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We Told You So

By: Mark Thornton

-- Posted Sunday, 25 March 2007 | Digg This ArticleDigg It!

This article was excerpted from a chapter in a forthcoming book, “The Economics of Housing Bubbles,” in America’s Housing Crisis: A Case of Government Failure, edited by Benjamin Powell and Randall Holcombe.

There are three basic views of bubbles that are held by economists. The dominant view among modern mainstream economists, including the Chicago school and proponents of Supply-Side economics, is to deny the existence of bubbles and to declare that what is thought to be “bubbles” is really the result of “real” factors. The second view, which is espoused by Keynesians and by proponents of Behavioral Finance, is that bubbles exist because of psychological factors such as those captured by the phrase “irrational exuberance.” The third view is that of the Austrian school, which sees bubbles as consisting of real and psychological changes that are caused by the Fed. This view has the advantages of being able to identify the economic cause of bubbles and directs us to policy choices that would prevent future bubbles. 

Until very recently, most people agreed with the majority of economists, that there is no such thing as a housing bubble – housing prices, they said, “never go down.” Although there is much diversity in the mainstream camp, it is well illustrated by two economists from the Federal Reserve Bank of New York who recently examined concerns about the existence of a speculative bubble in the U.S. housing market. While McCarty and Peach did find that a housing bubble could have a severe impact on the economy – if it existed and were to burst – they ultimately concluded that such fears were unfounded:

Our main conclusion is that the most widely cited evidence of a bubble is not persuasive because it fails to account for developments in the housing market over the past decade. In particular, significant declines in nominal mortgage interest rates and demographic forces have supported housing demand, home construction, and home values during this period. (2004, 2)

Furthermore they found “no basis for concern” for any severe drop in housing prices. In the past when the U.S. goes into recession or has experienced periods of high nominal interest rates, they found that any price declines have been “moderate” and that significant declines can only happen regionally so that they would not have “devastating effects on the national economy.”

This is essentially the view of Alan Greenspan the former chairman of the Fed and Ben Bernanke the current Chairman. In particular, Greenspan was aware of the possibility of a housing bubble, but he offered many reasons to suggest that it did not exist, and that if one did exist it would not be a major problem. The Chairman is usually so incomprehensible and misleading that I have labeled his testimony before Congress as “Greenspam” (Thornton 2004a). However, on the topic of the housing bubble he was clear and direct and worth quoting at length. 

The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually – scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the "national" housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole. (2002)

As the bubble was reaching its peak, Greenspan (2005) did admit that there was some “apparent froth” in some local housing markets, but overall he found that conditions in the housing market were actually “encouraging.” Incredibly, in his first speech after leaving office Greenspan said that the “extraordinary boom” in the housing market was over, but that there was no danger and that home prices would not decrease (Bruno 2006). The new Fed chairman, Ben Bernanke (2006b), has admitted to the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates. Bernanke also believed that the mortgage market is more stable than in the past and noted in particular that:

Our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved. (2006a)

Apparently he overlooked the then booming sub-prime market.

A second view of housing bubbles and bubbles in general is that they do exist, but that they are fundamentally caused by psychological factors. Many people and many important economists subscribe to this view of bubbles, including Keynesian economists and proponents of Behavioral Finance, such as Robert Shiller. From this perspective the business cycle is seen as the ebb and flow of mass consciousness and emotions. Real factors may play a role, but the important causal factors for deviations in the business cycle are psychological. Booms develop because people become confident and then overconfident in the economy. Investors likewise are confident and increase their tolerance for taking risk. Rising profits and asset prices lead to “speculative” behavior where economic decisions are no longer based on old rules and procedures, but on the bravery instilled by a “new era.” As the investment mania sets in the bubble expands. Then, for whatever reason, people begin to lose faith and new investments are exposed as disappointing. Economic reports and statistics turn sour, and stories of scandal begin to appear in the press. Many investors remain determined that this turn of events is only temporary, but results grow worse, prices continue to fall, and investment projects are postponed, halted or cancelled. The mood of the market is one of gloom or even doom. The economy enters a depression. This psychological camp did predict the housing bubble but their “solution” is to call for a mass array of government programs, regulations, and bailouts – as if the government isn’t already intimately involved in every aspect of housing.

