Supply: A Tale of Two Bubbles

November 11, 2011

To the extent that monetary policy influences asset prices, it does so via the demand for assets, by changing the borrowing costs to purchase assets, or via supply, where movements in interest rates can make investment in assets look more or less attractive.  While most discussions of asset bubbles focus on demand (or the sudden lack of it), a concentrated focus on supply side can also prove enlightening in establishing definitively those circumstances that give rise to bubbles.  The effects of supply-side economics can be seen in two of the more famous American asset bubbles of the last decade: the housing bubble and the dot-com bust, says Mark A. Calabria, director of financial regulation studies at the Cato Institute.

With the housing bubble, the tendency that really brought home prices down was that the supply and demand sides of the equation were never truly in sync.

  • As the government expanded generous programs in order to increase nationwide home ownership, aggregate demand for houses increased drastically, driving up the quantity demanded and prices.
  • Producers who sought to react to this development increased the quantity supplied, yet their efforts could not keep pace.
  • For instance in 2006, at the height of the housing bubble, there was an excess of almost 600,000 housing starts -- an almost 40 percent increase in supply -- yet, prices continued to rise.

Similarly, the dot-com bubble can be partially explained by the mandatory holding period that often accompanied internet stock initial public offerings.  These holding periods limited the ability to sell recently purchased stocks for a set amount of time, thereby limiting the ability of investors to react to contemporary changes in the stock market.  These kinds of policies lock up financial assets and limit flexibility, causing extreme resistance in the effort to bring supply and demand into equilibrium.  In this way, those policies which seek to interfere in the market should be assessed for their potential to cause this same problem.

Source: Mark A. Calabria, "Supply: A Tale of Two Bubbles," Cato Journal, Fall 2011.

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