 So, we've seen that financial booms are not only good for the economy while they last, but the worst thing about them is that they cannot go on forever. What will ultimately stop the boom is that with higher debts, people need to devote a larger part of their income to monthly loan repayment and interest. There is a limit to how much they can miss and still pay for their living, so debt growth will always have to stop at a point where people cannot afford to take on new loans. And since rising asset prices depend on increasing debt levels, the end of borrowing means the end of the asset price boom. And then what? Well, if house prices have been increasing for a long time because of all this borrowed money, then in the end, most of the price of a house will be due to debt creation rather than due to any real demand for living space. So when house prices stop increasing because people cannot afford more mortgages borrowing, then suddenly, most people see no more reason to buy a house. Anyone wanting to sell a house now will have to offer it for a lower price to find a buyer. In fact, there's no reason why the price should not go down all the way to the initial level that reflects the real demand for living space where it was before debt started pushing up the price. After all, without house prices rising, the only remaining reason to buy a house is because of the value it offers as a place to live in. And that was the value we started with before the mortgage boom came along. Now, that initial price is much, much lower than what houses sell for at the top of a debt-driven house price boom. And the longer and larger the boom was, the more house prices will now fall. Once this starts, everything goes into reverse. All that made the boom seem like such a great time now makes the bust a truly miserable time. A little borrowing by some made for great capital gains due to rising house prices for all. Now, a little less borrowing by some makes for large losses through falling house prices all around. And just like rising house prices trigger more demand and more borrowing. Now, a small house price decline causes further declines in demand and in borrowing. Also, the fact that your mortgage was fixed while your house price was rising made you rich without doing any work on the way up. Now, the problem is that debt levels are fixed just like before, but house prices are falling and this makes you poorer without anything you can do about it. In fact, with falling house prices soon some people will have larger debts than their house is worth. First, there was just a lot of debt with even higher house prices so no problem and now there is a lot of debt but with low house prices and not enough asset value to balance the debt there is a problem. People turn from positive net worth to negative net worth and suddenly credit is not a free lunch but a problem. It's also debt and you have to pay it with too little to pay it from. This is so scary suddenly everyone wants to pay off as much of the debt as possible perhaps by selling their house. So falling house prices increase the supply of houses which pushes down the price more which increases supply and so on. Soon enough with falling asset prices repaying debt by selling your house is simply not an option. The only way to fully repay debt is now out of income and this is where the debt burden comes in again. This ratio of debt to income was forgotten during the boom but now it's glaringly obvious that income is all you have to pay your debt from but remember debt has risen much faster than income so the debt burden is really high. A lot of income has to be devoted to debt repayment and that means it cannot be used to buy goods and services. As demand for goods and services falls GDP growth may fall or even turn negative and it gets worse. The other thing that happens is that banks will reduce their lending with falling prices of houses and other assets banks suddenly have much less security so this makes them much more careful to issue loans. Firms in the real sector suddenly find it much harder to obtain loans for investment and growth and to make matters worse their customers are buying much less since they're busy repaying loans. More money now flows as loan repayment out of the economy to banks than before that may be good for banks but the fall in house prices which is their security on mortgages is much larger so banks still do not lend. The combination of these forces more money flowing into banks less lending coming from banks this is called a credit crunch suddenly the economy is choking for lack of credit. Money is being pulled out of the normal economic process from all sides this developed as a result of the normal economic process it seems as if financial boom bust in stability and crisis is a normal outcome rather than an exceptional shock to the system. Now strange as it sounds that is actually the case our economic system is built to produce crises just like the boom the bust process is not like an equilibrium. Remember our carrot example where a lower price for carrots means you want to buy more of them so the price rises again but as we've seen stability and equilibrium through supply and demand do not work on asset markets now declining prices for houses and stocks means you want to have even less of it no one wants to hold assets that decrease in price so falling prices produce even lower prices they don't move back to equilibrium they spiral out of control upward or downward and if the banks cut back lending to real businesses then there is even less income to pay for the existing debt this means that the bust reinforces itself and will only reverse if debt is back at a sustainable level which may be really low. In the real world this happens again and again and that's no coincidence it's built into the system time and again people come to believe that the price of something will keep going up and they can get rich without working this ranges from the Dutch tulip bubble in 1637 the British South Sea bubble in 1720 recurring financial panics in the US such as in 1873 and again in 1893 both because of railroad speculation Charles Ponzi scheme in the US which collapsed in 1920 the US real estate and stock market boom which burst in 1929 and then the US savings and loans debacle in the 1980s the black Tuesday New York stock market busts in 1987 the US stock market dot-com bubble which burst in 2000 and now the US mortgage derivative bubble which burst in 2007 and in addition to all this many house price crashes occurred for instance in the Netherlands in 1979 in Japan in 1990 or in Sweden in the early 1990s what all these crises have in common is that they happen in financially well-developed economies and that each financial crisis starts with a boom in property or asset markets we've seen how investment in these markets increases debts but not income and so it sets the scene for crisis by raising the debt burden we've also seen that banks and investors and consumers all benefit enormously from a boom they don't have any reason to stop it while it lasts until it's too late so the boom is built into the very fabric of our economy and so is the bust this may sound obvious but the implication is this we should stop thinking about our economy as a system which will always go back to equilibrium we should recognize that it is always moving towards the next crisis and then we should think of policies and regulations to tame the boom and to prevent the bust so let's step back what have we learned the ability of banks to create money as they land means that they also create debt and if this debt is used only to inflate the prices of houses and other assets and to consume then what follows after that boom is a credit crisis and a debt deflation and a recession it's only natural or is it what should we do after this our greatest financial crisis ever how do we harness credit for growth and stability while dealing with the dark side of credit which is too much debt