“False Profits” by Dean Baker

by Daniel on April 3, 2010

Making a change from the usual run of the genre (ie, books about the “financial crisis” by people who didn’t tell you that there was a bubble while it was going on, but who nevertheless expect you to be interested in what they have to say about it now that it’s been and gone). A book about the bubble in the US, written by someone who was absolutely right about it, provably, ahead of time and in writing, and who is a lot more angry about the whole mess than those authors who just regard it as a great big game in which some entertaining characters made money at the expense of their dumb counterparties. Despite the comparatively microscopic size of his promotional budgets, I think Baker might have caught the spirit of the times a bit better than Andrew Ross Sorkin or Michael Lewis[1].

(Full disclosure –I got a promotional review copy of “False Profits”. Normally I don’t count the very occasional review copies I get as constituting a declarable interest because I am short of shelving space and so the gift of a book is only a good thing for me if it is a good book anyway – if it is crap, the publisher has gifted me the chore of lugging the thing to Oxfam. But I thought False Profits was a good book, and I am probably going to get some help on a different project from the person I am giving my copy to after I’ve finished this review, so purists might think me compromised).

“False Profits” has the big advantage that it gets the crisis right and doesn’t mess around with all the obfuscation that has been put into the debate by people who were trying to sell the line that “The Global Financial Crisis” was a very complicated thing that ordinary voters couldn’t possibly understand but nonetheless had to cough up ungodly amounts of money for. This wasn’t a global financial crisis; it was a crisis of US real estate valuations. Whatever else went on, whatever shady dealings or irresponsible banking practices or misplaced belief in models or whatever else, it wouldn’t have had much of an effect on the world if it hadn’t all been based on a foundation of overvalued property prices. True, a lot of the disastrous financial wizardry was aimed at justifying and enabling the property bubble to continue and (as John points out in a couple of CT posts) the causal relationship between financial malpractice and the property bubble was two-directional, but it’s necessary to be clear here – the original sin here was the real estate bubble, a bubble which could and should have been the object of anti-bubble policy, and which wasn’t, because of a massive, ghastly policy error on the part of the Federal Reserve. This is Dean’s thesis, and he names the guilty men.

My god, by the way, does he ever name the guilty men. One of the very attractive characteristics of Dean Baker’s economics writing, shared with the best bits of Paul Krugman and Doug Henwood, is that he is a left-liberal writer about economics who completely lacks the ‘cultural cringe’ common to the species. He doesn’t feel the need to call people like Martin Feldstein “really smart” and he doesn’t waste time giving house room to the normal platitudes of market theism or pretending that his view of the world is really properly considered quite close to orthodoxy. In general, he doesn’t crawl around seeking the approval of the economics profession. I would surmise that the constant torrent of scorn would get depressing at length (as I think it sometimes does on his blog), just as a boy who kept on shouting out that the emperor was bare-arsed every ten seconds would eventually get on your nerves, but really, we can cross that bridge when the airwaves are full of self-confident liberal economists giving their message as if they expect it to be agreed with and The Economist is a minor newsletter.

But anyway, the explanation of what happened and its consequences is clear and simple – this is economics the way it ought to be done, focusing on simple causal relationships and adding-up constraints. None of the arguments made by housing bulls during the bubble made a lick of sense, for the simple reason that the ratio of house prices to rents was constantly increasing – any fundamental change in the economics of housing ought to have shown up equally in the rental market as in the market for house purchase, and the “buy versus rent calculation” wasn’t an anomaly or a quirk – it was a simple and easily comprehensible piece of information showing that prices were in a bubble, which was almost universally ignored. The model that fits the data is a simple, myopic-expectations one under which people were prepared to invest in housing at ever higher rental multiples (or alternatively, ever lower rental yields) because they were making an implicit comparison of the cost of renting a house versus the up-front, teaser-rate cost of buying one on mortgage, with the highest level of gearing that the market would give them. Such a model works until it doesn’t, and then we had the crash.

As I mention in a bit more detail on my own blog, this pretty much gives the lie to any comparisons with the Internet bubble – there really were a lot of new technologies invented between 1997 and 2001, many of which did in fact change the whole structure of economic life. But rent is rent and has seen basically no technological progress since the Domesday Book. Failure to spot the housing bubble was much more unforgivable than failure to spot the dot com bubble, and the case for anti-housing bubble policy is therefore much stronger than for anti-stock-market-bubble policy. I am not sure that I agree with all of Dean’s views on the TARP (not necessary, massive con), bank nationalization (should have happened) or policy solutions going forward (rather heavier on IMO meaningless financial technocratic fixes), but the facts are that I’m much more prepared to listen to them because they come from someone who was actually right about this damn thing, and who did indeed sell his house at a profit. And his key policy prescription, on the subject of the Federal Reserve Board and anyone who served on it in the last ten years(sack the bastards!), is a good point well made; there really does have to be some sort of accountability for this sort of thing.

[1] Capsule review of the Lewis book – definitely don’t bother with the hardback, it costs 25 quid, and is basically a collection of chortlesome anecdotes. On the other hand, Liar’s Poker was also basically a collection of chortlesome anecdotes and that was a very good book; Lewis does get the finance right and explains it in very clear terms (he even gets the analogy right, between a CDO and a housing block – this was the only way I found to explain these structures too). The cast of characters are interesting and well-researched and if it wasn’t for the constant rankling of the expense of the book, I think I would have wholeheartedly enjoyed it. In paperback it will be a very good read and probably cleanses Lewis’s soul of the accumulated sins of a decade of ghastly magazine articles. Now he just has to write something to make up for The New New Thing and he can probably go to heaven.

