How to spot bubbles

When I was looking into buying a house, late in 2006, I got a bit suspicious. With a big smile the real estate salesperson said I could borrow extra money and only had to pay interest. When I asked if they were giving away free money (with quite some disbelief) I was told the prices would only go up. I felt the prices were quite high already and didn’t see much room for higher prices. As I said to my father at that time: “Who is going to buy that house at a higher price? Bill Gates?”. He didn't believe the prices were going to go down at first, so I told him about something I learned in school: business cycles (illustration). My father, who was an actuary, suddenly remembered prices of houses going down in the early 80's. My parents had bought a house just before that, so it was strange that he forgot about it. He then said financial institutions were not prepared for prices going down and they might get into trouble. I used the words “financial crisis” and decided to stay in my rented apartment.

Actually back around 1998 a former finance teacher of mine explained the same scenario when he said the merging of banks and insurance companies was a bad thing, because after that the only one who could lend money to banks would be the government. No one else has the amounts of money that banks use. He also said that the prices of houses were too high as it was impossible to get a decent mortgage to pay off your house in a sensible manner, and expected problems.

When too many people have mortgages that are not prepared for prices going down, they would get into trouble when they have to pay the banks their money back, a lot of banks would get into trouble as they have to write off assets they thought they had, had to borrow money from the government and (he actually said this) people would be upset about it.

In 1993 I went to study computer science. There were a lot of students there. Apparently the promise of money drew a lot of people who were usually not really into computers. I asked a classmate what he used to do on the computer at home and he replied: “Nothing, I like football”. This sounded strange to me because I was active in computer art and studied other people's assembler code, among other things. When I asked why he would study ICT he replied that he had heard a lot of money could be made in ICT. I told him that if everyone thought like he did, it would automatically no longer be true. A crisis hit ICT less than ten years later, but I had quit my ICT studies halfway through and went to study some business administration (where I learnt about the mortgages).

There was also a stock market crisis at some point. Again everyone thought they were going to make a lot of money. People started borrowing money to buy stocks as they were supposed to be an easy way to make money. The risks were unclear to almost all people, and considering the amount of people that tried to chip in it was guaranteed to create a fake high estimated value (bubble). Most people didn’t have a clue about stock markets. Same as with houses. In the long run the prices go up, but they do go down at times. When they do, you need to be prepared. My real estate broker failed to inform me of this in his enthusiasm.

It’s like a gold rush. Once word gets out that a lot of money can be made with something I can guarantee you a lot of people will go try their luck. That will automatically cancel the effect. These things are the opposite of a self-fulfilling prophecy.

If I put up a sign that says: “Free money”, I will probably have to remove it before everyone is satisfied. If I would keep on giving away money, there would not be enough goods to buy with it, prices would rise, and you would get what’s called: inflation. In the end, people don’t want money, they want food and other items that they buy with it. And perhaps some money in reserve as a security. This is why printing money without considering the economic growth rate is considered to be a bad thing.

As an example of goods scarcity: if a sports car manufacturer can make 100 cars per year  and the central banks print more money, it might increase the demand for their cars as people get their hands on that money. However as the limit is 100 cars the manufacturer will simply raise his prices as they cannot meet the higher demand and people seem to have the money to pay for their cars anyway.

You might think things become cheaper as they are produced in larger quantities, but it takes a lot of work to grow food and mine metals for example. There are limits to what the earth produces.

Getting back to the bubbles, when people tell you of easy ways to make a lot of money, you might want to consider not to follow it blindly. Even when it’s not one of those obvious internet scams. There is a limited amount of money in circulation and in order to get a bigger piece of the pie, you need to look for pieces that other people are not trying to cut at the same time as you. Stick to parts of the economy that you actually know things about.

Addition: a year or so ago someone came up to me and "tipped" me about gold. Apparently it was a good way to make money in those days. I started to check out the business as I suspected trouble. I ended up contacting politicians and pointed out that there was a gold bubble (albeit a small one). I later heard some people went into the gold business and lost money. Typical. I wrote a follow-up article on it.

Edit: It’s a fact.

© Koos Swart 2013