Q. The term “bubble” is used frequently in discussing the housing market—did we have a bubble, and what does that really mean?
A. Yes, we did. A “bubble” is created when many people believe that an asset’s price, which has already greatly increased, must keep on rising, and that it therefore makes sense to borrow in order to buy it—for example, to buy a house with no down payment. Speculators acquire loans that can be repaid only if the asset is sold for a higher price, temporarily driving up prices and debt; lenders grow confident that it is attractive to make such loans. As long as the prices rise, borrowers, lenders, and investors all make money. But bubbles, by definition, come to a sad end, with defaults, failures, dispossessions, scandals, and late-cycle political and regulatory reactions and often overreactions.
Q. Are bubbles just caused by stupidity?
A. No. They look stupid in retrospect, but when a bubble collapses many intelligent people get caught. Brilliant model builders and articulate Wall Street bankers helped create the most recent bubble. Economist Walter Bagehot’s 1873 observation remains true: “The period of rising prices…naturally excites the sanguine and the ardent…and the ablest and the cleverest the most…. Every great crisis reveals the excessive speculations of many houses which no one before suspected.” Isaac Newton, possibly the greatest genius in history, invested in the bubble of the early 1700s, the South Sea Company, selling at a large profit. But when the price continued to rise, he bought back in—and then was stuck with a large loss when the bubble turned to panic. Disgusted, Newton wrote, “I can calculate the motions of the heavenly bodies, but not the madness of people.”
Q. Why is a bubble so hard to control?
A. Bubbles are notoriously difficult to control because so many people are making money from them while they last. Also, this one made politicians of both parties happy because it was increasing home ownership.
Q. How big was the recent bubble in the U.S. housing market?
A. This time we had the greatest house price inflation in U.S. history. The value of U.S. residential real estate almost doubled between 1999 and 2006 (I believe that in Finland asset have a little bit more than doubled, especially when switching from Markka to Euro...). The U.S. residential mortgage market was already the biggest credit market in the world, and it grew to have total loans of over $10 trillion. Securitized prime and subprime mortgages were purchased by investors around the world.
A financial crisis occurs about once a decade, with markets relearning the same lessons and then forgetting them.