{ 71 comments }

1

kevincure 04.03.10 at 6:21 pm

I’ve not read Baker’s book, but I want to correct a misperception that seems more and more common, including in this post. I was at the Fed in 2006. *Everybody* at the Fed was aware that there was a housing bubble. The fact that rents and house prices had diverged was known to all of the policymakers I interacted with.

The question was not, is there a bubble, but rather, can monetary policy improve welfare by popping that bubble. The general opinion was no. First, monetary policy is an economy-wide hammer, and housing in only one sector. Second, housing bubbles were prevalent worldwide, and in fact were stronger in many other countries than the US, so it was difficult to imagine that non-extreme changes in policy would affect the bubble. Third, “use policy to clean up the mess after the bubble pops” was, I think, absolutely the right policy in 1987 and 2000, so a model of housing bubbles would have needed to explain what was different this time – even now, lost wealth from housing price declines are not, as far as I know, greater than the wealth decline of the dot-com bubble. That is, the housing bubble in and of itself required no different monetary policy, even with perfect hindsight.

The difference was in the financial markets, where for a variety of reasons (high leverage ratios, principal-agent problems, etc.), the decline in house prices led to what was functionally a bank run. The Fed was not the primary regulator of investment banks in the US, and is one of at least five regulators of local banks (OCC, FDIC, OTS, and state regulators among the others). This isn’t to excuse the Fed – they should have had an office looking at systemic risk! – but merely to point out that very few people saw systemic risk as a major problem in 2006, primarily because of a belief that shareholders and managers were capable of taking better care of their own firms and jobs. This was wrong, but the common criticisms of Baker and Shiller and others about Fed policy and housing bubbles completely abstract away from the real cause of the crisis, which was financial.

In any case, a housing bubble – by itself – would have been straightforward to deal with ex post with policy. That was not the problem.

2

Daniel 04.03.10 at 7:03 pm

I would argue that the first of these is not much of a reason – the housing bubble was distorting the whole economy, and in any case the Fed has plenty of policy levers other than interest rates. The second is also pretty irrelevant unless one seriously thought that US subprime customers would start taking out euro-denominated mortgages. The third is exactly ignoring the problem of systemic risk – it was clear in 2006 that this was reaching a level at which it could bring down the banking sector.

I agree with you that pro-active anti-bubble policy wasn’t carried out for more or less the reasons specified, but that’s really quite an indictment of everyone involved. I don’t agree that “That is, the housing bubble in and of itself required no different monetary policy, even with perfect hindsight.” -property bubbles are always correlated with financial crises and should be moderated by policy.

3

P O'Neill 04.03.10 at 7:13 pm

Ben Bernanke, summer 2007:

We will follow developments in the subprime market closely. However, fundamental factors–including solid growth in incomes and relatively low mortgage rates–should ultimately support the demand for housing, and at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.

That does not read like someone knowing there’s a bubble and lamenting only the lack of instruments to deal with it. Instead it is that as long as rates stay low and GDP growth continues, the party can continue … with the unmentioned fact of the housing bubble as a source of GDP growth!

4

bert 04.03.10 at 8:26 pm

On your own blog, didn’t you advance a rather stronger version of the price/rent relationship?
Not only does misalignment tip you off to a bubble, per Galbraith.
If the ratio remains constant, that’s solid reassurance that there’s no bubble.

The example you used was the British housing market. Obviously, there’s a need to explain why it hasn’t collapsed. But an upward shift in interest rates – and quite a small one by historical standards – is all that’s needed for today’s argument that the market is correctly priced (e.g.) to become in retrospect one of those this-time-it’s-different arguments that all bubbles seem to generate before they pop.
At which point the faithful reflection of inflated prices in inflated rents will be neither here nor there.

5

Metatone 04.03.10 at 9:06 pm

I also have to take major exception to kevincure’s attempt to excuse the Fed. The Fed made a whole slew of statements in the run up of the bubble, publicly claiming that there was no bubble, no need to worry… That alone is something concrete that could have been done differently…

The funny thing is, defending the Fed’s self-image ends up shifting the accusation from “ignorance” to something more serious. You all knew – and yet you went around denying it in public? Doesn’t that make you more culpable?

Finally – the monetary angle on this is – where is the money for the bubble coming from? Not just from homeowners doing silly things, it was happening in the commercial real estate market too – there was a lot of “hot money” sloshing around. But where “wage inflation” is a national emergency requiring jacking up interest rates, “asset inflation” doesn’t matter…

6

Daniel 04.03.10 at 9:37 pm

4: Yes I did, and in my professional research I’ve tried to convert the myopic-expectations model into something that can be used to make the call in real time. I wouldn’t be a buyer of UK housing right at the moment for that reason – it’s a long-duration real-yielding asset at a time when bond yields and inflation expectations are at an all time low.

