In essence, the bubble problem is tied to borrowing, that is, to put it [more or less] in the words of a character in the movie Popeye, “If you lend me money for a hamburger today, I’ll pay you back on Monday”. Presumably, there would be an extra charge for taking the risk, called interest. A ‘bubble’ appears when too much is lent in an unrealistic expectation that the borrower has the ability to pay all or an instalment on his or her loans.
Now, if the lender were a bank, it would have a certain amount of cash on hand (reserves) that it would not lend out, but not always. (There were 19th Century banks called ‘wildcat banks’, which had no capital, except possibly some fake gold or dummy share certificates, but sold shares in their wildcat to gullible investors and then would ‘slink like wildcats’ back into the frontier forest with their fraudulent gains.)
But, let’s get back to the honest ones. A bank makes money by lending its capital out to people who need money to meet a personal objective, like owning a house. but who do not have the necessary cash to make the purchase or investment.
Now, lending money at ‘no interest’ is no way to run a bank. The lender makes no profit and eventually there will be people, honest or not, who cannot pay the loan back. They default. With no interest charged, the default would mean that the capital in the bank is lessened by the default amount. Sooner or later, there would be no capital and the bank would close.
A more sensible way of banking is to charge interest on the loan. The word ‘Interest’ means the charge, which is defined as a percentage of the amount borrowed that the borrower must pay to the lender over an agreed- upon time period. When paid, the bank would have more capital and presumably could pay its employees’ salaries and shareholders without using up all its capital. The bank would make a profit and its business would continue.
In order to minimize possible losses, bankers try to estimate the risk that a borrower might not be able to pay back a loan. The interest rate might be adjusted depending on how likely it is that the loan would not be paid back. A farmer might want to borrow money to buy more land. He may already own land outright and so, the bank might take a promissory note tied to that property. If he can’t repay the loan, the property would go to the bank. Banks make their money by getting their loans paid back
Now, suppose we have had a long period of prosperity and the banks have been lending a lot of money to people who want to buy shares in companies. The borrower may put up some shares he or she already owns and the banker will likely value them at some discount, since their value may fluctuate over time. Were the company to lose money one quarter, then the value of the shares could decline and the borrower might be required to put up more capital to cover the loan. One alternative would be to turn over some property deeds to the lender as ‘security, that is, the loan would be paid back or, in the case of default, the lender could take possession of the security and sell it to cover the debt. What if the borrower could not cover the difference between the early share price and the price after the drop? Then the bank could seize the shares and sell them for what it could get for them’ losing some money.
Now, let’s get complicated. Suppose the bank sees the stock market as a place to make money itself. It could own shares in companies and take profits from the dividends the companies pay. Or it could play the stock market itself and get the profits (capital gains) by trading shares directly. Nice, as long as, like Lucy in the ‘Peanuts’ cartoons, the value of the shares goes up and up, especially when everyone is doing it, so why not the bankers? They’re only humans like us. Added to that is that banks don’t just lend out the value of the capital they have on hand. They lend out (print money if you will) at multiples of what they have in hand. They may even lend out money placed on deposit by savers and others.
Generally, bankers see a loan portfolio of, say, 8 or 9 times the value of their assets (their cash plus the value of the cash deposited with them by others). they are leveraging their assets. This lending out to asset ratio is very important. Suppose a bank has a ratio of 10, let’s say. It has lent out 10 times all the money it controls. So, were one-tenth by value of all the owners of the assets were to ask to take their money out, for any reason, called a ‘run’ on the bank, it may not be able to repay everybody and it will collapse—go bankrupt.
Of course, other banks will look to see who has been hurt by bank 1 and Bank2 will look at its ‘book’ of loans and start to call them in (a ’run’ on the borrower?) and the mess cascades into a recession or depression, with foreclosures and bankruptcies all over the place and lots of very angry depositors. Yes, it is a big confidence game, but, without it, we’d all be in igloos and small tents.
Let’s back up a bit and look at the housing bubble and associated Crash of 2007-8. There were banks and other financial houses leveraged, not at 8 or 9, but at 15 or 20, all keen to get into the cheap mortgage business and not too fussy about how good of risks the borrowers are. Do the ratio. If a bank has a ratio of 10, then that means if 10% of the loans go bad, the bank is insolvent, a nice word for bankrupt. If the ratio is 20, then all the damage has to be is but 5% of assets and the bank is insolvent. At 15, only 6.5% will bring a bank down. Then, because the various banks’ assets are all intertwined, one default may drag the others down, just like drowning swimmers.
Looking back further, the Great Depression was caused in major part by a ‘normal’ recession/default that was intensified when the lenders called in their loans and went to seize farm assets, only to find that the asset base, the farmland and associated buildings, were rendered valueless because of continuous drought across the Great Plains, the Dust Bowl; leaving the land valueless for growing crops .Everybody; farmers, bankers, manufacturers and governments went broke. This condition of no one having few or any assets to sell or trade lasted for years.
A variation on this theme, though on a reduced scale, went on with the ‘popping’ of the housing speculative ‘bubble’ in the mid 1980s, when cheap mortgages (loans for buying houses) led to the government raising the price of money (interest rates) until borrowers could not afford to meet loan costs. Of course, all those people lost their investments, leaving the debt hyenas to pick over cheap assets and hold them until good times returned, along with a new crowd of buyers.
Today we have a smaller financial problem in the digital currency market, where digital assets produced by computer-produced ‘coins’ have had a multi-year run making and selling bitcoins and the like until the government raised the cost of money and digital currency started to meet the fate of other bubbles, Fortunately, this bubble looks more like one in fine art pricing than a large-scale economic threat.
That is, until a new cycle comes around.