tisdag 25 mars 2008

Why do booms and slumps happen?

Why do these periodic booms and slumps occur? According to Paul Ormerod, writing in the Sunday Times, it is all due to the summation of people's optimism and pessimism.

Well, it's a theory, but there is a more plausible explanation, which is that it is due to the interaction between the land market and the banking system. Put simply, booms turn to slumps when the capital values (selling prices) of land are driven up to the point that the actual yields (rentals), as a percentage of those capital values, are unacceptably low. What drives up these land prices is indeed optimism, the expectation first, that capital values will continue to rise and second, that the rentals that ultimately underpin those capital values, will also keep on rising. The latter expectation is ill-founded and the capital values are themselves boosted to unreasonably high levels as the banks become recklessly willing to lend for land purchase by recklessly willing borrowers with unrealistic expectations of capital appreciation. This reckless lending is on the security of the land whose value is being driven up by the same over-easy lending by all of the banks.

This is a classic self-feeding bubble. And since rents tend to rise, if at all, at quite a modest rate, the yields, as a percentage of selling prices, tend to fall. The point eventually comes where the slightest shock to the market can cause people to panic as they realise that they are over-committed and cannot pay back what they have borrowed, with the lenders realising that they have lent to people who cannot pay back, on the security of collateral whose value turns out to have been a bubble value. Pumping money is a cure of sorts as it depreciates the real price of the loan, but it is at the expense of the prudent, including savers and those who have lent prudently, who find their loan repaid in depreciated currency.

The pessimism Ormerod refers to has a real cause and is not just a mood-swing. Which seems to be where the economy of both the US and UK have got to. Underneath the pessimism is a genuine problem that only just starting its wretched course.

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