As my wife and I were on our way to the home improvement store this past weekend, I saw the economic bubble that brought about the current bust illustrated in stark reality. Near our home in Orange County, California, driving on a beautifully-paved, 6-lane street with a landscaped median and surrounded by relatively new housing developments, the conversation went something like this:

HER: Wow, look at this beautiful street! I remember back in the 1980s when this was just a 2-lane dirt road.

ME: That’s right. In fact, I remember driving out here in 1997 or 1998. Even then all this land was nothing but vegetable fields.

HER: It’s amazing how quickly it all developed.

ME: This is a microcosm of the bubble.

HER: What?

[She’s deserves a lot of admiration for not changing the subject at that point.]

ME: This is a microcosm of the economic bubble.

When the Fed artificially lowered interest rates by creating more money out of thin air, it accelerated home buying ahead of what normally would have happened. This area would not have developed as quickly without that acceleration effect. There were people who otherwise would have stayed in their old home and eliminated some spending to save little-by-little for a down-payment. Suddenly they realized that with lower interest rates, they could afford to buy a new house without saving, and they could still buy all the consumer goods they wanted.

Also, because interest rates were low, home builders could borrow money to buy the farmland, bulldozers, and so forth to build all these homes. They hired workers and got the county to build these roads. In just 10 years, they totally developed this area. The problem is that without interference from the Fed, this area shouldn’t have been developed that quickly — there wouldn’t have been that natural demand. In reality, today there would probably be more demand for the vegetables they used to grow on this land than for the homes built on it. Our food prices are higher because we have to compete with other localities for the vegetables grown elsewhere and have them trucked in from greater distances.

Now, because the home purchases were accelerated, the home buyers who would have bought homes in 2009 had already bought a home in 2002 — over-simplifying, but you get the idea. So now all the people who would have bought a house in 2009 have already bought one. They have no savings because they have been paying on a big loan and buying all the consumer goods they wanted. As a result, there’s greatly reduced demand for new houses, and the value of all these homes around us has dropped over 30%.

Given that this 6-lane road has about 3 cars on it as far as the eye can see, the developers were apparently expecting even more development that’s not happening. So they had scaled up way beyond what real demand would support. The developer and construction company go bankrupt because no one is buying new homes and they are paying loans on the idle land and equipment they bought. They have to lay off all their employees, who had bought houses in the meantime and now can’t make their payments. People who are upside-down on their mortgages and can’t pay start to get foreclosed on. When that happens a few at a time, banks can handle it. But when it happens on a bunch of loans at the same time, then banks start to fail, too.

HER: And that’s what’s happening now.

ME: Exactly! Artificially lower interest rates cause future spending to happen now — that’s the boom. But there’s a limit to how long they can keep forcing the future into the present — it creates a big gap at some point, and that’s the bust. What the politicians call “stimulating the economy” always amounts to nothing more than accelerating future economic growth to the present, creating a current boom and a future bust. And of course, things in the economy as a whole move slowly, so these economic cycles are longer than our election cycles. That’s why the politicians have an incentive to do it.

When they force future spending into the present, it’s absolutely inevitable that there will be a bust at some point. That’s what we see here.

It’s a microcosm of the bubble.

HER: Hmm… When you explain it that way, it makes sense to me.

Isn’t she the best?

April 28, 2009

The Best of Myron Weber