mathgeek2

Defining a Depression

Interesting analysis, but I have to take issue with some of the specifics.

Your first quote references new industries as the source of bubbles. I don't think this is an essential component. I do strongly agree that bubbles are often a credit phenomenon, but I think you miss some key aspects of the self-reinforcing mechanisms.

At least in theory, any asset could be subject to a bubble, so long as there is some plausible way to belive in a very high future value of the asset. New industries have historically fit the bill, but so have assets which are belived to be functionally finite. What this allows is plausible speculation of very high future values. "The amount of land in California is fixed, demand will continue to grow, so prices will always go up."

I agree that a loose monetary environment often is a crucial trigger for the bubble. It is easy to obtain credit to invest in the bubble asset.

But this is where the truly pernicious aspects of an asset bubble kick in.

- The price appreciates rapidly. So much so that a wider and wider pool of potential investors begins to belive that any inherent economic value is irrelevant, and they buy on the simple anticipation of the asset rising in value. In other words, people start to buy the asset for no reason other than the expectation it will continue to go up in value. This drives the price up, which reinforces their viewpoint.

- Crucially, the asset also absorbs liquidity. An actively investable asset that is rising rapidly can readily absorb liquidity. What this literally means is that, as money supply expands, that excess money is sunk into purchases of the bubble asset. From the point of view of the central bank, all is well, because the economy is humming along, but yet there is not execessive inflation in the economy at large... all of the "inflation" is taking place in the bubble asset.

- Finally, the growth of the asset bubble reduces apparent risk. Loans made using the bubble asset for collateral are rarely or never incurr losses. Institutions or persons under financial stress can readily paper over their challenges either by selling any of the bubble asset they hold or by borrowing against it. This reduction in apparent risk leads to further increases in leverage.

This is an asset bubble, and we have yet to develop a method for dealing with them effectively in our economy. Nonetheless, this is an old problem.

Eventually of course, often triggered by an exogenous shock or a decrease in available credit / money supply / liquidity, there are no more buyers to sustain the ponzi scheme of ever-increasing prices, and the asset value goes into free-fall. This leads to removal of credit, demand for (non-bubble!) collatoral, and eventually forced liquidation, driving prices down further.

Depending on the amount of leverage involved, the net effect can be a severe contraction of the money supply, deflation, and a credit freeze. The intensity of the housing bubble collapse compared to the internet bubble is a direct correlate to the size of the asset and the degree of leverage employed.

Depending on what specific actions David Merkel is referring to, it can be argued that Herber Hoover certainly and FDR probably made the Depression much worse.

Specifically, allowing runs on banks is disasterous. Cutting government spending and raising taxes (as Hoover did, and FDR did in 34-35) is a huge mistake. And of course onerous trade restrictions made things much worse.

If, on the other hand Merkel is suggesting, as Herbert Hoover's economic advisors did, that the answer is "liquidate, liquidate, liquidate" then I must beg to differ. While that is part of the answer, government actions to counteract the contraction of credit and the money supply, and in extreme cases, directly support aggregate demand, are the appropriate responses to the threat of a major deflation-led depression in the wake of a major bubble.