I originally planned to write a single post on what caused the economic crash, but as there were so many aspects that have to be understood before seeing how they combine, I have decided to split it into four shorter articles. This first article will deal with what constitutes an economic bubble, and how it might happen in the housing market.

Although we often hear the term ‘housing bubble’ in the news, it is normally given out of context, with no explanation as to what a ‘bubble’ actually is. Thus, it is important that we have the definition of an economic bubble before examining its causes: although the term dates from the early 1700s and has no one exact definition, it is roughly defined as when the price of a certain asset deviates greatly from its intrinsic value. What we mean by this is that if a house in country X cost $100 in 2000, and correcting for inflation, cost $200 in 2010, in the perfect world, its intrinsic value would have doubled. There are many factors that determine its intrinsic value: if the price of the bricks doubled, or if the price of labour doubled, or the house were twice as big, then we could say it is fair that the house cost twice as much. While it is impossible to work out the exact intrinsic value of any particular asset, if the house built in 2010 for twice the price is identical to the house built in 2000, we can assume its price has risen beyond its intrinsic value (although other factors beyond the house itself can increase its intrinsic value, for example house location). One pair of factors that might drive the price up without intrinsically increasing the houses value is the twins of supply and demand.

Adam Smith posed the question of the paradox of water and diamonds. Why is water, something utterly necessary for us to live and therefore in high demand, so much cheaper than diamonds, something that we don’t need at all? The answer, of course, is that that water is in great supply, while diamonds are in short supply.

Consider how this applies to housing. If the housing association builds three houses, and charges £20,000, and Anna, Bob and Claire can all afford that, then the price ought to rise only with inflation. However, if only 2 houses are built, and Anna and Bob can offer more than 20,000, but Claire can’t, and all three ask for the house, it is only natural for the housing association to raise the price to £21,000 and increase their profits. This situation of under-housing is exactly what is happening in the UK today, as can be seen in the following graph:

When you add in the migration patterns of internal migration (away from the north of England, and towards London) to the housing shortage, it is easy to see why the following rates of inflation (2014) are so high:

In a historical perspective, the average house in 1979 was around £20,000, which in todays money is about £102,000. As it is, the average house today costs £195,000, just shy of twice the growth of inflation.

For interest, it is also worth noting that a housing shortage also drives up rents, and has lead to the UK having by far the highest average rent in Europe:

Source: http://www.numbeo.com/cost-of-living/rankings_by_country.jsp

Now it is important to be aware that a shortage of supply is not the only thing that can cause a bubble, and the US housing bubble prior to the crash was actually caused by a variety of other factors, such as ease of attaining mortgages (if it’s easy for people to get $120,000 in a mortgage, why only charge $110,000?). However, in understanding what caused the crash, it is only necessary to understand what a bubble is, and to know that there was a very large housing bubble, as can be seen here:

With the housing bubble (hopefully) clear, Part 2 explores financial derivatives and financial deregulation.