The third view holds that there are changes in both real factors and market psychology during bubbles and that both are driven by the cause of the business cycle – the Fed. This view of bubbles is based on the Austrian business cycle theory (hereafter ABC theory). This is a minority view held by Austrian school economists. According to the ABC theory, if the Fed does follow a loose monetary policy, then a bubble can develop somewhere in the economy, whether it be in tulip bulbs, stocks, or real estate. If the new money is directed toward housing, a bubble will develop in housing. Austrian economists further emphasize that the additional resources allocated to housing are resources that are not available elsewhere in an economy, so that while more resources than normal are allocated to housing construction, fewer resources are available to other areas of the economy such as manufacturing, which will experience higher costs for its inputs such as labor and materials and will produce a proportionately smaller output. It is this mismatching of resources across industries and sectors that has to be resolved – painfully – in the inevitable bust or correction.

Among the Austrians who identified the housing bubble is economist Frank Shostak who defined a bubble as any activity that “springs up” from loose monetary policies. “In other words, in the absence of monetary pumping these activities would not emerge.” As a result of this pumping, a misallocation of resources develops whereby non-productive activities increase relative to productive activities – something that seems to clearly characterize the U.S. economy since he wrote in early 2003:

The magnitude of the housing price bubble is depicted…in terms of the median price of new houses in relation to the historical trend between 1963 and 1979. In this regard the median price stood at 73% above the trend in December 2002. (2003)

A year later Shostak (2004) warned that there “is a strong likelihood that the U.S. housing market bubble has already reached dangerous dimensions.” While early warnings can be a problem for investors in home-building stocks, the problems of predicting the timing and magnitude of bubbles and business cycles affects all forecasters, and Shostak’s warning was primarily for the purpose of judging public policy. In effect he was noting that policymakers have made a mistake that they should correct immediately and not make the situation in the housing market any worse.

Also from the Austrian camp is banker Christopher Meyer, who noted that there is always a bubble in the making in a world of fractional reserve banking and fiat currency, and that housing has often been impacted by bubble conditions in the U.S. and elsewhere. In the summer of 2003 he identified the current housing bubble:

The strong housing market has all the makings of being the next bubble – in particular high leverage and unsustainable price increases. While the larger economy seems to sputter along, the housing market continues to run a hot race. Low interest rates have propelled refinancing, freeing up $100 billion last year alone, according to the Wall Street Journal. Not surprisingly, the low interest rates have increased buying power and supported housing prices. (2003)

Another Austro-banker with his finger on the housing bubble problem was Doug French who also identified the bubble in mid-2003.

Home sales are what fuel this land grab. And, with Alan Greenspan’s foot tromped on the monetary accelerator, low mortgage rates are allowing more people to buy bigger houses. In April, the median price of a new home in Las Vegas rose to just an eyelash below $200,000, a doubling in less than 14 years.

In early 2004 I pointed to the on-going housing bubble to investors and warned that it might not be a good idea to increase your mortgage: “it might not be a good time for you to obtain a home equity loan to invest in hot tech stocks. We are going through a housing bubble” (2004b). I followed this up later that year with a more detailed examination of the housing bubble and found:

Signs of a "new era" in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, "extract equity" to increase their spending, and lower their monthly payment! As one loan officer explained to me: "It's almost too good to be true." In fact, it is too good to be true. (2004c)

The historical fact is that the housing market and the construction of structures has experienced cycles of boom and bust, with prices rising and falling for residential, commercial, industrial, and agricultural real estate. Likewise, occupancy and lease rates, new construction, and the fate of construction firms and land speculators point us to the history of real estate bubbles.

According to the ABC theory, when a central bank makes loans or purchases government bonds from banks it is injecting bank reserves into the economy. Banks now have excess reserves which they can loan, but the existence of excess loanable funds means that banks must reduce the interest rate they charge, reduce the credit quality requirements of borrowers, or both. The result is a greater quantity of borrowing and investing. Lower interest rates also discourage savings because the return from savings is lower. In this manner the Federal Reserve drives the market rate of interest below the natural rate of interest that would have existed in the absence of Federal Reserve intervention.

