Why economies boom and crash

A town builds a new factory. Wages rise. People feel good, so they buy houses. House prices climb. Banks see prices climbing and lend more freely against them. People borrow against their richer-looking homes and spend the cash. Shops hire. Wages rise again. Everyone agrees the town is booming — and they are mostly agreeing with each other. Then one month house prices dip a little. And the whole thing runs backwards. To see why a boom turns into a crash, you have to see that it was never a straight line. It was a loop.

The two fuels: credit and confidence

An economy doesn’t just run on the money already in people’s pockets. It runs on credit — borrowing — and credit runs on confidence.

Credit is borrowed spending. When you take a loan, you spend money you don’t have yet against money you expect to earn later. That spending is real today. The bill comes later.

Confidence decides how much anyone will borrow or lend. A bank lends freely when it expects to be repaid. A family borrows for a house when it feels sure of next year’s wage. Confidence isn’t a mood for poets — it’s the switch on the credit tap. High confidence, tap open. Low confidence, tap shut.

In item 4 you watched money loop between households and firms, speeding up or slowing down. Credit and confidence are the foot on that pedal.

The boom feeds itself

Here is the part that surprises people: a boom is self-reinforcing. It is a loop where each step makes the next step stronger.

Walk the loop. Confidence rises, so people borrow and spend more. That spending becomes someone else’s income — wages, profits, sales. Rising incomes make people more confident. Asset prices — houses, shares — rise too, because more money is chasing them. Owning a rising asset makes you feel richer, so you borrow against it and spend more still. Banks, seeing rising prices and rising incomes, lend more freely. More credit, more spending, more income, more confidence.

Notice the shape. The output of each lap feeds back into the start of the next, and makes it bigger. This is a feedback loop — it amplifies its own signal. Nobody is doing anything strange. Each person responds sensibly to what they see. But what they see is partly caused by everyone else doing the same thing. The optimism is real, and it is also circular.

The seeds of the bust are planted during the boom

A boom doesn’t crash because of bad luck arriving from outside. It crashes because the loop quietly builds its own trap.

Each lap, debts get bigger — people borrowed against ever-higher prices. Each lap, the prices get further from anything the underlying thing actually earns or produces. A house that rents for £1,000 a month is now “worth” a price that only makes sense if it keeps climbing forever. People aren’t buying because they want to live there. They’re buying because the price is going up — which pushes the price up. The boom is now standing on confidence alone.

That is the fragile part. Debt is fixed — you owe what you owe. But confidence is not. And confidence is what the whole structure rests on.

A worked example: the town that bet on its own houses

Walk it in numbers.

1. Start. A house in the town costs £200,000. A family puts down £40,000 and borrows £160,000. Their home is worth £40,000 more than they owe.
2. The boom. Prices rise 10% a year. After three years the house is “worth” £266,000. The family still owes £160,000, so on paper they’re £106,000 richer.
3. They spend it. The bank lets them borrow another £50,000 against that gain. They buy a car, redo the kitchen. That spending is the shopkeeper’s income — so the shopkeeper feels rich and borrows too.
4. Everyone’s doing it. Across the town, thousands of families borrow against rising prices and spend. Shops hire. Wages rise. House prices rise faster — now demand is being fuelled by the borrowing itself.
5. The small dip. One year, prices fall just 5%. The £266,000 house is now £253,000. Not a disaster — yet.
6. The reversal. But a family that borrowed to the hilt now owes nearly what the house is worth. The bank, seeing prices fall, stops lending against homes. With no new credit, that family stops spending. So the shopkeeper’s income drops. So the shopkeeper stops borrowing and spending. So their supplier’s income drops.

The same loop that ran up now runs down — just as fast, because it’s the same machine. Less spending means less income means less confidence means less borrowing. A 5% dip in one number became a town-wide slump, because it flipped the confidence the whole boom was balanced on.

The loop runs both ways

That symmetry is the whole lesson. A boom and a crash are not two different events. They are the same feedback loop running in two directions.

Going up: confidence → borrowing → spending → income → confidence, each lap bigger. Going down: fear → less borrowing → less spending → less income → more fear, each lap smaller. Credit is the accelerator; confidence is the steering. When confidence turns, credit reverses, and a system built on borrowed optimism unwinds itself.

You’ll drive this loop in the lab next — push the boom up and feel how it builds, then watch a small shock flip it and run the whole thing backwards.

The whole, and the humble part

Step back. No siren announces the top of a boom. The people inside it aren’t fools — they’re being rational, each responding to a world that looks genuinely good, partly because everyone else is responding the same way. That’s what makes booms so convincing right up to the edge, and crashes so sudden once they start.

And the humbling part is this: you are inside the loop, not above it. Your own confidence — the urge to buy when everyone’s buying, to sell when everyone’s selling — is one of the small inputs feeding the thing. The herd isn’t other people. It includes you. No one sees the top or the bottom in advance, because the top and the bottom are made of everyone, all at once, deciding they can see them. Knowing the loop exists won’t let you time it. But it might let you hold your own certainty a little more loosely — which, when the whole town is sure, is the rarest move there is.