The connection between the money supply and the real estate market is closely intertwined. Real estate, being one of the most popular investment options globally, is often viewed as a safe haven and a reliable hedge against inflation. However, what many don’t realize is that real estate also plays a significant role in increasing the money supply. This is largely due to the workings of the modern fractional reserve banking system. As more real estate is developed and sold, more mortgage loans are issued, leading to an increase in the money supply. This article explores the cyclical relationship between real estate and money supply, demonstrating how they fuel each other’s growth.
The Self-Perpetuating Money Supply:
- In today’s real estate investment landscape, the industry effectively boosts the money supply within the economy. This surge in money supply then flows back into the real estate market, creating a continuous cycle between the banking and real estate sectors. This cycle often results in rising real estate prices, which can lead to the formation of real estate bubbles. These bubbles, driven by price increases without corresponding economic growth, eventually burst, causing a temporary decline in prices. Nevertheless, over time, the inherent nature of this process leads to a persistent increase in money supply and a self-reinforcing loop that drives the real estate market.
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How Mortgages Create Money:
- In many developed countries, about 80% of home purchases are financed through borrowed money, making the terms “house purchase” and “mortgage” almost interchangeable. This may seem routine until one considers the mechanics of the modern banking system. Banks do not simply lend out existing money; they create new money when issuing loans. Thus, every time a mortgage loan is granted, new money is introduced into the economy. The correlation between the growth of mortgage loans and the expansion of the money supply is clear, with both trends often moving in tandem.
The Inflationary Impact of Increased Money Supply:
- The creation of new money through mortgages has inflationary consequences. As this newly created money circulates in the economy, it dilutes the value of the existing money. For example, during the U.S. mortgage boom, the influx of money contributed to high inflation, which outpaced wage growth, effectively reducing real wages for workers.
Inflation Drives Real Estate Prices Higher:
- The money generated from mortgages often reenters the real estate market, fueling further demand and driving prices higher. As prices rise, more buyers are attracted to what they perceive as profitable investments. This excess money and demand push real estate prices up even further, reinforcing the belief that real estate is a highly lucrative investment. Over time, these inflated prices become the new normal, despite being detached from the underlying economic fundamentals.
Speculation and the Rise of Mortgages:
- When speculators see their peers profiting from real estate investments, they too join the fray, further inflating the market. This speculative activity creates a feedback loop where rising prices justify even higher prices in the future. This phase is characterized by a rapid increase in both mortgage issuance and housing prices, setting the stage for a bubble.
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The Inevitable Bust:
- Eventually, the bubble bursts, triggered by unsustainable economic conditions. Borrowers begin to default on their loans, leading banks to foreclose on properties and write off losses. What many don’t realize is that when banks write off these losses, they essentially eliminate the money that was created through those mortgages. As a result, the total money supply in the economy decreases, leading to a drop in prices.
Conclusion: Real Estate and Money Supply A Symbiotic Relationship
- In conclusion, mortgages and real estate prices play a crucial role in shaping the money supply, which is a fundamental economic parameter. Consequently, fluctuations in real estate prices can have a profound impact on the broader economy.