What’s up with bubbles?

Posted: February 14, 2012 by alephnaughty in Economics
Tags: , ,

Suppose you believe (unjustifiably) that real estate prices will keep rising for the foreseeable future. You thus believe you can buy real estate now, only to sell it later at a profit. You proceed, consequently, to buy lots of real estate.

Sold on the merits of your new investment strategy, you try to persuade your friends to do the same. On the one hand, if you’re right, they too would profit. On the other hand, their added demand for real estate would boost prices further, increasing the value of your investments.

Your friends, understanding this plan to be a win-win, try to persuade their friends. And so on. Eventually, enough people with enough savings sign onto the plan that they seem to be having a measurable (positive) impact on real estate prices. Their impact, in turn, supports your belief that real estate prices will keep rising for the foreseeable future. Selling the masses on your plan becomes easier, as the theory underpinning it proves increasingly accurate. As more amateurs come on board, prices start rising even faster.

Sophisticated investors begin to take notice. They conduct extensive research into the causes of the run-up in real estate prices. To their surprise, the real estate boom seems to have nothing to do with people’s desire to own real estate–instead, it seems to have everything to do with your success in promulgating your theory! They predict, therefore, that when your theory finally runs into a rough patch (real estate prices decline, for whatever reason), investors will sour on your plan, causing some to move their money elsewhere. This, in turn, will depress prices further, causing still more investors to call it quits. And so on. Anticipation of such a downward spiral will only serve to accelerate it, as investors compete to get out of the market while prices remain high. There will, in short, be a sudden collapse in real estate prices once reality sets in.

Initially, their inclination is to short real estate, which is sensible enough given their expectation of a bust. They then, however, recall the wise words of a famous speculator: “markets can remain irrational a lot longer than you and I can remain solvent.” Once reality sets in, prices will surely come crashing down, but reality may take a very long time to rear its ugly head. In the meantime, playing the contrarian is a loser’s game.

Despite the arbitrariness of your original forecast, then, you manage to bring the major players in the real estate market over to your side. With real estate prices skyrocketing, you become very wealthy indeed. But suddenly, to your dismay, the political discourse turns to the subject of illegal immigration. Some politicians want to make it easier for would-be immigrants to come to the United States, but many others demand that the problem of illegal immigration be forcefully dealt with first. With only the best of intentions, therefore, the government sharply escalates its efforts to identify and penalize the illegal immigrants in our midst.

The crackdown not only encourages many illegals to leave the US, but also discourages many would-be illegals from coming to the US in the first place. These incentives depress the demand for real estate, causing the price of real estate to stagnate, before gradually declining. Investors find themselves reading headlines like “Has the Real Estate Market Finally Peaked?”, making them fear a rush for the exits. As the market begins its rapid descent, you wonder whether you’re really the genius others believed you to be.

Cheer up, dude–it’s not the end of the world. If I were you, though, I’d buy US bonds. My sources tell me Treasury prices will keep rising for the foreseeable future…

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