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Obviously, while this bubble was being built up, central bankers around the world pretended that everything was all right.By the time Greenspan started raising interest rates in June 2004, the bubble in housing prices was already big. Between June 2004 and July 2006, the Fed raised interest rates from 1% to 5.25%.

This led to the housing bubble bursting. Home prices in the US fell by around 27% between 2006 and 2008. In the aftermath, central banks across the world, led by Ben Bernanke — Greenspan’s successor at the Fed — started to cut interest rates. The idea once again was to get people to borrow, so that they go out and make purchases, so the economy would recover.”

“But people are not buying things!”“No, they are not. In the past, every time the economy was in a precarious situation, central banks cut interest rates. And people borrowed money, bought things or invested in stuff, and the economy was back on track again. But now the situation is different. People already have a lot of debt to pay off and would rather not borrow.

As Cooper explains, ‘As the stock of debt rises, the central bank eventually reaches a point whereby lower interest rates is not sufficient to encourage more private sector borrowing… borrowers become concerned over their ability to pay off their stock of debt.’ Now, even though individuals are not borrowing, speculators are. Take the advent of the dollar carry trade, wherein speculators are borrowing dollars and investing them around the world. Stock markets across the world have gone up between 60% and 100% since their March lows. A lot of this money is going into commodities as well, hence the increase in their prices as well. So central banks around the world, led by the Fed, are helping to fuel more bubbles.”

“Wow. You always have a different point of view,” she remarked.
“Yeah. Efficient market theory says that markets are correctly valued primarily because investors start selling assets when they are too expensive and buy them when they are too cheap. This might be true when we are buying vegetables and other consumables, where we tend to buy more when prices are less and vice versa. But it doesn’t stand true for assets like stocks, commodities and housing, where we indulge in ‘conspicuous consumption’.”

“Wait a minute. What’s that?” she questioned.“This was term coined by an economist named Thorstein Veblen to describe markets where demand rose rather than declined when prices rose. ‘Veblen’s theory was that in these markets it was the publicly high price of the object that generated the demand for it,” writes Cooper. Asset markets are like that. As prices go up, people want to buy more of it, not less. And that’s what leads to bubbles.”

“Interesting. But don’t for a moment think I have forgotten what we were originally talking about.”“Efficient market theory!” I replied.
“We happened to be talking about de-addiction, mister.”
“De-addiction?” I looked at her. “What’s that?”

(The example is hypothetical)

This article borrows heavily from The Origin of Financial Crises - Central Banks, Credit Bubbles and the Efficient Market Fallacy, George Cooper, Harriman House Ltd, 2009 and Irrational Exuberance, Robert J Shiller, Doubleday, 2005