Bubble Economics: The Illusion of Wealth

by Doug French
by Doug French
Recently by Doug French: You Can't Print Production and Prosperity

The economic position that the United States is now in is the result of a series of economic bubbles. To explain the nature of bubbles, I'm going to start by talking about their history; I'm not going to go all the way back to Tulip Mania and John Law, but I do want to mention some things from the Roaring Twenties that might sound familiar to us today.

Over the eight-year period of that boom, the money supply increased by 62 percent. All kinds of new appliances and gadgets were sold: refrigerators, phonographs, electric irons, toasters, and vacuum cleaners. Many more cars were built – more than twice as many in 1929 than in 1919. More and more leisure activities became popular. More hotels were built, as were more roadside diners. There was an explosion of movie theaters, and of developments in Hollywood. Professional sports became a big business. Skyscrapers such as the Chrysler Building and the Empire State Building were started. There was a speculative boom in Florida real estate. The stock market boomed. Hoover promised a chicken in every pot. I don't know what Obama's going to promise – maybe pot in every kitchen.

I always talk about the economics of booms and bubbles in the framework that Murray Rothbard outlined in his great book, What Has Government Done To Our Money. He points out that inflation confers no general social benefit. Just creating more money does not create more benefit for the general public. It merely redistributes wealth to the first people to receive the new money.

Since 1998, the money supply (as measured by M2) has doubled. In fact, it has increased elevenfold since 1971, when we gave up the last ties of the gold standard. So we have an expansion in the money supply now that is similar to what we had during the Roaring Twenties. We also have a series of bubbles: a tech bubble, then a real-estate bubble – all part of what Bill Fleckenstein calls "Operation Enduring Bubble." Of course, inflation and the resulting bubbles have disastrous economic effects. But in Human Action, Mises wrote that

The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse.

That is exactly what most people are doing today. They're blaming Wall Street. Everyone congratulated themselves when their homes were doubling in value. Everybody thought they were smart to pick those stocks in their 401(k) plans. But now that the bubble has popped, it's all Wall Street's fault.

I spent 22 years in banking in Las Vegas – I guess that means I was somewhat in the bubble business myself. There was a couple in Las Vegas: the gentleman was a house painter and his wife was a hairdresser. One day, a lady came in to get her hair done. The hairdresser mentioned to her, "Gee, you know, I'm really interested in getting into real estate." This was 2004, at the height of the real-estate bubble in Vegas.

Well, the woman getting her hair done said, "Boy, have I got the person for you. My husband's a realtor, and he's a mortgage broker; he can find you tenants; he can do the whole thing, soup to nuts." The painter and the hairdresser had a combined income of $60,000. Nonetheless, they felt at the time that they were capable of buying seven homes. Of course, the guy who was a real-estate salesman and a mortgage broker found them not only one no-money-down loan; he found them seven no-money-down loans. And it just so happens that the broker's wife was also a mortgage-loan processor. It really was a one-stop shop.

So the painter and the hairdresser bought the seven houses, taking on a debt of $2.6 million. And the real-estate broker said, "You know, you've made a great investment because, based on my calculations about where real estate's going to go in Las Vegas, within five years you're going to have home equity of $1.3 million." Well, you already know how this turns out.

Their monthly debt payment was $5,772. If you take their $60,000, and divide it by 12, you get $5,000; so their payments were more than their gross income between the two of them. So they took on $2.6 million worth of debt, with the hopes that the properties would be worth $4.4 million within a couple of years. That assumption meant that the price of those seven homes had to reach $286 per square foot. Now, I can tell you that those homes in Vegas today are selling for less than $86 a square foot.

You might think that, in the end, these folks just filed bankruptcy, and learned a lesson – "Well, I guess we aren't as smart as we thought we were." No. They sued. They sued the realtor, who was of course the mortgage broker, whose wife was the mortgage-loan processor.

That story really captures what Mises was talking about in Human Action. In a boom, when it's going well, we all feel really smart; we believe that all the good things that seem to be happening are our own doing. Then, afterwards, when things don't work out, we blame it all on other people.

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August 21, 2009

Doug French [send him mail] is president of the Ludwig von Mises Institute and associate editor for Liberty Watch Magazine. He is the author of Early Speculative Bubbles & Increases in the Money Supply. He received the Murray N. Rothbard Award from the Center for Libertarian Studies. See his tribute to Murray Rothbard.

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