Financial bubbles have fascinated economists for hundreds of years. One of the earliest and best documented occurred in the early 1600s in Holland, where investors became obsessed with buying and selling tulip bulbs -- the rarest and most beautiful tulips sold, for the equivalent today of thousands of dollars each.
A brilliant financier named John Law, who induced huge investments in Mississippi land, engineered another bubble in France in the early 1700s. It eventually came crashing down in one of the most spectacular market collapses in history, wiping out the wealth and savings of thousands of Frenchmen.
At about the same time, something similar was going on in Britain involving the South Sea Company, which held a monopoly on Britain's trade with the Americas and also owned a big chunk of its national debt.
Since then, there have been many other cases where bubbles have emerged, and economists continue to study them. Most recently, millions of Americans had direct experience with the huge run-up in the stock market in the late 1990s and subsequent crash in the 2000s. At one point, people took seriously books predicting that the Dow Jones Industrial Average would reach 36,000 or even 100,000. Today, the Dow is exactly the same as it was when those books were published six years ago -- around 10,500.
Of course, the authors never said when the Dow would hit those numbers. Undoubtedly, they will be proven right someday in the far distant future. But as a guide to one's current investment strategy, they weren't very helpful. In retrospect, the presence of such books on the best-seller list was an almost sure sign that the market had peaked and it was time to get out.
Today, many of the same economists who correctly predicted the bursting of the stock market bubble, such as Yale University's Robert Shiller, are saying that the housing market is in a bubble. If it should collapse as the stock market did, the impact could be even more painful. Consider this evidence.
-- Homeowners are much more leveraged than they used to be. According to the Federal Reserve, Americans' home equity has fallen to 56.3 percent of their real estate, from 75 percent a generation ago. Another Federal Reserve study found that 16 percent of the money taken out was simply consumed.
-- According to Freddie Mac, people are taking more and more money out of their homes. Cash-out refinancings have risen to 18.1 percent of all refinancings, from 7.2 percent in 2003. In the last four years, homeowners have taken $559 billion in equity out of their homes.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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