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IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
1
CITY UNIVERSITY OF LONDON
BSc International Political Economy
Module: IP2039 Advanced Principles of Economics Essay
Are bubbles always driven by irrationality?
Examining the main theories behind the housing
market crash of 2007.
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
2
The turn of the twenty-first century stunned the world by bursting one of the largest economic
bubbles that have ever been formed. The crisis seemed to erupt out of nowhere, with most
economic minds being left perplexed as to what was happening. Theoreticians and policy
makers around the globe had failed to predict the massive financial crisis that unleashed in
2007 and continued in the following years. The housing bubble disrupted the orthodox model
that was mainly based on the idea of rationality and on the underlying principle of self-
stabilising market forces. This research paper sets out to explore the concept of rationality in
regards to economic bubbles, while also looking into the main constituents of the housing
market crash. This essay will also attempt to outline the fundamental notions of mainstream
and heterodox economics, and make use of systemic cycles to provide a further insight into the
idea of finance capitalism.
Economic bubbles are phenomena that can easily demonstrate how feeble the human mind is.
These happenings occur when investors increase the demand for an asset to such an extent that
they cause a soar in the asset’s price beyond any rational reflection of its intrinsic value (Abreu
and Brunnermeier, 2003). Identical to soap bubbles children like to play with when they are
little, economic bubbles eventually burst, and when they do, they dissipate all the invested
capital into the wind.
These bubbles have been experienced in numerous cases throughout history, starting from the
Dutch Tulip fever in the sixteen hundred and continuing with the South Sea and Mississippi
mania dominating the following century, to more recent cases of speculation with the dot.com
bubble and the subprime mortgage phenomenon (Garber, 2000). Episodes of mass hysteria
have taken place periodically, but every time they are close to re-occurring, experts seem to
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
3
erase the past from their memories and think it will be different this time around (Blanchard,
1979).
The nineteen-eighties represented a turning point in the global financial system as globalisation
and deregulation ensued (Turner, 2008). The end of nineteen century witnessed various crisis,
from runs on banks to currency attacks and oil price shocks (Kindleberger, 1978). This period
also saw the ascension to power of several advocates of deregulation in the United States that
ultimately contributed to the various crises of the twenty-first century (Inside the Fed, 2011).
A basic assumption of theorists is that bubbles are inherently irrational (Godelier, 1973). These
bubbles seem to constitute in a deviation of prices from their real intrinsic values, a notion that
enters into direct contradiction with standard economic theory (Avery and Zemsky, 1996).
While bubbles are seen as irrational beasts that disrupt the economy, few attempt to understand
how they actually work. The Dutch Tulipmania was just one of the examples that showed us
how important it actually is to decipher the enigma and look behind the notion of irrationality
(Garber, 2000). During the housing market crash, animal spirits were roaming at large through
all levels of the economy. The general public relied on the constant assurances put forward by
politicians, financiers, policymakers and various pundits that appeared to know what they were
doing. People were continuously told that the economy had entered a new era of prosperity,
where real-estate prices would rise indefinitely and where the American Dream is only one
loan away (Avery and Zemsky, 1996). Evidently, such an era never existed, and the dream
promptly turned into a nightmare. The housing market crash ran away not only with many
people’s homes but also with all their entire life savings, their self-respect and most
dangerously, their trust in the system – the trust that is regarded as the main constituent of
modern society.
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
4
After the collapse of the dot.com bubble in the early twenty-first century, the Federal Reserve
took the unnatural decision to suppress interest rates at one per cent for an extended period of
time (Davies, 2010). The same years witnessed a global savings glut, as developing nations
across the world had accumulated vast financial reserves through commodity production and
were looking to invest their savings (Turner, 2008). This era coined as The Great Moderation
concurred with the housing boom in the United States economy (Bernanke, n.d.). This period
of low volatility and high returns for a variety of asset classes led to investors from the opposite
side of the planet willing to capitalise the US economy.
To this day, economists still widely disagree when attributing blame for the unusually low-
interest rates. On one hand, some consider the Federal Reserves decision to maintain short-
term rates low as one of the main triggers of excessive lending and borrowing. Defenders of
the Federal Reserve shift the liability to the savings glut that emerged in East and flooded
western economies by buying reliable treasury bonds and pulling down interest rates (Chance,
2012). Due to decreased interest rates, investors, banks and hedge funds pursued riskier assets
that could offer higher returns.
In the years preceding the crisis, irrationally exuberant financiers thought they had found the
ideal way to eliminate risk when in actual fact they had only lost track of it (Shiller, 2008).