But I would query whether just having prices go up and down means that there must be a bubble – if UK interest rates go up and house prices fall, then that’s not a bubble – just the normal relationship between money market rates and rental yields. The idea that house prices can only go down if something weird or unnatural happens is part of the psychology that built the bubble in the first place.

7

Ken Houghton 04.03.10 at 9:45 pm

“I think Baker might have caught the spirit of the times a bit better than Andrew Ross Sorkin or Michael Lewis.”

Geez, I thought there was going to be a level of quality to Baker’s book. I repeat my contention that, if it were judged fairly, Too Big to Read would be a contender for the Nebula Award this year. (That Sorkin can’t write non-fiction as well as Charlie Stross is sad–but the copyeditors in the sf field are apparently better than those hired by Viking for their Best-Seller genre.

8

kevincure 04.03.10 at 10:30 pm

Metatone…perhaps a more vocal policy by Bernanke could have had some effects on the margin, but again, I don’t think history supports the idea that bubbles can be “talked down”; witness Greenspan’s famous “irrational exuberance” speech in the mid-1990s and the resulting continued increased in tech stocks.

Daniel…we’ll have to agree to disagree, I think. The point of there being bubbles in Europe and Australia and China, etc., is not that all of those bubbles were simultaneously reflecting monetary policy, but that something other than monetary policy was the primary driver of the bubble – the literature suggests everything from animal spirits to savings gluts due to a bad decade for equities, and on the precise reason I’m pretty agnostic. Tighter money in the US would surely have caused a recession (the non-housing sector was not in great shape, particularly after the runup in oil prices), and may or may not have popped the housing bubble anyway. If your point about the Fed having other policy levers than interest rates is that it should have applied stricter regulation….then I agree completely. But again, the Fed is one of many, many regulators in the US, most of which are more directly controlled by elected government, and most of which are legally better able to target specific sectors (say, investment bank securitization rules).

9

Metatone 04.03.10 at 10:56 pm

kevincure – That’s a convenient way to look at it… but it’s not about “talking the bubble down” it’s about the fact that by denying there was a bubble in public Bernanke and others helped dissuade other agencies (who you claim were in a better position to regulate the bubble) from doing so.

Keeping quiet is a complicity – and further, by keeping quiet it doesn’t make us all feel like you’re necessarily telling the truth when you say “we all knew” – because there’s no evidence that you knew…

10

bert 04.04.10 at 12:18 am

Re the US, this is Greenspan in ’02: “As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact–that is, when its bursting confirmed its existence.” If there’s a misperception about what was going on inside the Fed during the housing bubble, start by looking at the maestro’s straightforward epistemological claims about the dotcom crash, and his declared preference for intervening only to mop up afterwards.

Re the UK: The scenario I have in mind – in which a relatively modest rise in interest rates triggers a series of defaults and forced sales, shifts market expectations towards falling prices, and triggers an extended, self-reinforcing downward correction – is just one of a range of possible futures. But to describe such a turn of events as “the normal relationship between money market rates and rental yields” would I think fail to capture the situation in all its essentials. It wouldn’t just be the middle-market tabloids who’d be finding something rather more exciting going on.

11

MQ 04.04.10 at 1:05 am

I was in DC at the time too, and I want to speak up for Kevincure’s view of things in 1, although I do have disagreements with it. People in the financial regulatory establishment were calculating the losses from the end of the housing bubble, from much higher levels of e.g. subprime defaults and big declines in mortgage equity withdrawals. That was widely foreseen. What Bernanke’s quote in 3 is getting is that they believed the losses from a subprime collapse were sustainable. Just as Kevin says, what wasn’t foreseen was the fragility that led to a much broader collapse of the entire shadow banking system.

Other commenters seem to be taking this statement as making excuses for the Fed and others, but it’s not. The fact is that the regulators of the financial system didn’t understand the system they were supposed to be regulating.

12

MQ 04.04.10 at 1:13 am

Where I disagree with Kevincure is the notion that ex ante it was the right choice not to take on the bubble, that it was legitimate not to view bubbles as dangerous. The huge inverted pyramid of leverage resting on the U.S. housing market was something that could have been spotted if people had, you know, been interested in looking into it. It’s quite logical that massive asset inflation will lead to financial market distortions, especially with a totally unregulated market in securitizations and derivatives. Also, it’s just absurd for the Fed to point the finger at the other banking supervisors. The Fed always is and was the systemic risk regulator, it saw itself that way and was seen as such by others. Only the Fed looked at the whole system and asked what it all meant for economic growth.

13

J. Scott 04.04.10 at 1:59 am

To explain the housing bubble and the economic and financial debacle that we are now experiencing, we need a book titled “Illicit Profits.”

A robust investigation into this financial disaster will require the work of three professions: Legal, Economics and Accounting. Until we get these three professions working together a la the Pecora Commission, we are unlikely to ever know the truth about the causes of our current economic and financial catastrophe.

The Pecora Commission understood the financial trickery of Wall Street and the banks. According to Wikipedia: Ferdinand Pecora, in his memoir “Wall Street Under Oath,” wrote: “Bitterly hostile was Wall Street to the enactment of the regulatory legislation. Had there been full disclosure of what was being done in furtherance of these schemes, they could not long have survived the fierce light of publicity and criticism. Legal chicanery and pitch darkness were the banker’s stoutest allies.”

