Why Bubbles Burst

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The Austrian Business Cycle Theory sounds intimidating, but fundamentally it is about what happens when central banks encourage misallocation of capital with artificially low rates. In the short term there’s a boom as people and businesses take advantage of the easy money. However, sooner or later this easy money creates distortions within the economy. Buildings which should never have been built, businesses which should never have been invested in, etc. Sooner or later these projects topple over on themselves as the easy money piles up and there is a reversion to the economic mean, or a bust.

(From Better Living Through Liberty)

In the early 2000’s a bubble formed in the U.S. housing market in which housing prices rose dramatically, new housing projects were being constructed at increased rates, and speculative buying of homes and mortgages became the latest get-rich-quick scheme.  By 2008 the bubble burst and real estate prices dropped dramatically, affecting subsequent industries and triggering a worldwide economic depression.  Why did this happen, and furthermore, why is economic history replete with these boom and bust cycles?

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