How Real Estate Credit Bubbles Lead to Crisis

How is finance killing the economy? Credit is a powerful tool of capitalism. It can be used to stimulate economic growth, or it can be used to deter capital investment by shifting money creation into the Finance, Insurance, Real Estate (FIRE) sector. The latter will inevitably cause the economic system to go into crisis.

In the past, state regulation had the power to steer loan creation towards the industrial sector. These loans would be used to invest in new labour using it productively. This places more people into employment. New value is created, and those people go out into the economy stimulating demand for tangible commodities. The credit has expanded the money supply – but, it has also expanded the need for money because the economy also expanded.

As an economy expands, more money is needed to facilitate exchange. Commodities move because there is a demand for them, not because there is money. Remember: commodities have moved long before money existed. If that money ceased to exist, commodities would still be produced. The means of subsistence were created long before there was a profit motive.

Since credit creation has been largely deregulated, it hasn’t been used so wisely. Credit is now used to bid up real estate and stock market prices. Credit is being used for speculation, takeovers of companies, and management buyouts. Credit money flows into the FIRE sector with negative results. FIRE cannot create new value, it merely monetizes existing prices. The majority of this unregulated finance credit goes into existing real estate properties. Usually it’s done in the hopes of buying them up and selling them for a profit. This is also not any creation of value.

Debt service merely leaches off of existing portions of value.

For example: A firm buys up a bunch of properties because they anticipate the market will increase their price. (Which traditionally it has done.)  For simplicity, we’ll assume a loan of 1 million was borrowed for these properties, with an interest of 100,000 expected. The properties are then sold for 1.2 million. The debt service is paid, and a profit of 100,000 was made by the firm.

 

1,000,000

Credit money creation

100,000

Interest on the loan

100,000

Profit from the sale of the properties

1,200,000

Selling price of the properties

 

What’s wrong here? A pre-existing value has had its price increased, and credit money has expanded without an increase in value. This is significant because it’s part of a repeating process.

Once these properties are purchased, they are then sold again by the new owning firm. This happens all across the country constantly. Over time this has a cumulative effect, as we saw with the mortgage crisis of 2007-08. These prices were raised well beyond the ability of the public to purchase.

Mortgages are paid for out of the value collected by workers and industrial capitalists, but mostly workers. These workers have not received enough value because credit has been put towards non-value creating producing areas of the economy. This same phenomenon occurs with commodity speculation and stock market prices as well.

This all eventually leads to an economic crisis. Vast amounts of loans are not paid, and many defaults take place across the country. Theoretically, capitalists could just keep selling each other the same properties over and over again. But, this kind of nonsense could not be indefinitely maintained. These bubbles of credit will keep being created and expanded with the hopes that they’ll be paid for in the future.

Capitalist A

Capitalist B

Capitalist C

Purchase Price of property

1,000,000

1,200,000

1,420,000

Interest

100,000

120,000

142,000

Profit

100,000

100,000

100,000

Sale Price

1,200,000

1,420,000

1,662,000

This is an ever expanding credit bubble that eventually leads to crisis. These values continually expand until some capitalist or another decides they’re not worth the cost, or the mortgages become insolvent because the people living in them cannot afford them. We’re then left to ask; why does the capitalist do this? It makes no sense that the financial capitalists would sabotage their own economy.

There are two primary reasons:

  1. It makes money, and fast. The rate of return on such investments is higher than what would receive from investment in industrial production. The capitalist, ever the short-sighted one, is concerned only with the greatest of returns. Competition alone prompts him to make such ill considered investments. If he doesn’t, his competition will. The only result is him falling by the wayside.
  2. As witnessed by Thomas Piketty and others; the rate of profit from industrial production has decreased significantly, and steadily. As it becomes less profitable, the need of capital to maintain that rate will force them to move investments into this dangerous activity. This is what drove much of the deregulation of the banking industry under Ronald Regan and George Bush Jr.

There is a reason why credit was so highly regulated alongside the financial industry. The shear profit motive  and competition alone force capitalism into such a self-destructive drive. The problem with capitalism is that it doesn’t differentiate between the two; thus the price consequences of increasing credit one way or another can’t be measured.

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