Bubble Economics

0:00Title of my topic is bubble economics, and of course bubbles are how we get to the spot that we're in. And I'm not going to talk about Tulip Mania and John Law and all that, but I did want to mention some things from the roaring 20s. And of course, the roaring 20s did lead to the Great Depression that may sound familiar in the eight year period up to the boom or eight year period of the boom. And the money supply increased 62 percent. Auto companies produced 1.6 million cars in 1919. By 1929, they were producing 4.6 million cars.

0:48All kinds of new appliances were sold. Refrigerators, phonographs, electric irons, toasters, vacuum cleaners, All kinds of new gadgets, just like we have today. More and more leisure activities, more hotels were built, more roadside diners. There was an explosion of movie theaters in development in Hollywood. Professional sports became a big business in the Roaring Twenties. Skyscrapers such as the Chrysler Building and the Empire State Building were started during the Roaring Twenties. There was a speculative boom in Florida real estate. The stock market boomed. Hoover promised a chicken in every pot.

1:34I don't know what Obama's going to, maybe he's going to promise pot in every kitchen or something, I don't know. But I always talk about speculative, the economics or bubbles of economics in the framework of Murray's disastrous effects of inflation during the boom that he's outlined in what has a great book, what has government done to our money. And the first one that he talks about is inflation confers no general social benefit. Just creating more money does not create more benefit for everyone. and it just redistributes money to the first people who get the money, who receive the money.

2:20And just as the money supply grew 62% during the roaring 20s, M2 has increased 11 fold since 1971, when the last ties of the gold standard were there, and the money supply has doubled since 1998. So we have a similar expansion in the money supply just like we had during the 20s. And of course, it's been one series of bubbles after another. We get a tech bubble, we get a real estate bubble. It's what Bill Fleckenstein calls Operation Enduring Bubble. And they're still at it, of course. But Mises had this great quote in Human Action, The boom produces impoverishment, but still more disastrous are the moral ravages.

3:14It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application and probity. But reverses a fortune he always charges to other people and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse.

4:03And that's exactly what people are doing today. They're blaming Wall Street. Everybody was smart when their homes were doubling in value. Everybody was smart to pick those stocks in their 401k plans, but now all of a sudden it's Wall Street's fault. But a great story comes out of, and I'm going to mention Las Vegas a lot, because I spent 22 years there. And as you may have noticed from my bio, I was in the banking business. So that means I was probably somewhat in the bubble business myself. But there was a couple in Las Vegas. The gentleman was a painter and his wife was a hairdresser.

4:50And one day, a lady came in to get her hair done. And the hairdresser says, gee, you know, this was 2004. I mean, it just couldn't be rocking any better for real estate in Vegas than 2004. So the hairdresser says, you know, I'm really interested in getting into real estate. Well, the woman getting her hair done says, boy, I got the person for you. My husband's a realtor. He's a mortgage broker. He can find you tenants. The Painter and the Hairdresser had a combined income of $60,000 but they felt at the time that they must be sophisticated enough to buy seven homes with no money down because of course the guy who was the real estate salesman and the mortgage The mortgage broker could find him a no money down loan.

5:57Not only could he find one no money down loan, he could find seven no money down loans. And it just so happened that the guy's wife, who was the original woman getting her hair done, was a mortgage loan processor. So it was really a one stop shop. So the painter and the hairdresser buy the seven houses. And of course, the real estate broker says, you know, you've made a great investment because right now, based on my calculations, where real estate is going to go in Las Vegas, you're going to have equity within five years in your homes of $1.3 million.

6:43Now that's pretty heady stuff. Well, you kind of know how this turns out, right? All of a sudden, our very sophisticated hairdresser and painter, and I think a house painter, it's not like the guy was Picasso or anything, they were very sophisticated when they took on this debt, which is actually $2.6 million, by the way. The monthly payment was $5,772. So if you take their $60,000 divided by 12, you get $5,000. So their payments were more than their gross income between the two of them. So they took on $2.6 million worth of debt with the hopes that the properties would be worth $4.4 million within a couple of years.

