Home > Debt, Deflation, Economic Musings, Economics, Economy, Epistemology, Financial Crisis > Economic Musings III: The Bubble Analogy

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?“.

  1. 2010-03-21 at 12:47

    Great example of analogy! I really like it.
    Recently I started posting interestnig analogies I found on the web on blog.ygolana.com. I thought it could be a good idea to create a place where people can help each other to find useful analogies so I created a simple site (www.ygolana.com) Check it out!

  2. Michael Kotov
    2010-03-19 at 21:14

    When a bubble bursts people’s assets lose value, but their debts remain intact. So they end up with negative equity on their homes etc. This means that now they have to pay back the debts to the banks, taking money out of circulation. Because for every reserve dollar held at the Fed 10 dollars in credit can exist in the system, money supply begins to shrink pretty rapidly, like a balloon or a bubble. In fact, money like M3 is a bubble in itself.

    So basically in my opinion:
    money supply growth – GDP growth = inflation/deflation.
    If its inflation, it’s a net transfer of resources from financial institutions to the public, and deflation is the other way round. Thats why deflationary depressions are always so bad compared to inflationary ones (1930s vs 1970s). In the 1970s real value of the stock market decreased by A LOT yet the public was still doing OK cuz resources were constantly being transferred to them by the banks.

    So 10% inflation we can live with, 10% deflation is a disaster. Thats why printing money is a safe bet in this case.

    here is a best example of deflation ever , clearly more money needs to be created AND distributed WELL to get rid of all those houses.

    • 2010-03-19 at 21:54

      Well, Michael, I’m not convinced: you say when the houses are “underwater” people need to repay their debt – well, they need to repay their debt in any case, whether after default or under healthy conditions. So that to me makes no difference moneywise. And since under normal conditions they would retire their debt every month little by little, they default not because they think it’s a fun game but because they can’t pay, this to me suggests a default is actually inflationary rather than deflationary as the money supply (the money the bank lent and the home “owners” spent) is gone … into the economy, where others enjoy it and bid up prices of whatever they might want to buy. So far I believe I have proven that defaults and moratoriums retire less money with the banks than normal repayments. Now comes the second part: if a robber robs a bank and runs away with the money and the Federal Reserve then “recapitalises” the bank – does that not effectively double the amount of money available? The robber can spend “his” loot and to the bank it looks as if the robbery never had happened. Without meaning to be derogatory – whether a robber robs 200,000 dollars or a debtor doesn’t repay the same amount – it makes not a cent difference to a bank’s balance sheet. So this cannot be called deflation; if it actually via bail-out doubles that money supply it must to all intents and purposes be called inflation.
      I also don’t agree that 10% deflation is a disaster if you mean prices falling (it’s always a bit difficult to ascertain when people refer to prices and when to money supply) – effectively, prices for TV sets, computers, head sets and a host of other electronic gadgets have fallen far more than that and are constantly falling still and no one gets hurt, in fact the manufacturers thrive and no one would give Apple a bad rating on their debt because, as wisdom has it, in a deflationary environment debt cannot be serviced. In fact, all I can see is that since the Fed inflated the money supply debt is ever more difficult to service. While coincidence does not prove causation certainly non-coincidence disproves causation or so I should think.
      As for China you argue, one needs to print money to buy empty houses. Well, I argue, these houses are empty because too much money was printed which bid up their price and led to a glut in the real estate market and now they need desperately to “deflate” to again become affordable. The sellers want their value in real terms, not nominal “value” – why, otherwise they could get Zimbabwean dollars and be proud of their business acumen. If, as you suggest, all were needed to buy these houses is even more credit you just do what happened in early 2007 in the US: one last flip and whoever then owns the house has a big problem. Creating more money instead of capital cannot solve a problem in the real world. My thoughts on China are here: Will China Survive the Crisis?.

  1. 2010-03-22 at 11:25

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