Before the turn of the century, house loans in the United States were becoming increasingly
popular, they were a way of self-fulfilling the American Dream. Nonetheless, when the 2000s
arrived, the housing market had already reached saturation of credit-worthy borrowers, thus
lenders started offering mortgages to subprime people with inferior credit histories that had
little chances of ever paying them back (Shiller, 2008). These risky mortgages were then passed
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
5
on to financial innovators at large banks that were responsible for packaging them into safe
securities.
The mortgage-backed securities were ultimately used to create collateralised-debt-obligations,
which were then cut into tranches based on their degrees of default. Investors were tricked into
buying the safer tranches as these were awarded triple-A ratings by specialised biased agencies.
Pooling unrelated loans into one security was thought to disperse the risks associated with
default, as banks insisted that property markets in various American cities would increase and
decrease independently of each other. Financiers and large banks seemed to have found the
perfect solution at the time, for oversea investors that were looking for higher returns in a world
dominated by low-interest rates. This assumption proved to be wrong when the United States
began to experience a national house-price decline.
Nonetheless, in spite of the research done by financial historians and economists who had
studied the spectacle of bubbles beforehand, the vast majority of people at that time refused to
see the bubble for what it actually was. Each and every active player in all industries, from
bankers to economists and policy-makers were as unknowledgeable as the homebuyers
themselves.
The market bubble that was created in the early 2000s can also be analysed through two
theoretical frameworks, orthodox and heterodox. Orthodox economists follow the neoclassical
view that regards disruptions as mere exceptions to the rule and not as inherent flaws within
the system (Lavoie, 2011). In contrast, heterodox theorists validate Hyman Minsky’s vision of
the modern financial world. The analysis of the latter can be considered superior as it expands
on the work of John M. Keynes and regards the causes of economic crisis as endogenous to the
system (Minsky, 1986).
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
6
Rational choice is seen as a basic principle in orthodox economics (Lavoie, 2011). This idea
sees individuals as logical beings, always acting in their own self-interest as a way of
maximising their own utility. For orthodox economists, the average of these rational individual
decisions is thought to aggregate into what is referred to as a society. They are firm believers
that markets are the optimum way of organising society, as these are regarded to be stable
constructs that can always self-regulate and return to their natural state of equilibrium (Lavoie,
2011). In their view, the global financial crisis has been the outcome of various factors that
inhibited the self-equilibrating mechanism, such as irrational behaviour, state interference and
information asymmetries (Allen and Gale, 2007). In this view, the financial bubble was an
irrational anomaly and not an inherent flaw of capitalism.
Mainstream theoreticians see rationality as the logical pursuit of chosen goals, and anything
that falls outside of this orthodoxy is simply discarded as being irrational The idea is mainly
based on the assumption that financial agents hold the fullest information available at all times
and are not subjected to irrational behaviour or distractions brought by unconventional
preferences (Lavoie, 2011). Nonetheless, the financial crisis has proven that this view is flawed
and that market players are not always in complete knowledge of future trends.
Mainstream economists are also well versed in using statistical and mathematical models to
price factors such as risk and uncertainty. According to Eugene Fama, at any point in time, the
Efficient-Market Hypothesis can rightly price a security by closely estimating its intrinsic value
(Fama and Miller, 1972). Creating a price for risk is a highly dangerous activity and the globe
has witnessed this with the financial crisis when eminent financiers and economists relied on
David X. Li’s formula to quantify collateralised-debt obligations (Jones, 2009). David X. Li
was deemed as the world’s most influential actuary at the time, a remark that was swiftly taken
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
7
back in the aftermath of the crisis by the same Financial Times (Jones, 2009). Once again,
mainstream economists disregarded what they could not understand and only priced the little
slice they considered knowing, being conceited enough to regard their model as fully rational
and perfectly informed.
Another major concept of this school of thought sees no way around regulating inflation and
the supply of money. Orthodox economists deem the trade-off between inflation and
unemployment rates as necessary conditions of capitalism; the idea being mainly based on the
Phillips Curve model (Phillips, 1958). An instance that contradicted this assumption took place
during the mid-nineties when many mainstream practitioners could not explain the
phenomenon taking place around the world, that witnessed both a period of low inflation and
an unprecedently low level of unemployment (Fuhrer, 2009). This new age of capitalism, the
period of The Great Moderation, where prosperity was thought to be spreading around the
world and crisis were nowhere in sight did not last long, as the speculative bubbles started to
burst, first with the dot.com bubble and once more with the house market crash (Ofek and
Richardson, 2003).
