the market—like your parents' experience—are often very bad representations of the big picture. You have to take the whole market into account. To get our heads around this, let's imagine a simplified market in which there are only two people: you and me.

Now let's say I buy a $100,000 house to rent out for a little extra income. Then let's say you buy the house from me for $200,000. And then I go and buy it back from you for $300,000. We both made a profit, right? How cool! Let's keep doing that! After a few more exchanges, you're buying this house from me for a million dollars. Same house, but now it's worth 10 times what I paid in the first place. And if I borrowed that first $100,000 to buy the house, then I have literally made hundreds of thousands of dollars from nothing. How did I do that?

Norm: You did that because you wisely saw that demand for housing prices was rising and jumped into the real estate market.

Zack: But in my little example, demand for housing wasn't rising. We were just borrowing money from banks for the purpose of paying each other bigger and bigger prices. Who's renting the house? If that person was willing and able to pay a rent that increased along with our mortgage payments, then maybe what we were doing made sense. But in my example we were just agreeing to increase the price for the sake of making ourselves feel richer. It had nothing to do with the rental income, or the demand for housing. And that's exactly what happened to the actual housing market over the last couple decades.

Norm: But what's the problem? At the end of your example, I have a house worth one million dollars and you have hundreds of thousands in surplus in the bank.

Zack: Here's the problem: What if I decide that I don't want to play this game anymore? I don't buy the house from you for more. Then, suddenly, the house you bought for a million dollars is worth $100,000 again. Because there are no other buyers in our little two-person market.

Norm: Hm...

Zack: Think about what was really going on in that example. You and I were both borrowing money from our banks to buy this house from each other. Each time, one of us would take out a new loan, and the other would pay off an old one. Behind our personal experiences of feeling richer, our banks were really just swapping the same chunk of money back and forth. There was no actual wealth being created. At any moment, one bank was in the hole and the other was up—they canceled each other out.

Norm: Until you decided to stop playing. Then you got to keep your million minus the hundreds of thousands you borrowed.

Zack: That's right. But now you can't find a buyer—so you are in debt one million dollars, with a house that's worth only $100,000 as your only collateral. But it's not really you who lost all that money—it's your bank.

Norm: Ah! So that's why the banks are failing?

Zack: Exactly! But it's not just houses, it's all kinds of different assets that they lent money for other people to buy. And it's not just banks—it's all kind of investors including pension funds, university endowments, etc... In other words, not just a few rich people. This effects everything.

Norm: OK, I get it—but let me push back one more time: Why can't prices just stay where they are? Why do they have to crash?

Zack: It's because, if they act logically, people will all try to sell their assets when they see that the prices are not going up anymore. It's not enough for prices to stay the same, they have to go up. When people realize that they are not going to cash out at a big profit, then what's the point of making this mortgage payment? It dawns on them that they are going to be in deep debt for the rest of their lives. For tens of millions of Americans, their homes were their retirement plans. So they try to do exactly what your parents did and sell their house for their profit, but now it's just for whatever they can get. The first few will get a nice big profit. But soon prices are collapsing as everyone puts their homes on the market. That's why now we have all these folks who can't pay off their mortgage for the sale price of their homes.

Norm: And since banks had all these homes on their books as assets, suddenly the banks are in trouble as home prices evaporate?

Zack: That's the basic principle. But in reality it's more complicated. Banks often sold their mortgages to investors in the form of "mortgage-backed stocks." It was that abstraction of risk that partly allowed us to get into this mess. Banks might have been more careful in lending if they knew they'd have to live with the consequences. The investors could pretend that the banks were being cautious. And the banks could pretend that they were being cautious. In the end, it was just like any speculative bubble: everyone simply agreed to forget about reality. It was a collective effort.

Eventually, such a huge amount of the world's money was wrapped up in these bad mortgages—mostly American, but also from around the world—that when prices starting falling, there were big consequences for all markets. When investors lost all that money on mortgage stocks, they started taking money out of other markets, like the stock market. Also, some financial companies with heavy exposure to the mortgage stocks went out of business, leaving the holders of corporate bonds (which were considered to be safe investments) with big losses. That freaked out investors so much that now companies can't raise any money by buy selling bonds. The whole mess is making everyone with cash very leery of lending it out to anyone. But the economy is set up right now to run on credit. And so the whole economy is seizing up like a stalled engine.

Norm: Now you've finally gotten to the "credit crunch" that they keep talking about on the news.

Zack: Yes. Well, let's leave that till our next session. But for now here's just a preview: Imagine a kid with a paper route. He has to buy his papers from the newspaper company, then he resells them at a profit. But imagine that he's spending all his profits on video games and McDonalds as soon as he makes them. The only way he keeps his business going is that his mom lends him the money each day to buy the new batch of papers. This works fine for a while. What if his mom suddenly refuses to lend him money? Then he can't buy the next batch of papers. His business is done. That's exactly how most business have come to be run. And that's why the withholding of credit is causing so many businesses to cancel new investment or to close down all together.

Norm: Whoa, that sounds bad.

Zack: That's what's happening. More next time!