I'm not sure where I'm headed with this, so I am going to do something I don't usually do and just start writing. Hopefully, I'll find a point along the way. Vaguely, I want to connect "bubbles" to the invisible hand concept identified with Adam Smith, i.e. to the process that moves resources to their most efficient uses. [...continue...]
Okay. Let's start with some diagrams you must have seen if you've taken principles of economics at any level. The diagram on the left-hand side shows an individual firm and the right-hand side graph is the entire market. The market is competitive. The graphs show the response to an increase in demand. I assume the diagram is familiar, so I won't spend much time explaining it. (Demand increases do D', price rises, there are profits, firms enter in response to profits, supply shifts to S' and price falls back where it started. In the end, there are more firms serving more people, but the price is at its initial level, though the unchanged price in the long-run depends on the long-run cost structure of the industry which is assumed constant in the diagrams):
For illustration, suppose this is the pizza industry, but most any industry will do, and suppose it is adjusting to an increase in demand along the lines shown in the diagrams (though not all of the detail described below is shown).
Before going any further, I should also point out that I am using the term bubble according to its current popular usage rather than according to its technical definition. Technically, a bubble is an increase in price that is disconnected from underlying fundamentals, but I am allowing the term to cover any run-up in prices. In the case of, say, housing markets while some of the recent increase in prices may have been due to a bubble in the technical sense, a lot of the price movement was also driven by fundamentals such as low interest rates and robust demand. On to the example:
1. Start at equilibrium with zero economic profit. As pizza demand goes up due to, say, the opening of a new university in the area, price rises leading to profits in the short-run (this is the points labeled sr in the diagram).
2. It is widely reported on local financial pages that the industry is booming. In response to these reports, and buttressed by their own analysis, firms enter. In fact, and there's nothing in theory that says this won't happen, it's possible that too many firms enter. That is, the demand for pizza goes up and twenty firms enter, but there's only room for fourteen to survive in the long-run. Extra firms, i.e. firms that won't survive in the long-run can also enter if the increase in prices is higher than justified by the underlying economic conditions (i.e. there is a bubble in the technical sense due to over exuberance or other reasons) and false signals are delivered to the market.
3. Makers of products such as pizza ovens, pizza boxes, and pizza trucks are getting the word out to all who will listen. They're building a new university and it's now open! There's a boom in the pizza industry! Get in now while profits are high, before it's too late. Pizza's never been better! After all, the suppliers stand to profit from every firm that enters and they have an incentive to encourage as many firms as they can to join in the boom. While not actually telling falsehoods, at least in most cases, they make the opportunities in the industry sound as rosy as possible to all who will listen, offer enticing good credit terms to entering firms, and so on.
4. City officials and others who stand to gain from the growth in the industry join in, particularly after the campaign donations begin rolling in from those profiting from the influx of new pizza firms. Zoning laws are changed, and tax laws altered to keep the firms coming.
5. For awhile, the industry booms. But, as noted above, suppose too many firms enter and after more time has passed the clean-out process begins. If twenty firms enter and only fourteen can survive long-term, six will fail. It's ugly to watch as people lose large investments in the industry, doors are closed and jobs are lost, and it's possible for the problem to spread if other firms are relying upon these six firms for their survival. In fact, it turns out that three of the failed firms weren't quite on the up and up about collateral against the loan, and the bank that made the loan to them, as well as a few others that are intertwined with it, may face some troubles and this compounds the difficulties in the industry. City leaders are worried.
6. As the industry clean-out continues, the finger pointing starts. Why did the pizza oven manufacturers encourage so many firms to enter? Aren't they guilty of fraud? Look at this ad! They must have known there wasn't room for all three firms, everybody did - it was obvious twenty firms couldn't survive- yet they encouraged people to come and set up shop anyway. They need to be regulated so that doesn't happen again, maybe fined and charged with fraud as well. The banks too. What were they thinking making these loans? Where were the regulators? People got hurt because of this.
7. People begin looking at what happened to pizza prices during this time. A newspaper publishes the following graph with the headline "The Collapse of the Pizza Bubble":
And while it could be due to fundamentals, it does look surely, obviously, like a bubble. And bubbles pop. There are calls for government to make sure that we don't let another one of these develop. It encouraged fraudulent behavior, reckless lending, over investment in pizza, wasted resources, banks in trouble, people lost jobs as the excess was cleared out, there were all sorts of problems because of the bubble. Bubbles are bad and the people who cause them need to be stopped.
