Note: I originally wrote this post with the thought of trying to get it published on The Baseline Scenario. Unfortunately, they don’t take unsolicited submissions as they don’t want to be thrust into the role of editor and curator of quality economic writing. The Baseline Scenario is the best blog on economics and finance currently on the internet, you should be reading it if you’re not already.
Wealth must be destroyed. There is too much capital chasing too few returns. Much of this capital has been created by and is the cause of ever increasing bubbles.
Over the past thirty years there have been a series of bubbles, both large and small. There have been multiple real estate and stock bubbles, oil bubbles, and even a uranium bubble. In each of these cases, an event triggered a revaluation in the market. The IRS changed a couple tax rulings which lead to a commercial real estate bubble in the 1980s. A new industry was created which lead to a stock market bubble as we all famously saw in the late ’90s. And a uranium mine flooded leading to uncertainty of short-term supply and causing a bubble in uranium prices.
In each of these bubbles and many others, market prices have far exceeded what would be rational given the underlying change in the asset. Good investors see the change and move the market to match the new conditions. Everyone else sees the profits made by the good investor, expects that the trend will continue, and bids up values to unrealistic levels.
Partly, this is investors trying to meet their fiduciary responsibility to maximize profits. However, chasing these market corrections has much more to do with unrealistic expectations for a return on investment than fulfilling that responsibility. The popular business media has raised expectation for returns to be a real 7-9%. The adage that the stock market has grown at an average 9% per year since the end of World War II has been repeated so many times that it is now taken as gospel. As investors chase these unrealistically high returns on their investments, they create these bubbles we’ve seen over the past several decades.
While each bubble is a problem in itself, they create a more insidious problem as well. Each bubble creates even more capital chasing the same returns. This helps fuel future bubbles. The recent housing bubble is a good example of this phenomena in a context nearly everyone understands.
Many people were buying houses at inflated prices. These market prices bore no relation to a rational asset value. Prices were so high because the conventional market wisdom was that real estate never loses value, even though all evidence pointed towards a boom/bust cycle in real estate like any other market.
Most real estate is purchased using borrowed funds. These mortgages are tantamount to banks printing money*. If the mortgage is backed by an asset, it’s like printing money under the gold standard. If the mortgage is not backed by an asset, or the asset price is less than the mortgage, it’s like printing money under the Weimar Republic.
The problem comes when the market price of the assets fall. As the asset’s price falls, the mortgage is no longer backed by something tangible. Banks don’t write down the value of the mortgage to the real market value of the asset which means there will be less value backing the same number of dollars.
As long as everyone believes the value is still there (that the mortgage will be repaid) then this situation does not cause inflation. The property owner bears the burden of the destroyed wealth since they own an asset worth less than they paid for it. If the property owner defaults, the bank bears the burden of the destroyed wealth because they’re forced to write off the bad mortgage.
Inflation occurs when people realize that there are not enough assets backing the dollar, and nobody is taking the loss in value. When bubbles burst, some party takes the loss, ensuring that the non-rational wealth is destroyed. Unfortunately that hasn’t happened with the most recent boom/bust cycle. Instead we have institutionalized the banks’ ability to offset the write-down in asset prices. By nationalizing these losses and not making investors mark assets to market, we’ve ensured this capital is backed by nothing more than the full faith and credit of the Federal Government.
In Europe today, we are seeing what happens when currency is backed by over-priced assets. The government bonds sold to the European Central Bank to backstop the currency have been declining in market value over the past several months. As soon as European bondholders lost faith in these assets, the government bonds, problems started to occur. The governments of the weaker European states have had to scramble to roll over their debt that is coming due. Others, mainly Europe’s solvent nations and the IMF, needed to pledge support to back the bad assets issued by the weaker European states. These actions still might not be enough if there are insufficient assets available to back all of the Euro money supply. The fear in the market is that there aren’t sufficient assets, which is why the Euro has declined in value relative to the dollar. The value of the Euro has been diluted because too much money was created without the backing of sufficient assets.
For the United States, there are three possible outcomes of having too much money: 1) the money supply stays at its current size without additional assets backing it, which leads to inflation; 2) the government raises taxes or cuts spending to destroy this new capital and shrink the money supply; or 3) the government backs the value of the capital with promises of future tax revenue, which either means higher taxes in the future (see #2 above) or sovereign default. In all of these cases, the population at large bears the burden of the destroyed wealth instead of either the bank or borrower.
To avoid these problems, capital must be backed by real assets. Today it is not. That excess wealth must be destroyed one way or another. The only question is: who should bear the burden of that destroyed wealth?
* It’s not the government that is the primary creator of money; they just regulate how freely the banks create money. Banks create money by loaning out other people’s deposits. Let’s say a depositor puts $100 into the bank and the bank has a requirement to keep 10% of all deposits in reserve. That allows the bank to loan out $90 to somebody else, who then deposits it into the bank as well. Now the bank can loan out another $81, ad infinitum. Now, there is $271 on deposit with the bank that’s only back by $100 in real value. The bank created money.
tvgide, 
logikal 11:53 AM on June 28, 2010 Permalink
I know its anecdotal, but I feel like I get more out of articles with all the links at the bottom. I’ve also noticed that using a newsreader has destroyed my concentration. Having a Gizmodo article followed by a gaming article, followed by some lolcat makes me “switch hats” so often, I can’t remember what I read half an hour later (the infamous “I read somewhere that….” problem).
Grant Henninger 12:10 PM on June 28, 2010 Permalink
I feel like I can comprehend articles that are filled with links, even when I’m reading those links and then going back to the main article. What I’ve found problems with is writing non-hyperlinked essays and articles. Often times, I have a web of ideas that don’t fall into a nice narrative thread. I find it very hard to organize these disparate but related ideas into a narrative form that other people can understand. Since identifying this problem, I’ve always seen it as stemming from doing most of my reading online.
tvgide 11:11 AM on September 1, 2010 Permalink
Wonder how related this is to Wikipedia. They hyperlink associated references, but push all the research/bibliographical links to the end of the entry for whatever you searched.