A video that recently appeared in YouTube describes in just a few minutes how the current financial crisis came about.

The producer, Jonathan Jarvis, uses model-like images to illustrate what happened on the US housing and financial markets which subsequently led to the crisis that saw major investment banks come crashing down. Terms like leverage, credit debt obligation and subprime mortgage are visualised in a way that makes them very understandable. The film itself is rather unusual in terms of its presentation and layout, and the speed at which the facts are presented requires your full attention!

On behalf of the iconomix team

Ronald Indergand

The current financial crisis is largely due to undesirable developments in the US housing market. Following a major rise in house prices within very few years, the trend turned suddenly in mid-2006. For two years, prices have been sinking fast and an end to the nosedive is not yet in sight.

When searching for reasons for these developments, people often speak of speculative bubbles. What do they mean?

For economists, real estate is comparable to other assets like bonds or shares. The market price of an investment of this kind reflects the expectations of investors with regard to future flows of assets (dividends, interest payments, increases in value, etc.). If the outlook for the real economy worsens, the price will generally fall, and vice versa.

Alongside the market price, economists use the concept of fundamental value. This reflects the ‘true, realistic value’ of an investment, the intrinsic value of the security from the current point of view. Unlike the market price, this cannot be measured anywhere and has to be estimated by analysts and investors.

If investors’ expectations are speculative and over-optimistic (or over-pessimistic), the market price of a security may diverge radically from its fundamental value over a long period of time. In a situation of this kind, economists speak of a bubble.

Although the divergence may be large and often depends on psychological factors, the market price cannot depart from the fundamental value for an infinite length of time or by an infinite amount, but must ultimately readjust to it. This correction is typically very abrupt.

The reason is that once market participants have realised that a given category of assets is overvalued, a lot of them try to sell their securities simultaneously. This results in a crash.

Sometimes demands are made for monetary policy to try and actively combat scenarios of this kind. Although this sounds good in theory, it is hard to put into practice. This is because it is not possible to be certain whether price rises in given assets are actually a speculative bubble until the bubble has burst because of the uncertainties with respect to the fundamental value, as outlined above.

And even if a speculative bubble can be recognised as such in advance, it is unclear how monetary policy should react. It would require a massive intervention by the central bank (by means of a substantial increase in its key rates) to burst the bubble. However, this would have a very negative impact on the real economy (an extremely sharp downturn). Consequently, there is a substantial danger that such a policy would do more damage than good.

Thus, monetary policy is not really in a position to combat speculative bubbles. However, it can help to increase the resilience of the financial system so that the results of burst speculative bubbles are less serious. More on this in one of the next blog articles.

On behalf of the iconomix team

Ronald Indergand