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Bubble Economics: The Illusion of Wealth

Tags Booms and BustsThe FedFree MarketsInterventionism

08/12/2009Doug French

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.

"The individual is always ready to ascribe his good luck to his own efficiency…. But reverses of fortune he always charges to other people…."
– Ludwig von Mises

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.

The Illusion of Efficiency

During a boom, inflation distorts business calculations. Entire business plans are built on a boom, based on the ability of people to borrow and consume. Look at the recent bankruptcies that we've had: Circuit City, Sharper Image, Goodies, Gottschalks, CompUSA, and Levitz Furniture. In Vegas, Herbst Gaming has already gone bankrupt, and now even the Riviera is talking about it. All these business plans that seemed like a good idea in the boom didn't work out. The most obvious effects this time around are in real estate. We all know about real estate.

What you may not realize is there is still more excess real estate coming online. There are 93,000 high-rise condos coming online this year. That's a 28 percent increase in the US inventory of high-rises. When you build a big tall cylinder, it's not like you can quit halfway up. You've got to go all the way. It may have seemed like a good idea during the boom, but now you have to finish it during the bust. There are these 93,000 condos; 12,000 of those are in New Jersey and New York (I don't think they're creating a whole lot of new jobs in New York right now) 4,000 of them are in Vegas; 5,500 in Chicago; and 3,500 in Florida. So we'll see more and more real-estate fallout.

The main difficulty is getting people to close on real-estate purchases. This is a problem even if you're The Donald. Donald Trump built a nice tower in Las Vegas, and it was completely sold out within days. However, now that the project is ready for people to move in, he's only closed 25 percent of his sales. He's been quoted as saying, "We're really doing very well in Vegas, if you take into account that Vegas is in a depression." That's keeping the sunny side up, I would say.

I read in the Wall Street Journal recently that the downturn will be less severe because the service economy is more stable than farming was during the Great Depression. And I thought, that doesn't make sense. That would mean that the masseuses and blackjack dealers are more likely to keep their job than the farmers — the people who grow food? It seems crazy, but that's what people are talking about.

During a boom, inflation creates illusory profits and distorts economic calculation. What the free market does best is penalize the inefficient and reward the efficient. But when you get a boom, the rising tide lifts all boats. I used to have borrowers who built houses. They were continually over budget and never got anything done on time. But during the boom, were they penalized? No, because the price went up over time. In fact, they thought they were doing the right thing; they were smart by being over budget, and taking an extra six months to build a house — the price went up! Well, that's not what's supposed to happen, and in the end, the bust penalized them.

Because of these illusory profits, everybody wants to get in on the boom. Everyone thinks they can do everything. My favorite example is that doctors become real-estate developers. You go into a doctor and all he wants to talk about is his real-estate project.

Furthermore, during inflation, the quality of work goes down. Everyone tries to manufacture products as quickly as they can. There's no emphasis on how long things will last. That was certainly the case with new houses in Arizona, California, and Nevada.

In general, people become enamored with get-rich-quick schemes. In fact, entire countries have done this with the collateralized debt obligation (CDO) market. Iceland, for instance, has become one big hedge fund. And now we're going to have entire countries go broke.

People scorn sober effort in favor of getting in on the house-flipping craze. Bartenders become real-estate agents and mortgage brokers. I remember a guy in the locker room at the country club, talking on the phone, telling somebody that he was on the list to buy a home at nine different new home tracts. That was whole his business plan. If he got on the initial waiting list, it was certain that immediately after each home was built he was going to be able to flip it and make 50 or 100 thousand dollars. He planned on becoming a millionaire just like that.

I had a borrower who was a real-estate developer. We went to dinner one night, and he brought his girlfriend. I asked, "Harry, how'd you meet your girlfriend?"

"Well," he said, "I was driving through our project one night and I saw a girl jumping over a fence, looking at the homes." It turns out that she was a schoolteacher and she wanted to buy a home, but didn't have time to tour the models during the day.

"When you build a big tall cylinder, it's not like you can quit halfway up."

Of course, by the time I met Harry's girlfriend at dinner, she was not a schoolteacher anymore. She was now selling real estate for Harry. Is that any wonder in Vegas, during the boom? There were 17,700 real-estate agents: one for every 100 people in the city. It was hard not to have a bunch of friends who were selling real estate. Nowadays, one in every 60 homes in Las Vegas is in foreclosure. Those two numbers are probably connected somehow.

During a boom, everybody also wants to get involved in banks. Investing in new start-up banks was a craze all over the country. Investors in small community banks in Las Vegas made a lot of money. So everyone just assumed that once you got your bank opened, it would be worth one and a half times what you put in it. And by the time you showed a profit, your investment would have doubled. By 2006, there were 17 new banks in Nevada, and 50 in California, seeking regulatory approval. I remember being in Phoenix, Arizona, on a business trip, and stumbling on an ad in a business journal that said, "Start Your Own Bank."

Inflationary booms penalize thrift and reward debt. The most poignant story about this is a man named Scott Coles, who was a hard-money lender in Phoenix, Arizona. He had a huge operation that he had inherited from his father. Hard money is lending money — that investors have actually saved — to real-estate developers who can't get bank finance. Lenders like Mr. Coles can generally charge 10 to 15 percent for these loans. The banks may be a lot cheaper, but the hard-money lenders are a lot easier to deal with. At that time, Phoenix real estate became so overheated that people were borrowing on their home-credit lines at 5 percent, in order to turn around and lend hard money at ten percent, to play the arbitrage. Of course, this all didn't work out: the projects didn't get done; the loans didn't get paid back; and, unfortunately, Mr. Coles committed suicide.

Inflation also lowers the general standard of living. In the very course of creating a tinsel atmosphere of prosperity, people have to work harder. They have to have two-income families just to keep up. We all think we're doing better: we're buying more stuff, and we're buying bigger houses to put our stuff in. But we're really getting less prosperous, and that's what inflation does during a boom.

Mises wrote,

If the crisis were ruthlessly permitted to run its course, bring about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs — not only banks but also other businessmen — would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over than the banks are spurred on to a new expansion of circulation credit.

And that's where we are today. That's exactly what the Obama administration, and Ben Bernanke at the Fed, are trying to do.

There was a Treasury secretary, once upon a time, in 1929, named Andrew Mellon. He said to Herbert Hoover,

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.… It will purge the rottenness of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.

Herbert Hoover did not listen to Andrew Mellon. And believe me, Tim Geithner is no Andrew Mellon.


Doug French

Douglas French is President Emeritus of the Mises Institute, author of Early Speculative Bubbles & Increases in the Money Supply, and author of Walk Away: The Rise and Fall of the Home-Ownership Myth. He received his master's degree in economics from UNLV, studying under both Professor Murray Rothbard and Professor Hans-Hermann Hoppe.