Manfredini 1
Bubbles
Nouriel Roubini, in his book “Crisis Economics”, is able to explain how he almost single
handedly predicted the collapse of the housing bubble and of the global banking system. His
prediction was not just luck. Roubini realized that the efficient market hypothesis, which claimed
that markets always price risk correctly, was incorrect. He proves that crises are creatures of
habit and assemble the toxic elements that brought about the recent financial collapse: lax
monetary policy, reckless financial innovation, moral hazard, poor corporate governance, growth
of a shadow banking system and easy foreign money. Roubini uses his excellent economic
knowledge to give the reader a neat, coherent and convincing explanation of the causes and
consequences of the great meltdown of 2008.
To get a better understanding of the overall concept, crisis economics is the study of how
and why markets fail. “Mainstream economics is obsessed with showing how and why markets
work – and work well” (Roubini and Mihm39). The origin of this profession is dated back to the
Scottish thinker Adam Smith. He is famous for creating the metaphor of the invisible hand to
capture the miraculous process by which the egotistic and different interests of individual
economic actors somehow unite into a stable, self-regulating economic system. Initial ideas
differed from current ones, but not too much. In the 19th century, the main idea was that markets
are self-regulating. Currently, we know that the markets are always changing and they depend on
what we, the people, do with our money.
Starting as a mania of flipping real estate for a quick gain, people created the boom. A
boom is described as a process characterized by sustained increases in several economic
indicators. One of the problems was that there was a popular “belief that prices could only go
up” (13). People were unaware that when there is a boom there is also a bust. A bust is a rapid
Manfredini 2
contraction of the boom process. These processes are called “Bubbles”, when prices of assets
(e.g. housing and stocks) become over-inflated (boom) and the demand is not enough to sustain
it (bust) the economy suffers. This happened almost a century ago, few investment banks
managed to survive, on the eve of the Great Depression. The recent crisis had so many things in
common with the Great Depression, but no one expected that “the same forces that gave rise to
the Great Depression were at work over the years leading up to our own Great Recession” (14).
Ignoring them is not an option.
Before the recent crisis, in the early 2007, the crisis was obvious, yet everyone’s reaction
was incredulity and denial. So much that Treasury Secretary Henry Paulson said the following
statement: “I don’t think it poses any threat to the overall economy” (15). Even once the Bubble
busted people continued to refuse the facts. In time, people realized the problem and tried to
define it as being a “black swan event” (16), a rare and unpredictable game-changing event. As
previously stated Nouriel debunks this statement and proves that crises are creatures of habit. All
of them, or at least most of them, have the same process. They begin with a bubble with an asset
price that rises above its fundamental value. As credit becomes increasingly cheap and abundant,
the desired asset becomes easier to buy. Demand rises, supply drops, and prices rise.
An example of such is the United States starting in 2000. People used their homes as
ATMs, using their houses as collaterals, prices kept increasing and by 2005, home equity
withdrawals peaked up to a trillion dollars. Unfortunately, bubbles need leverage and easy
money just as fire needs oxygen (19) once those exhaust deleveraging begins. This moment
came over the course of 2007 and 2008, when homeowners defaulted on their mortgages,
beginning the bust. All this was to show that contrary to popular belief, crises are white swans
and not black swans simply because the booms and busts are extraordinarily predictable.
Manfredini 3
The solution to this bubble was certainly not inflation, as Greenspan tried. By adding
large amounts of easy money into the economy and leaving it there for too long, Greenspan
nullified the effects the effects of one bubble’s collapse by creating a new one. He enacted this
strategy when he was chairman of the Federal Reserve, also known as Fed, the most powerful
instrument of government control over the economy. Its power can be used for good and for bad
purposes. Certainly, Greenspan had the uttermost best in mind for the economy, but his plan
ended up being an ulterior problem.
Government policies helped inflate the bubble while deregulation helped remove
constraints on financial firms, but there is a third component, the failure of government to keep
pace with financial innovation. During this period, thirty-plus years, Pacific Investment
