How Bad Could It Get?

In "What Goes Up", I discussed the law of booms and busts. A big boom with easy credit leads to a big bust.

The question is, given the boom we had between 2001-2007, how bad a bust might we have?

Real Estate

Well, in the greatest financial crash of all time - the crash of the 1340s in Italy, which brought on a new dark Age - real estate prices fell by 50 percent by 1349 in Florence when boom became bust.

How does that compare to 2001-2007? The price of Southern California homes is already down 41%, Southern California hasn't fallen as fast as some other areas, and we're nowhere near the bottom of the market.

Moreover, the bubble was not confined to the U.S. There was a worldwide bubble in real estate.

Indeed, the Economist magazine wrote in 2005 that the worldwide boom in residential real estate prices in this decade was "the biggest bubble in history". The Economist noted that - at that time - the total value of residential property in developed countries rose by more than $30 trillion, to $70 trillion, over the past five years – an increase equal to the combined GDPs of those nations.

Housing bubbles are now bursting in China, France, Spain, Ireland, the United Kingdom, Eastern Europe, and many other regions.

And the bubble in commercial real estate is also bursting world-wide. See this.

Derivatives

Moreover, the real estate bubble formed the base upon which a series of bubbles in derivatives were built. Specifically, mortgages were packaged in "collateralized debt obligations" (CDOs), which were sold in enormous volumes all over the world. Credit default swaps were then bet against the companies which bought and sold the CDOs.

Now, with housing prices crashing, the CDO bubble is crashing, as is the CDS bubble.

A series of other derivatives bubbles are also crashing. For example, the "collateralized fund obligations" - sort of like CDOs, but where the assets of a hedge fund are the asset being bet on - are getting creamed as hedge funds are forced to sell off many hundreds of billions in assets to cover margin calls.

As everyone knows, the size of the global derivatives bubble was almost 10 times the size of the world economy. And many areas of derivatives are still hidden and murky.

So the bust of the derivatives bubble could even be bigger than the bust of the housing bubble.

What Does It All Mean?

The bigger the boom, the bigger the bust. Because we have likely just lived through the greatest boom in history, we may see the biggest bust in history. (No wonder the guys who predicted this crisis are gloomy about the future. Is this why the big players are selling everything that's not nailed down to raise cash?)

If true, this is saying something dramatic. Because the bubble in 1340 Italy was so big that its bust brought on a new dark age.

Believe it or not, I am an optimist by nature, and believe that we can dig ourselves out of this hole if we restore sound financial policies, a true representative government, and a return to sanity and living according to the time-tested ideals of liberty, justice, freedom and living within our means.

If we don't, it could get very dark . . .

Note: I hope the Economist is wrong, and that the 2001-2007 bubble was not the biggest in history. If someone can produce inflation-adjusted figures for the 1340 Venice bubble, it would help to double-check the relative sizes of the bubbles.

I also hope I'm wrong, and that the unprecedented size of the boom will not lead to a catastrophic bust. Boom-bust cycles are highly complex, especially when they involve billions of people around the world, and complex instruments such as derivatives. It is thus impossible to map out what will happen with any confidence. Hopefully, things will somehow get better due to factors which we have not included in our boom-bust model.

Finally, while some writers have blamed the plague, famine and other problems which came after the 1340 crash on that financial crash, others have blamed climate or other factors. So the crash might not have been as bad as suggested.