Constructivist and Ecological Forms of Rationality: Experimental Economics and Housing Bubbles that Engulfed the Economy, 1997-2009, and 1920-1931

Abstract

Asset market bubbles occur dependably in laboratory experiments. They have also been frequent in economic history, yet they do not usually bring the global economy to its knees. The ongoing Crash of 2008 was caused by the bursting of a housing bubble of unusual size, fed by a massive expansion of mortgage credit. Mortgage credit was itself facilitated by the longest sustained expansionary monetary policy in the past 50 years. Much of this mortgage credit was extended to people with little net wealth and slender down payments so that when the bubble burst and housing prices declined their losses quickly exceeded their equity. The losses of these borrowers were then transmitted to the financial system, including banks, investments banks, insurance companies, and institutional and private investors who provided liquidity to the mortgage market through structured securities. To an uncertain extent many of these institutions became insolvent. The liquidity loss and solvency fears created a strong feedback cycle of diminished financing, reduced housing demand, falling housing prices, more borrower losses, and further damage to the financial system. Eventually distress spread to the stock market and an economy that had in many other respects been performing well. Evidence is reported suggesting important parallels with the housing and financial market boom in the 1920s leading up to the Crash of 1929, and the Great Depression.