The graph below depicts the history of the Federal Funds rate, which is the rate that banks can borrow from other banks in order to meet their reserve requirements imposed by the Fed. The Fed “targets” this short-term rate and injects reserves into this market by purchasing government bonds from banks, thereby freeing up reserves in the banking system. This essentially is the engine of inflation because the Fed simply makes a bookkeeping entry in the bank’s account with the Federal Reserve – modern inflation is essentially an electronic bookkeeping entry system. Under Greenspan the rate was reduced from 6.5% in November of 2000 to 1% in July of 2003. The Federal Funds rate remained at 1% until June of 2004, coinciding with the launching of the final phase of the housing bubble. At this low level, interest rates were actually negative when price inflation is taken into account.

When banks have access to bank reserves from the Fed at low rates they can offer their customers lower rates on loans. The graph below shows the impact of changes in the Federal Funds rate on mortgage rates; increasing during the 1970s and peaking during Volcker’s war on inflation at 18%, and then generally declining throughout the 1980s and 1990s and reaching historical lows during the early 2000s. During the housing bubble interest rates on 30-year conventional mortgages were at their lowest levels ever during the post-gold standard era. When interest rates fall, asset prices and real estate prices tend to rise, and vice versa.

Naturally, lower rates for home mortgages stimulated borrowing for real estate purposes. The chart below shows that the amount of real estate loans at commercial banks first exceeded $1 trillion in November 1994 and then in quick succession exceeded $2 trillion in November of 2002 and $3 trillion in May of 2006. In addition to the Fed, there are other factors that helped direct all this new credit money into real estate. First, in 1997 homeowners were given a $250,000 exemption ($500,000 for couples) for capital gains that resulted from the sale of their house, adding greatly to the tax benefits of home ownership. This tax break could be said to have lit the fuse of the housing bubble. Second, government-sponsored credit corporations such as Fannie Mae and Freddie Mac, who can acquire capital at a subsidized rate because of the implicit assumption that the Federal government will bail them out, began to collateralize home mortgage debt on a grand scale so that lenders could quickly and easily resell the loans they make. These government-sponsored agencies have helped stimulate the flow of credit to riskier borrowers who might not otherwise have access to credit, and have therefore helped to lower the credit standards of lending institutions. The problem with these institutions is so large that even Alan Greenspan has publicly scolded them (Hays 2005). In truth, the original problem lies with Alan, not so much Fannie or Freddie.

The artificially low rates generated by the Fed also have the effect of discouraging people from saving money and encourages them to borrow more for consumption and speculation. The impact of monetary pumping by the Fed has driven down the personal savings rate (as depicted on the graph below) down throughout the 1980s and 1990s, and during the early 2000s it has driven the rate to zero – and even below – which means that on average people are spending more than they earn. Contributing to the problem of the low personal savings rate are the artificially inflated asset and real estate prices which naturally make people feel wealthier and allow them to “cash out” equity from their homes when they refinance their home mortgages. During the housing bubble many Americans have used their homes as a kind of giant ATM to withdraw cash from the equity in their homes. Others have used the “magic checkbook” from second mortgages to spend the equity they have in their homes (Lloyd 2006).

At this point one should be wondering – how can borrowing be going up and savings going down? One answer to the question is that America is borrowing money from overseas in the form of the trade deficit, but the main answer is monetary pumping by the Fed. By artificially lowering rates via increases in the money supply the Fed has created a giant gap between borrowing and saving. In the graph below, the U.S. money supply is given from 1959 to 2006 as measured by MZM (money of zero maturity).1 During the period from January 1959 to August 1971 (11.7 years), when Nixon took the U.S. off the gold standard, the money supply grew by 82.2% for an average annual growth rate of 5.26%. Between August of 1971 and 1984 (complete monetary decontrol) (13 years), the money supply increased by 180.4% for an average annual growth rate of 8.25%. Since 1984 (16.6 years), MZM has grown by 390.1%, or an average annual growth rate of 10%. It would seem that all this new money first went into the New York Stock Exchange, then the NASDAQ stock market during the late 1990s, and finally into the housing market since the bust in 2000.