The financial crash of the twenty-first century has demonstrated once more the inherent
imperfections of orthodox economics and its neoliberal economic policies. According to
Hyman Minsky (1986), the orthodox strand of economic thought can easily demonstrate that
markets will always lead to a coherent or optimal result only once they disembbed their model
from the very fabric of society. Orthodox economists are able to justify and defend many of
their ideas in theory, but they often fail to implement them in the real world due to the irrational
exceptions to their perfectly rational framework. The established economic theory thus
abstracts its mathematical quantifications out of time and historical space, transforming the
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
8
model into a static concept. This model disregards information asymmetries and does not deal
with elements such as time, money, uncertainty, financing of ownership of capital assets or
investment (Minsky, 1982).
The main heterodox position that brings a critique to these concepts is the Post-Keynesian
strand. In the nucleus of Post-Keynesian economics lies the idea that money is fabricated
endogenously by the private banking apparatus (Smith, Suchanek and Williams, 1988). One
can also find at the base the concept of effective demand and uncertainty, the idea that
quantitative easing and increases in budgetary deficits do not link directly to inflation, and that
financial markets are prone to periodic booms and busts (Dymski, 2009). In addition to the
Post-Keynesian thinking, behavioural finance theorists also assign the blame for these bubbles
to cognitive biases, where market players are subjected to herd behaviour and groupthink
(Baker and Nofsinger, 2010). For behaviourists, emotional prejudices appear to be at the core
of financial bubbles.
Encompassed in Arrighi’s The Long Twentieth Century (1994) lives the idea that systemic
cycles of capital accumulation have constantly re-occurred all throughout history. Arrighi
(1994) evaluates modern times by contrasting them with the longue durée - the economic,
cultural and social history of capitalism across centuries (Braudel, 1984). By virtue of his work,
Arrighi (1994) provides an insight into how societies and their institutions have reshaped
themselves across time, and how contemporary events are a constant re-occurrence of past
dynamics. The 2007 financial crisis can be regarded as a sign of autumn for the capitalist cycle,
as capitalism has reached the stage of financial expansion, where, according to Arrighi,
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
9
"[Every] capitalist development of this order seems, by reaching the stage of
financial expansion, to have in some sense announced its maturity: it [is] a sign of
autumn" (Braudel, 1984, p. 246; emphasis added).
The signs of autumn are indicative of the culmination to an S-cycle, at the end of which inter-
state conflicts and major crisis ensue (Mensch, 1979, p. 73). The world has witnessed a mini
episode of such a systemic shift with the emergence of the crisis, that caused a massive
disruption to the global economic system. The financial phenomenon of 2007 was just one of
the symptoms to the dawn of contemporary capitalism, that has lately disembedded itself from
the bottom layers of material life and has ventured to the top layers of the anti-market (Braudel,
1982).
The causes hiding behind economic bubbles have been debated plenty of times before, and the
notion of irrationality is still widely regarded as the main contributor (Blanchard and Watson,
1982). Markets were normally considered to be efficient mechanisms where economic agents
act rationally at all times. However, the infamous mania of tulip bulbs was just one of the
earliest demonstrations of the mayhem irrationality can cause.
Nonetheless, as it happened with the housing bubble of the twenty-first century, mainstream
experts dismissed concerns regarding the irrationality of overpriced assets by invoking a new
economic era where old valuation rules no longer apply due to reduced volatility of the market,
greater stability and improved policy making (Bernanke, n.d.).
The past few decades have seen the blame for the global financial crisis being passed around
from one sector to another, from Greenspan to Bush, from corporations to the state, from banks
to institutions. Ultimately, the crisis has been the outcome of an ever-increasing leveraging
ratio across all sectors, that were overly confident in asset prices rising indefinitely. This
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
10
financial disaster resulted from the conventional view that markets do not deviate a great
distance from their equilibrium point and that the experts presiding over them are rational
individuals with full access to all information available and an inherent ability to correctly price
risk and uncertainty.
In respect to bubbles, the essential fault in the system is people assuming that this time it will
be different - a mass delusion of a new era taking shape that can escape all natural laws of
economics. Such an era ends once there is no more capital available to drown the market in. At
that point, someone notices that the emperor has no clothes, and everything comes down
collapsing. Contemporary economists have not yet found a way to outrun economic bubbles;
all they can do at the moment is just to take a seat and wait for the next one to emerge.
IP2039 ADVANCED PRINCIPLES OF ECONOMICS
Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
11
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Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
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Are bubbles always driven by irrationality? Examining the main theories behind the
housing market crash of 2007.
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