A financial bubble often arises in the stock or real estate market. Buying shares or real estate on credit benefits the buyer from the rising price. At the same time, it creates additional demand. This creates a rising price that makes the credit purchase itself profitable. The movement often accelerates toward the end of the bubble, which eventually bursts.
An example illustrates the process: someone has $100,000 in their bank account and wants to buy a house that costs $200,000. Now the buyer goes to the bank, takes out a loan of $100,000, and buys the house.
The balance sheet of both parties is as follows: The buyer owns the house for $200,000 and owes over $100,000. His net worth is still $100,000. The seller now has $200,000 in the account, and the combined assets of both parties are still $300,000.
When aggregate demand increases
So much for the static consideration of the individual case. However, in a bubble, there is not one but many instances of leveraged real estate purchases. The loan financing made the purchase in the above example possible in the first place because without it, it would not have happened.
Credit financing itself has thus created demand. Assuming many such purchases, the price increases according to the law of supply and demand. Credit-financed purchases, therefore, cause the price level to rise.
So when many people in an area take out loans and buy houses, the prices of the objects go up. They do this without anything having changed in reality. Credit financing is the only reason for the price increase.
How a financial bubble develops
How is the price increase affecting the balance sheet? The house’s value may increase from around $200,000 to $300,000 due to the many loan-financed purchases. After deducting the debt, the buyer now has assets of $200,000, and the seller still has $200,000 in his account.
The total assets of both parties involved are no longer $300,000, but $400,000. The additional purchases, made possible by additional loans, ensure an increase in assets of $100,000 for the property buyer, without anything real being produced. This phenomenon is called blistering.
In a bubble, market forces no longer apply
In a credit-financed bubble, numerous credit-financed purchases increase the assets of those involved without creating anything else.
In bubbles, credit-financed purchases raise the price level and thus simulate an increase in wealth that only exists on the books but not in reality. In doing so, they override the timely regulatory forces of the market.
A market cannot be efficient if mere accounting operations have the same effect as actual production activities. The leveraged buy that makes itself profitable only works until the bubble bursts.
The harsh awakening comes later
The failure of the market to be efficient by feigning a profit makes credit-driven bubbles belatedly corrected, as was evident in the financial market crisis of 2008 when the real estate bubble burst in the USA. Many market participants who had previously benefited from the boom lost their profits again.
So, credit-fueled bubbles create wealth on the books. As they emerge, there are only winners among all those involved. As a rule, the necessary consequences are only drawn when a bubble has burst. This is usually followed by recessions, crises, or even an economic collapse.
Consequences for investors
Only the state can prevent a financial bubble through monetary and credit policy measures. But states often allow bubbles to form because they collect more taxes during the boom and the voters are happy.
Individuals can only protect themselves from the economic consequences of a bubble bursting by examining carefully when and at what prices they are buying a property. This is also recommended when the price level is solid, but investors should be careful when the market is overheating.