Since the recession of 2001 the increase in mortgage debt is about equal to the increase in MZM. This one stylized fact probably best illustrates the housing bubble and its cause. Another measure of the housing bubble is the amount of real private residential fixed investment as presented in the graph below. Investment in housing was low during the Great Depression and WWII, but beginning in the mid-1940s investment in housing (adjusted for price inflation) has shown a positive trend, which is based on economic and population growth over that same period. Superimposed on the graph are upper and lower channel lines based on the period from the 1940s to the mid-1990s. This channel allows us to illustrate the normal booms and busts that occurred in the housing market. A dot-and-dash trend line is drawn over the basic trend in housing investment. This shows us that the cycle in housing investment was less severe before we went off the gold standard, more severe on the fiat standard, and even more severe after monetary deregulation in the early 1980s. Most noteworthy is that investment in housing hit a boom high during the bubble of the late 1990s and then “jumped the tracks” during the recession of 2001, when historically it would have retreated back toward recessionary levels. It therefore seems clear that in terms of investment value there has been a housing bubble since at least the recession of 2001. The bubble could also be seen in statistics on housing starts and housing prices.

The policy lesson of the housing bubble, as provided by the ABC theory, is that the Fed is responsible for the housing bubble as well as the normal booms and busts in the economy, and that as long as it retains its authority to set what are in effect price controls on interests rates, such bubbles will periodically appear in the economy. Instead, policy toward housing should be guided by the principles neutrality, laissez faire, and do no harm.2


Bernanke, Ben S. 2006a. Speech to the Independent Community Bankers of America National Convention and Techworld, Las Vegas, Nevada, March 8.

Bernanke, Ben S. 2006b. Reflections on the Yield Curve and Monetary Policy.

Remarks before the Economic Club of New York, March 20.

Bruno, Joe B. 2006. Former Fed Chair Says Housing Boom Over. Associated Press, May 19.

Cochran, John P. 2004. Capital, Monetary Calculation, and the Trade Cycle: The Importance of Sound Money. Quarterly Journal of Austrian Economics. 7 (spring): 17–25.

French, Douglas. 2003. “The Land-Price Bubble,”, June 10.

Greenspan, Alan. 2002. Monetary Policy and the Economic Outlook. Testimony before the Joint Economic Committee of the U.S. Congress, April 17.

Greenspan, Alan. 2005. Mortgage Banking. Speech to the American Bankers Association Annual Convention, Palm Desert, California (via satellite), September 26.

Hays, Kathleen. 2005. Greenspan steps up criticism of Fannie: Fed chief says company and Freddie Mac have exploited their relationship with the Treasury., May 19.

Herbener, Jeffrey M. 2002. After the Age of Inflation: Austrian Proposals for Monetary Reform. Quarterly Journal of Austrian Economics. 5 (winter): 5–19.

Lloyd, Carol. 2006. Home Sweet Cash Cow: How our houses are financing our lives., March 10.

McCarthy, Jonathan and Richard W. Peach. 2004. Are Home Prices the Next “Bubble”? FRBNY Economic Policy Review (December): 1–17.

Meyer, Christopher. 2003. The Housing Bubble. The Free Market (August).

Shostak, Frank. 2003. Housing Bubble: Myth or Reality? Mises Daily Article (on line), March 04.

Shostak, Frank. 2004. Who Made the Fannie and Freddie Threat? Mises Daily Article (on line), March 05.

Thornton, Mark. 2004a. Greenspam., February 16.

Thornton, Mark. 2004b. Bull Market?, February 9.

Thornton, Mark. 2004c. Housing: Too Good to be True. Mises Daily Article (on line), June 04.


  1. MZM is a relatively new measure of the money supply and one that is close to the Austrian school definition of money, where "money" is immediately redeemable at par. MZM includes currency, demand deposits (checking accounts), traveler’s checks, savings deposits, and deposits in money market mutual funds.
  2. For recent statements concerning Austrian recommendations for reform regarding the money and the business cycles see Herbener (2002) and Cochran (2004).

March 24, 2007

Mark Thornton [send him mail] is an economist who lives in Auburn, Alabama. He is author of The Economics of Prohibition, is a senior fellow with the Ludwig von Mises Institute, and is the Book Review Editor for the Quarterly Journal of Austrian Economics. He is co-author of Tariffs, Blockades, and Inflation: The Economics of the Civil War and is the editor of The Quotable Mises.

Copyright © 2007

-- Posted Sunday, 25 March 2007 | Digg This Article

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