Why small booms cause big busts

Berkeley

AS bubbles go, it was not a very big one. From 2002 to 2006, the share of the American economy devoted to residential construction rose by 1.2 percentage points of GDP above its previous trend value, before plunging as the United States entered the greatest economic crisis in nearly a century. According to my rough calculations, the excess investment in the housing sector during this period totalled some US$500 billion - by any measure a tiny fraction of the world economy at the time of the crash.

The resulting damage, however, has been enormous. The economies of Europe and North America are roughly 6 per cent smaller than we would have expected them to be had there been no crisis. In other words, a relatively small amount of over-investment is responsible for some US$1.8 trillion in lost production every year. Given that the gap shows no signs of closing, and accounting for expected growth rates and equity returns, I estimate that the total loss to production will eventually reach nearly US$3 quadrillion. For each dollar of over-investment in the housing market, the world economy will have suffered US$6,000 in losses. How can this be?