I suppose that's enough. My point is that the housing bubble is an enlarged, very exaggerated version of a process we see regularly when a market opportunities open up. In the case of housing markets, for example, financial innovation allowed a segment of the market to be served that had not been well served in the past, and it also allowed existing markets to expand creating highly profitable opportunities. The result was just what you would expect when there are profits to be made, a rush of resources into the industry. Real estate agents, loan companies, builders, etc. all entered, in fact too many entered and now we are seeing the clean out that is the equivalent of the failure of the six excess pizza firms (we shouldn't forget that this is the excess that is being cleaned out, at least in the example above, the industry itself has grown and now serves more people than before).
I don't mean that nothing went wrong in housing markets, things did go wrong and there are regulatory and other responses that need to occur both in the private sector and the public sector to help avoid problems in the future. But having winners and losers is part of the "bubble" process, part of the way the economy finds its efficient allocation of resources as described by Adam Smith long ago. It would be better if we knew the exact quantity of resources needed in each industry, which firms can survive, and so forth so we could avoid having a rush of resources to an industry in response to price bubbles, too many resources in many cases followed by the market cleaning out the weaker performers. But we don't know how to make sure nobody gets hurt as markets adjust, how to make sure prices remain connected to fundamentals. If we want to have a dynamic economy, while the process is sometimes smoother than described above, there will be winners and losers as resources are reallocated. We should, of course, help those who are victims of the market process as best we can while doing our best not to create poor incentives for the future (helping can actually encourage risk taking and innovation), but a dynamic economy is not always pretty to watch.
What we see in housing markets has happened before and it will happen again with the next gold rush, whatever it might be, it's part of the process of moving resources where they are needed most. We saw the same thing as the tech sector developed and expected profit opportunities were present. There are winners and losers when the resources move from one sector of the economy to another (less cars, more accountants), and there can also be subsequent problems - as described above - when the adjustment is less than perfect and too many resources enter in response to a false price signal. So let's fix the problems we've discovered in the industry, at least the ones the private sector can't fix by itself -- these are relatively new assets and the private sector will also respond to protect itself from this happening again, e.g. it will reprice risk, demand more transparency, etc., so the government may not have to mandate all change -- and let's help people as we can. And we should do what we can to make sure prices don't disconnect from fundamentals, e.g. through transparency requirements. But let's not overreact to the point where we interfere with the economy's ability to quickly move resources where they are valued the most to take advantage of profitable opportunities.
I am biased. When I was younger, loans were much harder to get. There was, for the most part, one kind of loan. It had a high required down payment with restrictive rules on how the down payment could be obtained, and there were also strict debt-to income and other ratios that you had to meet to qualify. You either met them or you didn't, yes or no, and that was that. The first time I tried to get a house, the answer was no. Today, I have no doubt that a loan under the same circumstances would be easily approved, solicited even, but it wasn't then and it still irks me to this day. I could have paid the monthly amount on the loan I wanted, would have paid it, I had a pretty secure job as those things go, but there was no way to convey that information to the market.
But I got lucky soon after. The house I was renting was repossessed. It was the 1980s and it had been purchased on speculation during a boom, but the owner defaulted and turned over a bunch of houses to the bank. The bank wanted to dump the house, badly, and I wanted to buy it. All of a sudden the ratios didn't matter so much and somehow they got it through the underwriters. I suppose I was subprime in that market, but my house payment was less than the rent I had been paying (even before tax breaks), and making the loan payment was no problem. House prices went up substantially in the next few years, and that allowed me to move up the ladder. So not everyone loses when there are crashes. Houses are cheap(er), sellers are motivated, and there are people like me who can benefit if loans are available. But I don't mean to minimize the losses of others.
There was, in my opinion, a large unserved segment of people in mortgage markets at that time. There were lots of people who were pretty good bets, but they could not get loans, even at higher interest rates. The recent financial innovation changed that and I would hate to see us stop serving people as part of our efforts to clean up the industry. Not every subprime borrower failed, many are living happily ever after and I hope we'll remember that, while there are problems to avoid, fraud to clean up, and so on, there are also lots of good things that have happened as a result of financial innovation. As we try to make these markets work better, we should be careful to preserve or even improve the changes in the mortgage market that have allowed so many people who could not get loans in the past to purchase a home.