Another Must Read on the Origins of the Crisis

Steven Gjerstad and Vernon Smith have published a really nice article that starts out with bubbles in general and goes on to explain why the bursting of this particular bubble hurt the economy so much.  It echoes a lot of themes that I’ve covered before, but is obviously much more soundly though out.

The short version is that the effect of a bubble on the economy is determined by its effect on consumer spending.  The Dot Com Bubble didn’t have much of an effect because it primarily affected institutions and already relatively wealthy consumers. However, the Fed’s attempt to shorten the resulting recession created a loose monetary policy which forced dollars into the most attractive asset class: homes.  This attractiveness stemmed from relaxed lending standards and tax-free capital gains on homes, which created more buyers. But asset appreciation in this class is fundamentally limited by the ability of consumers to repay loans from income, which was not growing fast enough. As the institutions insuring mortgages reached their limits, they slowed the issuing of policies, which dried up the market for new mortgages, which dried up the ability of people to buy, which decreased prices, which sent home equity under water, which further decreased the flow of insurance policies.

Because home equity and home ownership help drive consumer spending, this burst bubble then affected the real economy.  Cool.  Fortuitously, Vernon Smith’s Rationality in Economics is the next book in my pile.