The Plebian

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How Bubbles Happen.

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The December issue of the Atlantic provides an excellent article on the nature of asset bubbles.  While most MSMers have played the finger pointing game (blame the CRA, Greenspan, Fannie, plenty more), author Virginia Postrel turns to pyschology for some insight. 

With decades of experimentation and advancements in methodology, the conclusions of each study appear rather entrenched. FTA:

‘These lab results should give pause not only to people who believe in efficient markets, but also to those who think we can banish bubbles simply by curbing corruption and imposing more regulation. Asset markets, it seems, suffer from irrepressible effervescence. Bubbles happen, even in the most controlled conditions.’

The birth of asset bubbles occur when speculators anticipate that others would be willing to pay more than what they believe the asset to be worth.  If I believed the price (where demand curve meets supply) for a new pair of shoes was twenty dollars. I would still be willing to pay $25  if i believed other’s were willing to pay $30. I am speculating that people will be willing to  do so, and in the process I am artificially increasing demand, subsequently increasing price, and consequently making profit. 

This uber-simplified example is the essense of the housing bubble.  Speculators fed off the desire for homeownership.  They bought, held and sold for more and often repeated the process.  And they did so until it bacame painfully obvious  to some (ahhem) that the homemarket had priced out the consumer.  Until homeprices reach parity with household incomes, expect homevalues as a whole to fall. 

As noted from a recent article in the Economist:

“Bubbles are the funny and unpredictable phenomena that happen on the way to the ‘rational’ predicted equilibrium if the environment is held constant long enough.”“


Written by eastwood24

December 15, 2008 at 7:44 pm

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