Economic Musings III: The Bubble Analogy
There’s this fear that if a financial bubble bursts this would be tantamount to deflation (after all, when an inflatable dinghy bursts it’s called deflation). And because deflation is deemed to be a bad thing the panacea must be (re)inflation of “the” economy. Well, let’s look at what happens when a balloon bursts …
(Find more statistics and indicators etc. in our References section!)
A balloon is not filled with a vacuum, not even with air at the same pressure than the surrounding atmosphere, right? To stay round and “chubby” the gas inside that balloon actually needs to contain even more gas per cubic foot or cubic meter than what is in the same volume of its surrounding atmosphere. After all, this is why there is a loud “bang” when it is pricked with a needle.
So, after the housing bubble burst, people saw house prices falling. That gave them (and some Nobel [Memorial] Laureates no doubt) the impression that “wealth was destroyed” and since they felt richer when houses appreciated they felt poorer when they lost “value”. But rising stock prices make no one richer as little as do rising house prices – not, as long as you are not able to sell for that alleged price. Only then can you be sure the alleged value was real. And if many people try to sell at that “high price” at the same time it is nowhere to be got. This is exactly what happened with housing.
And here’s where the balloon analogy fits in: when a balloon bursts, is the air inside it “destroyed”? Certainly not, it is actually set free. When the housing bubble “burst” was the money already paid for the houses destroyed? Not at all. Lives may have been destroyed but neither the houses nor any money whatsoever. So where is that money now? It is with the builders, the surveyors, the former owners who sold a house or the land, with the builder’s workers, Caterpillar Inc. got its share, some truck manufacturers too, some realtors etc. Now after the bubble burst, did someone hand a hat around and Caterpillar, the builders, the former land owners etc. had all to give back their share?
Why would it then be so difficult to see that declining house prices cannot lead to monetary deflation? If the balloon analogy is sound physics then the bubble analogy is sound economics. And why it makes no immediate “deflationary” difference to a bank’s monetary position whether a mortgage defaults or if it is still “healthy” has already been explained in “Economic Fallacy III: Looming Deflation?“.