Here is a question and answer from the financial sector topic | A-level Economics syllabus.
Explain how a housing market bubble works, and explain why it may be bad for an economy.
A housing market bubble occurs when there is an inflated and unsustainable price level in the housing market; the increase in asset prices attracts even more buyers/investors to the housing market, which inflates the bubble further.
The increase in prices is caused by speculative demand, because people think prices may go up further in the future. Keynes referred to a case of “animal spirits” whereby people in the economy act based on impulse or animal instinct, rather than logic.
When many people do this, house prices tend to increase beyond their true value, and this can be devastating to an economy. At some point, the bubble cannot inflate any further, which means the inflation of asset prices starts to decrease. This destroys confidence in the market, and what follows tends to be a mass sell-off of assets: this results in radically lower asset prices.
While a few lucky or well-informed people may make financial gains, the majority of those in the market end up making losses. This is because the price decrease often comes very suddenly, and the bad news in the market convert people from buyers into sellers. This means many properties may get listed for sale, but new buyers become sceptical and instead wait for prices to crash.
Asset bubbles lead to instability within an economy, because there are many agents who affect one another. One example of this is the sub-prime mortgage crisis of 2008; after years of steady house inflation, house prices suddenly took a turn for the worse. Many people found the value of their properties were less than the value of their mortgage loans: this led to record levels of defaults. This then led to a credit crisis within the banking industry, as man sub-prime borrowers had all defaulted on their mortgages at once, creating an absence of liquidity. Many banks were unable to run as normal, because they had much of their balance sheet tied up in illiquid assets (such as bad loans and bricks and mortar which nobody no longer wanted to buy).
The major reason why the housing market crash was so devastating was because people financed the purchase of their houses with mortgages (which they got from banks). The subsequent crash of a few banks led to a worldwide systemic failure, because banks lie at the centre of a nation’s economy. Depositors rely on banks to be stable and to safely hold onto their cash, so any bad news about the banking system creates an innate fear throughout the economy (another reference to Keynes’ animal spirits). This then led to a huge drop in consumer/business confidence levels, which led to decreases in spending. In some instances, it also led to bank runs, where people endlessly queued to withdraw their deposits (an example is the Northern Rock bank). What followed was a major economic recession, which took years to recover from.
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Suggested Reading:
Learn about the financial sector. Understand and learn more about how the financial market failure. Learn more about systemic risk, market bubbles, externalities, asymmetric information and market rigging. Revise using Mr Banks's A-level economics revision pages at mrbanks.co.uk. Attend our A-level economics revision courses!