Greed and corruption were the “bacteria” that infected Wall Street and the banks in the 1920s and 1930s, and once the regulatory “antibiotics” created in the 1930s were deemed unnecessary by Congress these same germs returned in a more virulent state; creating our most severe financial and economic downfall since the Great Depression.

14

Sebastian 04.04.10 at 2:37 am

So daniel, flat out, should we be worried about a housing bubble popping in the UK? Are any other European countries in danger of a housing bubble collapse? If so, should such governments be popping the bubble? How?

15

McDruid 04.04.10 at 5:14 am

Considering that by 2006, The Economist was calling the housing bubble the “Biggest Bubble in History,” it would be professional malfeasance for the Fed not to be thinking about it by then. But Baker recognized it, and proved it, in 2002. So perhaps professional malfeasance is not far from the mark.

Furthermore, Dr. Baker estimates the housing bubble (alone, not including second order financial leverage effects) was some $8 Trillion, which pretty much beggars the dot com piffle.

Also, the remark about Greenspan’s “irrational exuberance” remark ignores the fact that he almost immediately retracted it. Indeed, in his autobiography he goes on to defend this retraction by stating that bubbles are not recognizable beforehand and his I.R. remark was ill-advised. History shows him to be wrong on both counts.

16

glenn 04.04.10 at 6:43 am

Be very worried about Australia. Big, big bubble. Big, big trouble. I think the best that the average person can do is figure out the price/rent equivalent for themselves and act accordingly.

17

Steve Sailer 04.04.10 at 7:03 am

What’s widely forgotten is how much the politicians, such as George W. Bush, and financiers, such as Angelo Mozilo of Countrywide, behind the real estate bubble justified their actions at the time as needed to increase racial equality in homeownership rates. For example, at Bush’s October 15, 2002 White House Conference on Increasing Minority Homeownership, the President targeted down payment requirements as the primary hurdle to narrowing the racial gap in homeownership. Angelo Mozilo’s 2003 Harvard address centered around the same rationalization: regulations requiring down payments on home purchases were effectively racist.

18

annie 04.04.10 at 7:42 am

kevincure’s example of the fed’s powerlessness in ‘talking bubbles down’–greenspan’s ‘famous irrational exuberance’ speech–is exactly an example of the fed chairman’s power to talk down bubbles: when greenspan uttered that phrase, the market panicked; greenspan famously backtracked, subsequently using his platform again and again to agree that absurd valuations might indeed be justified in some new tech-driven world.

but kevincure’s justification (that whole second paragraph) of bubble economies–don’t pop, clean up pop-slop by creating new bubble–is the most cynical ‘insider’ take i’ve seen. what in the world could this greater ‘welfare’ be, anyway? employment? now we have a banking system that no one in the world trusts?

(i do disagree with daniel that the real estate bubble is the original sin. the real estate bubble was the solution to the effects of the burst dot com bubble. the arguments about rents can be applied to all sorts of metrics for evaluating price/earnings. it was certainly possible in real time to spot crazy valuations of tech stocks as well as the absurd rationalizations for them. people did.)

okay, tell me that the fed right now understands the ramifications of the coming inflation. tell me that economists do.

19

Daniel 04.04.10 at 10:07 am

The point of there being bubbles in Europe and Australia and China, etc., is not that all of those bubbles were simultaneously reflecting monetary policy, but that something other than monetary policy was the primary driver of the bubble

But Europe and Australia had exactly the same (easy) monetary policy as the USA, didn’t they? I’m sure there were plenty of people at the Fed who saw that there was a housing bubble (it was blindingly obvious after all), but I would guess that this was similar to how the equities bubble was viewed when I was at the Bank of England – something that was an amusing intellectual exercise but didn’t connect up to the rest of the economics we were doing.

I have more sense than to mention Zizek in a front page post, but he has a very useful coinage in one of his books about Iraq – that to Donald Rumsfeld’s famous three categories, we should add the “unknown knowns” – things that we do know, but for one reason or another are going to behave as if we didn’t know we knew. The housing bubble is a wonderful example of an unknown known.

Sebastian – see 4 – I would guess there’s a significant probability of UK house prices falling in nominal terms, but I would disagree that this would constitute the popping of a bubble. The European country I’d be most worried about would be Sweden – look at what’s happened to house prices there over the recession – but the analysis is made a bit more complicated by the fact that there’s basically no private sector rental market and no reliable yield series. Nonetheless, if I were at the Riksbank I would definitely be advising that Basel 2 should not be implemented in the current form, because it deliver a capital charge on Swedish mortgages which is much too low; I’d set an absolute floor at a 30% weighting. There you go, a specific prediction and policy recommendation!

Annie: re equity valuations, I agree with you that they were ridiculous but at least there was an actual debate to be had there – it was not absolutely ridiculous to say that growth was going to take off and justify those valuations because of technical progress, Moore’s Law and network effects – if you look at the specific company Apple Computer this is basically what happened and although something like this couldn’t have happened to the whole market, that’s what the underlying logic was. Rent, on the other hand, as I say, is rent.

Steve Sailer – oh do put a sock in it, will you?

