How to create a bubble

To my last breath, I will insist that economics is not really that complicated, if only the people would take a little time to understand its basic principles. Until that time, the people will be easily misled.

One of those principles is the so-called “business cycle” of booms, bubbles, and busts. In reality, these cycles are not inherent in free markets, but in markets that are “managed” by allegedly intelligent, well educated folks in Washington.

I recall, as a high school student, being taught about the causes of the Great Depression. Foremost among those causes, the earnest teacher said (quoting the text), was something called “over-production.” Left to their own devices, you see, businesses will tend to overproduce, causing a price collapse in their particular trade. As proof of this, the text showed a picture of a warehouse at the start of the Great Depression, full of unsold shoes.

Why, those foolish cobblers, overproducing! They need a wise Czar of Shoes in Washington, telling them how many shoes they may produce. All to avoid the tragedy of “overproduction,” you understand.

The glut of shoes on the market, I learned later when I read up on Austrian School economics, was a predictable result of government intervention in the economy, specifically of loose credit and fiat money. There was, in this case, malinvestment, or a “bubble” in shoes.

Often, to understand economics, it helps to simplify. Suppose an angel (or more accurately, a demon or politician) magically doubled everyone’s money. The cobbler notices, the next day, that everyone is buying new shoes. He is delighted.

He orders more shoes from his supplier. Since there is now so much money, the costs of everything are bid up, so the cobbler has to pay more for his shoes. No problem: the demand for shoes is up, so he knows he can raise his prices, too. He does, and people continue buying shoes. The price of shoes rises from a dollar a pair, to ten dollars a pair, to a hundred dollars a pair. At that point, however, the bubble bursts. The price has risen to a point where no one wants to buy. The poor cobbler, misled by the false information of an inflated money supply, finds himself sitting on a warehouse full of shoes no one wants to buy.

What’s the solution? The logical solution is to let the price of shoes fall, clear out the excess inventory, take your losses, and vow to hang any politician who inflates the money supply again.

But this will only happen if a large portion of the public understands basic economics. It’s not really difficult at all, but governments have a vested interest in making economics seem difficult. Thus the deliberate evasion of the point in the story of the warehouses full of shoes.

This bubble effect is exactly what has happened recently in real estate. The solution, just as with shoes, is to let the market for real estate collapse, allow prices to plummet, and clear out the excess inventory. The upside of such an approach is that the low prices will allow common people to invest in homes, who never had the opportunity to do so when they were insanely overpriced.

Politicians, however, will do whatever they can to maintain the illusion that fifty thousand dollar homes really are worth half a million. That is the gist of the Obama plan: keep prices high!

Politicians curry favor with the electorate by inflating and causing a boom. To the cobbler in our example, the politicians looked like geniuses at first. After all, they seemed to create prosperity, merely by creating more money. Then, when the scheme collapsed, the politicians blamed everyone but themselves.

Exactly as they are now doing with the collapse of the real estate market today.