7:35Now that assumption meant at the time that the price per square foot of those seven homes had to grow to $286 per square foot. Now those homes in Vegas today, I can tell you, would be selling for less than $86 a square foot. So, you might think these folks just filed bankruptcy, learned a lesson, gee, we weren't as smart as we thought we were, and go on about their business. No, they sued. They sued the realtor, who was, of course, the mortgage broker, whose wife was the mortgage loan processor, and so on and so forth.

8:34So, you know, that's what happens in a boom, is it's, when it's going good, everything is, everything is our doing. We feel real smart. I know this for a fact. I mean, when all your loans you're making are getting paid off, you're real smart, and everybody's telling you you're real smart. But then when things don't work out, they don't think you're so smart. And it's the same way with these investments. So that really, I think, really captures what Mises was talking about with that quote. The second thing that happens in a boom is inflation distorts business calculations. In fact, there's entire business plans built on a boom.

9:22The ability of people to borrow and consume, and I think we're seeing this all over the place. Look at the recent bankruptcies that we've had. Circuit City, Sharper Image, Goodies, Gottschachs, CompUSA, Levitts Furniture, and in Vegas, we would have never imagined that station casinos, MGM Grand, Harris, might possibly go bankrupt, Herbst Gaming already has, and now the Riviera is talking about it, so all these business plans that seem like a good idea, don't work out, And that's not to mention real estate. We all know about real estate. What you may not realize is there's more excess real estate coming online this year. 93,000 high-rise condos coming online. A 28% increase in the inventory of high-rise condos coming online this year after the real estate bust. But of course, when you build a big tall cylinder, it's not It's not like you can quit halfway up, you've got to go all the way, and then you've got to try to get people to close, and that's what they're having trouble doing.

10:38Even if you're the Donald, the Donald has problems all over the United States. He's got a nice tower in Las Vegas, and it was completely sold out within days. When the project got ready for people to move in, he's only closed 25% of his sales. He's actually been quoted as saying we're really doing very good in Vegas. If you take into account that Vegas is in a depression. So that's keeping the sunny side up, I would say. So 93,000 condos, 12,000 of those are in New York and New Jersey. I don't think they're creating a whole lot of new jobs in New York right now. In fact, they may be bleeding a few jobs. 4,000 in Vegas, 5,500 in Chicago, 3,500 in Florida.

11:26So you'll see more and more real estate fallout. The other thing that inflation does during a boom creates illusory profits and distorts economic calculation. And what the free market does best is it penalizes the inefficient and it rewards the efficient. That's what capitalism does best. But when you get a boom, high tides lift all boats. And I know this, I used to have borrowers who built houses. And they were continually over budget. And they never got anything done on time. But during the boom, were they penalized? No, because the price went up. In fact, they thought they were doing the right thing.

12:11They were smart by being over budget. And it took them an extra six months to build the houses. And that was great, the price went up. They must have been smart for that to work out. Well, that's not what's supposed to happen. and of course, the boom penalized those folks. The other thing that happens with these illusory profits is everybody wants to get in on the boom. Everybody thinks they can do anything. Doctors become real estate developers. It's my favorite example. You go into a doctor, all he wants to do is talk about a real estate development. Actually, my best example is strippers to Become Day Traders.

13:00Yeah, I used to take a lot of stock tips from strippers, but I stopped. Actually, I can actually tell you what stock it was, Golden Bear Enterprises. But anyway, poor Jack, it just didn't work out. The other thing that happens is the quality of work goes down during inflation. They're trying to build houses as fast as they can, trying to build products as fast as they can. There's no emphasis on quality, there's no emphasis on how long things will last. And that was certainly the case, I'm sure probably here in this area, certainly case in Arizona, California, Nevada.

13:47Houses, you had attorneys scouring for construction defects, and it's certainly something that happens during a boom. The other thing that happens, people become enamored with get-rich-quick schemes. They scorn sober effort to get in the house-flipping craze. Bartenders become real estate agents and mortgage brokers. I remember guys in the locker room at the country club being on the phone telling somebody that he was on the list to buy a home at nine different new home tracks. And that was his business plan.