20

Alex 04.04.10 at 10:31 am

The scenario I have in mind – in which a relatively modest rise in interest rates triggers a series of defaults and forced sales, shifts market expectations towards falling prices, and triggers an extended, self-reinforcing downward correction

This scenario *is* a housing bubble, isn’t it? If prices are high enough, and lending loose enough, that the normal range of variation in the BoE interest rate is enough to render significant numbers of buyers unable to service their debts, that’s another way of saying the market has already reached Minsky Stage 2 (“Speculative”) and is heading for Stage 3 (“Ponzi”) at a rate of knots.

I understand Daniel’s earlier post on D^2 Digest to mean that the unique feature of housing bubbles is that they bring the full power of a leverage-driven financial crisis within reach of the common man; businessmen will always lever up too far and get burned every now and again, but only real estate lets the workers do the same across the entire economy. It’s a little like James Nicoll’s remark about the commercial-space fans who talk about the “interplanetary Conestoga” without realising that it implies giving everybody access to as much energy as is contained in a small nuclear bomb – a participatory weapon of mass economic destruction.

The worst of it is that the distributed nature of the bubble means that any action that pops it will do so by bringing about mass default and bankruptcy and a systemic banking crisis. Arguably, the whole point of prudential regulation with regard to the housing market is to prevent this situation, where the primary counter-inflation tool becomes mass default, bankruptcy, and systemic financial crisis, from coming about.

21

Alex 04.04.10 at 10:37 am

Steve Sailer well knows that the vast bulk of the famous subprime mortgages were issued by institutions not subject to the CRA. This makes no difference to him. Nor does the fact, as the good people at Calculated Risk would point out, that in the event, the bubble and crash reached the Alt-A and prime markets fairly well too.

Strangely, I note that he doesn’t single out the CEOs of Washington Mutual, ABN AMRO, IKB Industriekreditbank, RBS, HBOS, Citigroup, or indeed any other of the many, many financial institutions that disgraced themselves. I hypothesise that this may be connected with the fact that Angelo Mozilo’s surname ends in “o”, and predict that Sailer is now going to whine at me and probably get disemvowelled.

22

Barry 04.04.10 at 12:10 pm

“Steve Sailer well knows that the vast bulk of the famous subprime mortgages were issued by institutions not subject to the CRA. This makes no difference to him. Nor does the fact, as the good people at Calculated Risk would point out, that in the event, the bubble and crash reached the Alt-A and prime markets fairly well too.”

Where (from memory), ‘vast bulk’ means ‘99.5% of’. CRA mortgages accounted for 0.5% or thereabouts of mortgages. If they were capable of taking down the mortgage market and Wall St, then we need to rebuild our economic ideas from the level of ‘1+1=2′.

23

Daniel 04.04.10 at 12:20 pm

Alex makes a good point above that the other difference between the dot com bubble and the housing bubble was that the dot com (like the Amsterdam tulip bubble if you believe Peter Garber) was basically a rich man’s amusement – some people got rich, some got screwed, but very few people actually underwent real hardship; it was mainly a device whereby a chunk of private equity cash was handed over to techie types and/or sent up the noses of the advertising industry. The housing bubble (like the Amsterdam tulip bubble if you don’t believe Peter Garber) was a widespread phenomenon that, more or less by definition, reached every level of society down to the poorest, and was debt financed. I don’t see how Kevin Cure’s mates could not have realised it was going to be very destructive.

I would just note though that anti-bubble policy doesn’t necessarily mean causing major crises. This one was clearly visible in 2005/6 and if it had been “popped” then we would have had something significantly less bad than the UK housing pop of the 1990s. As I say, the psychology that any house price fall is per se a disaster is a big part of the problem.

24

Henri Vieuxtemps 04.04.10 at 1:24 pm

The housing bubble (like the Amsterdam tulip bubble if you don’t believe Peter Garber) was a widespread phenomenon

Widespread, yes, but house is not a tulip. If you already owned a house – the price went up, then down, you still own the same house. If you bought a house at the peak, no money down/low interest deal – you lived in the house for a while, paying, probably, less than you would renting, then walked away. You only underwent real hardship (because of the bubble itself) if you bought/refinanced around the peak while retaining significant equity. Am I wrong?

25

Ebenezer Scrooge 04.04.10 at 1:39 pm

Kevincure would have a very good point–if the only tool at the Fed’s command were monetary policy. But the Fed is also responsible for consumer regulations, which had a little bit to do with the housing bubble. (Pardon my litotes.) And the Fed is authorized to supervise nonbank mortgage companies that are affiliated with banks–something it pointedly chose not to do over the Greenspan era.

26

ken melvin 04.04.10 at 1:46 pm

Bubbles, be they somewhat like tornadoes? Are certain conditions requisite? Without the housing bubble, the economy had been in the tank at least since 03, probably 01. I suspect that there’s been little real economy in a long long time. Reagan’s ‘recovery’ was really massive deficit based defense spending spree (FMC making armored whatevers farming out to every machine shop within 200 miles). Show me the real economy behind Clinton’s.

27

annie 04.04.10 at 2:07 pm

daniel, you say valuations were ‘ridiculous’ but it was ‘not absolutely ridiculous’ to argue that they were not ridiculous?

