Understanding How Debt-Driven Bubbles Develop in the Economy

By Sean Masaki Flynn

There is always discussion of bubbles and how they develop in the economy. Bubbles typically have a significant impact on the economy and economists often discuss the causal factors and outcomes of these events. Debt contracts, such as bonds and mortgages, are promises to repay particular amounts of money. When negotiating such contracts, lenders normally believe that those to whom they’re lending will be able to repay — or else lenders wouldn’t extend the loans. On the flip side, borrowers typically believe that they’ll be able to repay — or else they wouldn’t take out those loans.

However, a circular, self-reinforcing process can develop in the economy between the total amount of borrowing and the anticipated ability of borrowers to repay their loans. These situations drive asset-price bubbles, in which speculative purchases financed with borrowed money drive the price of an asset (such as real estate) upward.

As long as the bubble continues to expand and prices continue to rise, nearly every loan gets paid off — leading both borrowers and lenders to erroneously conclude that lending and borrowing are very safe. That drives the demand for even more borrowing and lending, further inflating the bubble. This continues until the bubble finally pops and prices collapse. Here, you examine the details on how bubbles get started and expand.

Embracing borrowing in a booming economy

During the periods preceding financial crises, the expectations of both lenders and borrowers tend to be overly optimistic, usually because the economy has enjoyed a period of sustained growth in output and living standards. With the demand for goods and services high, jobs are plentiful and wages tend to grow strongly. Thus, both borrowers and lenders come to believe that the financial prospects of borrowers are very strong — and therefore that to borrow or lend successively larger amounts of money at successively lower interest rates wouldn’t be overly risky.

The problem is that the lending and borrowing facilitated by the initial optimism can quickly become self-justifying, because when people spend borrowed money, that money stimulates the economy even more and causes an even higher level of optimism that justifies making even more loans.

Firms use the loans to expand factories, and individuals use borrowed money to purchase houses, cars, and durable goods. All this economic activity makes it easy for both borrowers and lenders to conclude that the boom will go on indefinitely and that paying back loans will always be easy for borrowers.

Offering larger loans as collateral values rise

The sharp increase in lending and borrowing that precedes a financial crisis is exacerbated by the fact that lending can drive up the value of the assets (such as real estate) that are used as collateral for loans. Collateral is property that a borrower pledges to a lender as security for a loan. People refer to the collateral as security because if the borrower fails to repay the loan, the lender receives the collateral. Thus, the collateral provides some financial security (safety) for the lender.

For instance, when a home buyer takes out a mortgage, the contract with the bank from which she’s borrowing specifies that the house itself serves as collateral for the mortgage loan. Thus, if the borrower defaults on the loan, the home will become the property of the bank, which can then sell the home at auction to raise money to pay off the defaulted loan.

Having houses serve as their own collateral helps fuel housing bubbles. Because rising home prices imply rising collateral values, banks feel comfortable lending successively larger amounts of money for home mortgage loans. But as loans become easier to obtain, more buyers take out loans, increase the demand for houses, and drive up home prices.

People then get into a self-reinforcing process as increased lending leads to higher demand, which leads to higher prices, which leads to increased lending because higher prices imply higher collateral values. This sort of process drove the real estate bubble in Japan during the late 1980s as well as the real estate bubbles in the United States, Ireland, and Spain from 2000 to 2006.

Relaxing lending standards in the economy

Beyond increasing collateral values, rising prices also cause lenders to become lax about their lending standards in an additional way. During normal times, lenders verify that borrowers can pay off their loans with their labor income. If you have a low labor income, then you normally aren’t allowed to borrow very much money because you won’t be able to afford large monthly loan payments.

This logic gets shunted aside during periods of rapidly rising real-estate prices. In fact, banks become increasingly willing to lend large amounts to anybody, including people with very low incomes, because rising real estate prices imply that borrowers should always be able to sell their houses for more than they paid for them.

For example, consider how willing a bank will be to give even a poor person a loan of $200,000 to purchase a house if the price of the house is expected to rise to $225,000 over the course of the next year. With the market price of the house expected to rise by $25,000, the bank will assume that the chance that the borrower will default on the loan is virtually zero because he’ll always be able to sell the house for more money than he borrowed. Thus, in situations where home prices are expected to keep on rising, banks become willing to lend even to those with low incomes.

Borrowing more in hopes of economic profit

The willingness of banks to lend when home prices are expected to rise is matched by borrowers’ desire to take out loans in attempts to profit from the rising real estate prices. For instance, if home prices are expected to rise from $200,000 to $225,000 over the next year, potential borrowers will assume that they can easily repay a $200,000 mortgage loan by selling the house the next year for $225,000. In fact, they’ll expect to come out almost $25,000 ahead on the deal, even after accounting for accumulated interest on the loan.

The risk is that the house prices won’t rise by as much as expected and may even fall, but during a housing-price bubble, many people become so convinced that home prices will rise that they feel that they’re not really taking on any risk when they borrow money to purchase real estate.

Indeed, because the potential $25,000 gain looks like free money, many millions of people are tempted to take out loans to purchase houses that they’d otherwise have no reason to care about. Their goal isn’t to live in those houses or to rent them out to tenants but rather to use borrowed money to “buy low and sell high,” hoping to profit if home prices continue to rise.

Watching the process gain momentum in the economy

Both borrowers and lenders are willing to participate in a real estate bubble. The lenders think that rising real estate prices almost certainly guarantee that loans will be repaid, and borrowers think that rising real estate prices almost certainly guarantee that buyers can make money for nothing.

As soon as that process gains momentum, it can become temporarily self-sustaining. Lots of borrowed money drives up real estate prices, causing even more people to think that price increases will be sustained, which tempts both borrowers and lenders to increased borrowing and lending — thereby driving even further price increases. Sadly, though, there’s no such thing as a party that never ends — or a party for which nobody has to pick up the tab.