14:34Because if you got on the initial waiting list, it was for sure that immediately after the home was built, Bill, he was going to be able to flip the house and make 50 or 100 thousand dollars per house. So he's going to become a millionaire just that way. In fact, entire countries have done this with the CDO market. When you look at Iceland, Iceland has become one big hedge fund and you're going to have entire countries Now Go Broke. I remember I had a borrower, a real estate developer, and we went to Derry one night, he brought his girlfriend, and so I said, Harry, how'd you meet, how'd you meet your girlfriend? Well, I was, I was driving through our project one night, and I saw a girl jumping She was a school teacher and she wanted to buy a home, and she didn't have time during the day to tour the model, so she was looking, so he caught her, but of course by the time I met her, was she a school teacher anymore? No, she was selling real estate for my borrower, and is it any wonder, in Vegas during the boom, there were 17,700 real estate owners.

16:02Real Estate Agents. That was one real estate agent for every 100 people. I mean, it was hard not to have a bunch of friends who were real estate agents. Strangely enough, now one in every 60 homes in Las Vegas is in foreclosure. Those two probably match up somehow. I read I read in the Wall Street Journal recently that the downturn will be less severe because the service economy is more stable than farming was during the Great Depression. And I thought, that doesn't make sense. So that means all the masseuses and blackjack dealers are more likely to keep their job than farmers?

16:49People that grow food? It seems crazy, but that's what people are talking about. Of course, the thing that everybody wants to get involved with during a boom is banks. Investing in new startup banks was all the craze all over the country. And investors in small community banks in Las Vegas made a lot of money. And it was just assumed that once you got your bank open, that it was worth one and a half times what you'd put in it. And by the time you showed a profit, then, you know, your investment would have doubled.

17:40And so by 2005, 2006, there were 17 new banks in Nevada seeking regulatory approval. There was 50 in California. In fact, I remember being in Phoenix, Arizona on a business trip and I stumbled on an ad in the business journal that said, start your own bank. www.startabank.com backslash how to. Of course, you should say, well, why didn't you run away screaming at that point? Well, it's another story. The other thing that happens is inflationary booms penalize thrift and it encourages debt.

18:27And my favorite story about this is a guy named Scott Coles who was a hard money lender in Phoenix, Arizona. And he had a huge operation that he had inherited from his father. And what hard money lenders do is not the hard money that this audience would understand, Hard Money is lending money that investors have actually saved to real estate developers when they can't get bank financing. And so they can generally charge 10% or 11% or 12% or 15% for these loans. So the banks may be a lot cheaper but the hard money lenders are a lot easier to get along with and Phoenix Real Estate was so overheated that people were borrowing on their home credit lines at 5% so they could turn around and lend hard money at 10% to play the arbitrage.

19:30Of course, this all didn't work out, these projects didn't get done, the loans didn't get paid back, and unfortunately Mr. Coles committed suicide. But I think the most instructive quote that came out of this was an elderly woman who lost her home because of all this. But she said, I think the problem is greed. We're all greedy. We've heard about greed so far today. It's probably the reason for all our ills. I think she probably had this right in the sense that that's why my money was there because he paid 10% instead of 4% at the bank. at the Bank. And that's what happens when the government debases money. They lower interest rates. People are retired. Their costs are going up over time, but their interest that they earn is not going up. They have to take more risk. And if some flashy salesman says, I can pay you 10 percent and it's good solid Arizona real estate, then they take the plunge.

20:37Inflation also lowers the general standard of living in the very course of creating a tensile atmosphere of prosperity. People have to work harder. You have two income families just to keep up. We all think we're doing better. We're buying more stuff. We're buying bigger houses to put our stuff in, but we're really not any more prosperous. and that's what inflation does during a boom. Mises said another great quote. It said, if the crisis were ruthlessly permitted to run its course, bring about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs, not only banks, but also other businesses would exhibit more caution in granting and using credit in the future.

21:32Instead, public opinion approves of giving assistance in the crisis, then no sooner is the worst over, then the banks are spurred on to a new expansion of circulation credit. And that's where we are today. That's exactly what the Obama administration is and Bernanke at the Fed are trying to do. But there was a Treasury Secretary once upon a time, in 1929, named Andrew Mellon, and he told Herbert Hoover, he said, liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.

22:18It will purge the rottenness out of the system. High cost of living and high living will come down. People will work harder, live a more moral life, values will be adjusted, and enterprising people will pick up from less competent people. Herbert Hoover did not listen to Andrew Mellon. And believe me, Tim Geithner is no Andrew Mellon.