28

Gareth Rees 04.04.10 at 2:13 pm

If you bought a house at the peak, no money down/low interest deal – you lived in the house for a while, paying, probably, less than you would renting, then walked away. You [didn’t undergo] real hardship

“Walking away” is only possible in jurisdictions where, in the event of mortgage default, the lender’s recourse is limited to the collateral. In most places (e.g. the UK) the debtor can’t “walk away”—after the lender repossesses and sells the collateral, they can and do pursue the debtor for any remaining shortfall. And even in “non-recourse” jurisdictions like California I can’t believe that foreclosure is not a real hardship for most people. No doubt you can find some examples of people who walked away laughing, but most mortgagors would have struggled to keep up with payments (perhaps drawing down savings) before defaulting, and afterwards found their access to credit denied. In order to rent, you need savings (for deposits) and good credit (to satisfy the landlord) too.

29

Daniel 04.04.10 at 2:20 pm

yes, I’m perhaps not at the height of my powers after an exceptionally nice Easter lunch, but what I meant to say that there was a case to be made that valuations were not ridiculous, and that while wrong, this case was at least intellectually respectable.

30

bert 04.04.10 at 2:25 pm

#20: “This scenario is a housing bubble, isn’t it?”

Yup.
As I understand it, though, Daniel’s counsel (this is the post I’m thinking of) would be to look at the price/rental ratio, and check on any slippage. Is the relationship steady? If so, there’s no bubble, and you’re worrying yourself unduly.
This seems to me rather too narrow a definition to be useful. Daniel means it to apply merely to the housing market. As he observes, you need to complicate matters to take into account broader economic change before you can talk about stock bubbles. And I don’t know how you’d even start talking about tulips in terms of return on equity.

31

Minor nonsense 04.04.10 at 2:59 pm

Mention of the Doomsday book. I read an analysis of the ownership of plowed land in England at the time of the Norman takeover. One sixth of all land in England was owned by one single monastery. The total land owned by the church was well over half of all land.

Henry VIII was right to have seized the church’s lands and break up them into viable parcels at the time of the Reformation. The steady accumulation of wealth that was held in England instead of flowing to the mother church financed the Industrial Revolution a couple of centuries later in Great Britain.

The Papal States at the time that Italy seized them from the Papacy were incredibly backward and definitely not a safe place for a peasant to live.

32

roger 04.04.10 at 3:20 pm

Of your housing bubble books, I’d add Our Lot. Alyssa Katz’s book looks at how the bubble worked from the ground level. The chapter on the decimation of Cleveland’s neightborhoods, for instance, is absolutely horrifying.

Myself, I am still hoping for the ‘general strike” – the mass jingle mail of the 10 million homeowners who are so undersater they are never coming back.

33

leederick 04.04.10 at 3:48 pm

“But I would query whether just having prices go up and down means that there must be a bubble – if UK interest rates go up and house prices fall, then that’s not a bubble”

I don’t really follow the significance of the talk about bubbles. If the problem’s overvaluation, does it matter whether this is caused by a bubble or not? What’s the practical consequence of the distinction? Suppose house prices fall due to changes in interest rates or planning laws or whatever, then people and institutions exposed to changes in house prices are still in trouble even through there’s no speculative bubble.

The reason I mention this is if that’s your diagnosis, then talk of an anti-housing bubble policy seems an incomplete solution, surely maintaining house prices (or at least trying to prevent house price falls) should be the policy goal. And that’s a big broader that just an anti-bubble target.

34

Sebastian 04.04.10 at 4:32 pm

“I would just note though that anti-bubble policy doesn’t necessarily mean causing major crises. This one was clearly visible in 2005/6 and if it had been “popped” then we would have had something significantly less bad than the UK housing pop of the 1990s. “

I guess this has always been my sticking point. I’m not knowledgeable enough to be able to analyze all of the Fed’s tools, but I thought the general consensus was that any attempt to pop the bubble was likely to cause a major crisis, which is why everyone was scared to do it. (Which is why the irrational exuberance speech, subsequent freakout and then walkback is instructive).

So I guess, what Fed action (taken in say 2002? 2004? 2006?) would have had both a good chance of popping the bubble and a good chance of not sinking the frankly anemic recovery that was going on at the time? That seems like the fear.

(Now in hindsight it would clearly have been worth tanking the recovery even quite a bit to avoid the actual outcome, but politicians and even central bankers don’t like tanking even strong recoveries, much less slight ones).

And that is kind of why I’m curious about the UK. It looks like it might still be “in bubble” and you seem to be rather cagey about whether it is/isn’t. Most people probably wouldn’t counsel risking the slight signs of recovery we are getting to deal with it. And that, is pretty much how the Fed felt, right? Sort of: “yeah it definitely has some bubble characteristics, but it doesn’t seem worth the risk of tanking our recovery to try to pop it, and maybe it will go away on its own, and we can just pick up the pieces later”

I’m not trying to be argumentative for the sake of it. More like pointing out that your famously strident style becomes uncharacteristically modest and hedging when you are close to home. And if even you are loathe to make the call when it might impact your local economy, I can see how bankers might be loathe to tank their local economies.

(I guess this all changes if there was an easyish way to both pop it and not risk tanking the economy, but I haven’t been exposed to it).

35

Henri Vieuxtemps 04.04.10 at 5:07 pm

No doubt you can find some examples of people who walked away laughing, but most mortgagors would have struggled to keep up with payments (perhaps drawing down savings) before defaulting, and afterwards found their access to credit denied.

