Peter Lyons: Why bubbles don't go down well at barbecues

The year before the GFC, the banks had been falling over themselves to lend. By late 2008 they were demanding their money back. Photo / File

I was working my way through a pile of lamb chops at a barbecue recently as well as a tiny attempt at a salad.

The guy beside me was talking about his bitter experiences with the banks following the global financial crisis (GFC). He had had a portfolio of speculative housing investments.

The year before the GFC, the banks had been falling over themselves to lend to him. By late 2008 they were demanding their money back. He was forced to take a big hit and sell some of his houses on a depressed market. The experience had left him poorer yet wiser. His experience highlights a fundamental flaw in modern market economies and the economic theory taught to students.

The financial sector has always been the Achilles heel of modern capitalism. It has almost been forgotten that central banks such as our Reserve Bank were initially set up as the lender of last resort for the commercial banks. This was because throughout modern history commercial banks have a nasty habit of periodically stuffing up the wider economy through bad lending.

The most common scenario is that an asset class becomes fashionable for people to invest in. In the mid- to late-19th century the fashionable investment was railway companies. In the 1920s it was shares. In the 1990s it was tech companies. In the new millennium it was housing.

People would borrow to invest in the latest fashionable investment. This would inevitably drive up the price of the asset such as houses or shares. This would increase the value of the collateral which would allow the banks to lend more.

When this process is occurring it is very difficult to determine when the investment is no longer being driven by fundamentals such as future returns like rents or dividends. At some point the process, which has played out in most market economies at various points in history, becomes an "asset bubble".

When something causes the bubble to burst the banks quickly take fright and reduce their lending. Investors who require credit suddenly find the taps turned off. They may be forced to sell their shares or houses in a depressed market which further depresses the market.

What was a euphoric self-reinforcing feedback loop suddenly moves into reverse. As the banks scramble to reduce possible bad debts by cutting lending and demanding loans be paid back, this accelerates the vicious downward spiral. If depositors think a bank is shaky they will start demanding their money back. Bank runs can spread like wildfire, as occurred in the 1930s leading to the Great Depression.

It was the initial role of central banks such as the US Federal Reserve or our own Reserve Bank to prevent such a scenario which can lead to a total collapse of the financial sector and wider economy. Central banks were set up to save the system in such a scenario. Those who preach that competitive market forces always get it right seem totally ignorant of history. If competitive markets always get it right this makes it very difficult to explain the creation of central banks.

Modern economic theory teaches little of this. It teaches that people are rational and independent individuals in their decision making. Discussions at barbecues or in the media about the next hottest suburb do not influence individual decisions. People are far too rational for that.

Current economic theory teaches that markets always tend to equilibrium. This equilibrium seems a long time coming in the current Auckland housing market.

Blind faith in the efficacy of markets and competition was a major contributing factor in the GFC. The theory of free markets may work well for goods and services such as tomatoes or taxi rides or bananas but can go horribly wrong with banks and lending.

Many central banks, including our own, have come to this conclusion. That is why the Reserve Bank introduced the loans-to-value ratio and is considering further moves to curb property lending to investors. It recognises that market forces and competition can get it horribly wrong when it comes to lending.

I was about to explain all this to the gentleman who was sitting beside me at the barbecue but I had a pile of chops to work my way through as well as a six-pack. I also get tired of sitting by myself at such functions.