Why Small Booms Cause Big Busts?

Prof J Bradford Delong says this is because of credit cycle. If credit is behind the boom then even a small boom will lead to a big bust..

As bubbles go, it was not a very big one. From 2002 to 2006, the share of the American economy devoted to residential construction rose by 1.2 percentage points of GDP above its previous trend value, before plunging as the United States entered the greatest economic crisis in nearly a century. According to my rough calculations, the excess investment in the housing sector during this period totaled some $500 billion – by any measure a tiny fraction of the world economy at the time of the crash.
The resulting damage, however, has been enormous. The economies of Europe and North America are roughly 6% smaller than we would have expected them to be had there been no crisis. In other words, a relatively small amount of overinvestment is responsible for some $1.8 trillion in lost production every year. Given that the gap shows no signs of closing, and accounting for expected growth rates and equity returns, I estimate that the total loss to production will eventually reach nearly $3 quadrillion. For each dollar of overinvestment in the housing market, the world economy will have suffered $6,000 in losses. How can this be?

It is important to note that not all recessions cause so much pain. Financial blows in 1987, 1991, 1997, 1998, and 2001 (when some $4 trillion of excess investment was lost when the dot-com bubble burst) had little impact on the broader real economy. The reason why things were different this time can be found in a recently published paper by Òscar Jordà, Moritz Schularick, and Alan M. Taylor. Large credit booms, the authors show, can greatly worsen the damage caused by the collapse of an asset bubble.
Historically, when a recession is caused by the collapse of an asset bubble that was not fueled by a credit boom, the economy is roughly 1-1.5% below what it otherwise would have been five years after the start of the downturn. When a credit boom is involved, however, the damage is significantly greater. When the bubble is in equity prices, the economy performs 4% below par, on average, after five years – and as much as 9% below par when the bubble is in the housing market. Given these findings, it is clear that the distress experienced since the beginning of the economic crisis is not far out of line with historical experience.

He quotes Keynes:

For many economists, recessions are an inevitable part of the business cycle – the bust that necessarily follows, like a hangover, from any boom. John Maynard Keynes, however, had little time for this view. “It seems an extraordinary imbecility that this wonderful outburst of productive energy should be the prelude to impoverishment and depression,” Keynes wrote in 1931, after the boom years of the 1920s had given way to the Great Depression. “I find the explanation of the current business losses, of the reduction in output, and of the unemployment which necessarily ensues on this not in the high level of investment which was proceeding up to the spring of 1929, but in the subsequent cessation of this investment.”

A few years later, Keynes proposed a fix to the problem. In The General Theory of Employment, Interest, and Money, Keynes explained how booms are created when “investments which will in fact yield, say, 2% in conditions of full employment are made in the expectation of a yield of, say, 6% and are valued accordingly.” In a recession, the problem is flipped. Investments that would yield 2% are “expected to yield less than nothing.”

The result is a self-fulfilling prophecy, in which widespread unemployment does indeed drive the returns of those investments below zero. “We reach a condition where there is a shortage of houses,” Keynes wrote, “but where nevertheless no one can afford to live in the houses that there are.”

His solution was simple: “The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semi-slump; but in abolishing slumps and thus keeping us permanently in a quasi-boom.” For Keynes, the underlying problem was a failure of the economy’s credit channels. The financial reaction to the collapse of a bubble and the resulting wave of bankruptcies drives the natural rate of interest below zero, even though there are still many ways to put people productively to work.

Amazing writing. These guys could write so well as they were exposed to all kinds of writing from philosophy to literature to history. Today’s econ training has limited itself to writing just abstract models. Such a pity..

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