Still, it’s nothing like investing in tulips. One could, one had the choice to default and stay in the house until evicted; probably for at least 6 months. Unpleasant? Sure. Hardship? Not necessarily. Could be viewed as an opportunity. Your mortgage company invested in tulips, not you.

36

guthrie 04.04.10 at 6:01 pm

As a somewhat well educated man in the street I knew that a houseprice bubble was inflating, and based my 2 year fixed mortgage around that fact. I expected the irrational exuberance to run out by early 2007 and interest rates to start falling after then, so that I could re-mortgage on a lower rate. How optimistic of me, the madness went on a year longer than I expected. (I’m in Scotland)

On the other hand one or two people at work heard what I said about a crash being due, and still hold me in high regard for it.

So what is happening to the UK market just now? I know there is probably a short term bottleneck in terms of new housing, but why are prices rising so fast towards the old peak? Certainly round my area prices are still maybe 10% lower than they were at the height of the bubble, and I know of people who can’t get amortgage because the banks have increased the deposit requirements, so where is the money to fund the current bubble coming from?

37

Metatone 04.04.10 at 6:32 pm

guthrie – one element in the current UK housing bubble appears to just be low transaction volumes. It seems that the people who are in economic distress are largely not homeowners… thus few people are lowering their selling price…

38

Sandwichman 04.04.10 at 6:40 pm

At the risk of changing the subject from endless rehashing of the past, I would like to suggest that Dean Baker’s proposed policy response to the employment consequences of the bursting of the bubble is more intimately related to the bubble dynamics than perhaps even Dean recognizes. Dean’s proposal of a tax incentive for work-time reduction meets the criteria for one of Daniel’s “unknown knowns”.

The relationship between working time and productivity has been known for well over a century. Yet post-war American economists have made a fetish out of ignoring its implications. Here is one form of productivity enhancement that is unambiguously pro-labor and job creating. But policy to encourage work time reduction is anathema to American economists. Better to always “invest” in new capital formation or bubble inflation. Witness Larry Summers’s curt dismissal of the alternative, “It may be desirable to have a given amount of work shared among more people. But that’s not as desirable as expanding the total amount of work.” It’s bubble or nothing!

Where most critics of bubble-fueled growth fall down is that they fail to acknowledge that the bubble-blowers really have no other option. Having excluded work time reduction as a policy option, the only way left to induce satisfactory employment growth is to pump debt into the system. It’s not as if you can “reflate” more prudently and moderately. That’s like getting only a little bit pregnant. At this point in the evolution of post-war, post-Keynesian growth policy tinkering, to get the requisite employment effect, the bubble-blowing must be appropriately reckless.

Why not try the alternative? Try? People don’t seem to want to even talk about it. 32 comments into a discussion of Dean’s book, there hasn’t been a single mention of Dean’s proposed alternative!

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dsquared 04.04.10 at 6:50 pm

I don’t think I’m being cagey about the UK, Sebastian – I don’t think that it is currently a bubble. But, I do think that house prices ought to vary with the level of bond yields and interest rates more than they have in the past, and I think they will more in the future (because of the importance of the buy-to-let market). My point being that house prices can go down even when there isn’t a bubble, and this might even be quite likely to happen. So my view at the moment is that because the UK doesn’t have a housing bubble at present, raising rates wouldn’t be an anti-bubble policy – it would have the effect of making house prices go down, but this is just because it would be an inappropriately deflationary policy. In general, though, I don’t think any policymaker should have a never-falling-house-prices objective; although housing is one of the few assets that the man in the street can speculate in with leverage, mortgage debt is one of the few forms of speculative finance that isn’t subject to variation margin. A little bit of volatility in house prices doesn’t hurt very much; what hurts is when it’s all stored up and then released on one big lump.

40

engels 04.04.10 at 7:00 pm

“It may be desirable to have a given amount of work shared among more people. But that’s not as desirable as erranding the total amount of work.”

What a dick.

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Salient 04.04.10 at 7:32 pm

HV — lots of well-meaning people feel a strong moral obligation to fulfill their mortgage and/or equity loan terms, for as long as possible, rather than walk away. Also, declaring bankruptcy’s expensive and damaging, even where it’s possible, and just walking away has significant painful long-term consequences (e.g. when obtaining credit).

I don’t get the idea of “investment” because a lot of folks bought a home in order to live in it. (I have no strong sympathy for flippers who lose out or lost out.) In the “we would rather live in house A but house B is obviously a better financial investment” calculus, doesn’t house A generally win?

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Sandwichman 04.04.10 at 9:19 pm

Further to the point I raised above, beyond a certain minimum set-up or settling-in time, there is an inverse relationship between the length of the working day (week, year, etc.) and the intensity of work effort. That is to say, for a working period that exceeds an optimal length (which is a function of the state of technology) ADDING an increment of time to the usual length will SUBTRACT an increment of output. Similarly, failure to progressively reduce working time in response to technological advances will result in diminished productivity gains, relative to the technologically-determined potential.

To make a long story short, a long hours bias leads, necessarily, to higher labor costs (relative to capital), lower wages and constrained employment growth. This is not always a bad thing — IF YOU’RE a RENTIER! Otherwise it sucks. Where Summers screws up is not so much in desiring an expanded total amount of work to a presumed “given” amount but in the unjustifiable presumption that work time reduction is a “zero sum game” while debt-fueled expansion is inherently dynamic. The opposite is true.

Now the conventional economists’ way around these fundamental laws of supply and demand and human capacities is to ASSUME that profit-maximizing firms will optimize working time. That assumption, however, has been demonstrated to be false. It is the great “unknown known” of neo-classical economics. Sydney Chapman’s theory of the hours of labor is the canonical but unknown neo-classical analysis. It confirms Marx’s analysis of human capacities and the relationship between the extensive and intensive dimensions of labor. Keynes himself affirmed that “working less” is the “ultimate solution” to the long term problem of full employment. But even the enlightened readers of this blog seem hesitant to rid themselves of the “bubble or nothing” straitjacket.

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Witt 04.04.10 at 9:31 pm

the psychology that any house price fall is per se a disaster is a big part of the problem.

And maybe another part is that sins of omission are often judged less harshly than sins of commission. (Medical malpractice as a common example.)

I know nothing about this field, but when I read kevincure’s comments, I hear an undertone of ‘People won’t be as mad at us for NOT having done something as they would be if we *did* try doing something and it turned out to be the wrong thing.’ Or less kindly, ‘People like bubbles and they’ll be mad at us if we pop them.’

To add to what Gareth Rees and Salient said: People also don’t walk away from their mortgages because:

1. Abandoning your debt is often seen as shameful (otherwise collection agencies wouldn’t make so much money convincing bereaved families to pay off their deceased loved one’s credit card debts).

2. Many, many jobs in the US require a good credit record. If you stopped paying your mortgage because you lost your job, you’re probably pretty tense about finding a new job, and wary of doing anything that will lessen your chances. If you’ve watched one friend go through a lengthy hiring process only to have an offer yanked at the last minute due to a bad credit history, you’re probably doubly wary.

3. If your child custody agreement depends on “providing a good living environment,” you may be afraid that losing your house means losing access to your kids. Terrifying.

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ken melvin 04.04.10 at 10:19 pm

@ 43: It so cause I saw it on TV.

45

Sandwichman 04.04.10 at 11:14 pm

Dean Baker:

“If we lack enough useful ways to employ our workforce, we could simply work less. Instead of having 10 percent of the workforce unemployed, we could have the whole workforce employed, but working 10 percent fewer hours. If everyone got paid the same as when they worked 10 percent more hours (a situation that we can bring about using government money, because of a shortfall in demand), everyone should be better off and we will have eliminated unemployment. The real world will never be this simple, but we can follow this logic to try to bring the economy to full employment by shortening working hours and leaving total pay unchanged.

“Reducing unemployment through a reduction in average work hours can be accomplished by giving a tax credit to employers to give their workers paid time off, which can take the form of paid family leave, paid sick days, paid vacation, or a shorter work week. This tax credit would both provide short-term stimulus and an incentive to restructure workplaces in ways that are more family friendly. It is likely that many workplaces will leave in place changes enacted to take advantage of this tax credit long after the credit has expired.”

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scathew 04.05.10 at 12:38 am

Like the first commenter here, I’d have disagree with the contention that the bubble in itself was the biggest problem. As the system is set up, there will always be bubbles, but the effect of the deflation of those bubbles is ultimately the problem.

The number of “innovative” (ie: high risk) products out there and the industry’s use of them took a recession causing debacle into a potentially depression causing debacle. It was the over-leveraging of the industry, in part through deregulation and policy capture, that took something that would been painful but correctable to something life threatening.

Yes, my dog (and this true) died because he was hit by a car, but had he not had a unknown cancer that depleted his platelets he would have survived. Certainly I blame the driver who was blind to us on the crosswalk, but ultimately anything that made him bleed would have killed him.

In short, the Internet bubble would have been just as devastating in 2008 as the housing bubble – the cancer came from inside. You can blame the people who let the wound happen, but the cancer is what killed us.

47

bianca steele 04.05.10 at 12:44 am

No signs that the dotcom bubble was a bubble? Maybe not if you don’t distinguish between the historically high P/E ratios in normal tech stocks and the new “dot coms.” And even then: there were too many “sure things,” in retrospect, which probably (I don’t know much about it) suggests that things like IPO’s were deliberately priced much too low to begin with (and yet that’s the opposite problem to high P/E’s, which doesn’t make sense to me either). The people involved might have burned out after 15+ years of startup mode anyway, even if the cash hadn’t dried up, but there’s no way of knowing. The dotcoms were entirely different. The big bust-ups you heard about were the successes: the ones who actually had something to show for their work even though it consistently lost money. The worst of them did everything wrong, and their tendencies to make those mistakes were in the paper week after week.

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Jesse 04.05.10 at 1:15 am

Metatone is exactly right in his response to kevincure.

The Fed was not quiet or helpless in the face of the housing bubble – it was complicit and aggressively supportive. I am not talking about the rank and file, but the policymakers.

Robert Reich does a better job than Dean Baker perhaps in naming names, starting with Greenspan and moving on to Summers and Rubin. Greenspan was a disgrace as Fed chairman, and I find it madly discouraging that even now economists will concoct fairy tales to excuse his egregious misbehaviour in tearing down regulations and those who sounded warnings while pouring grain alcohol into the punchbowl.

49

Consumatopia 04.05.10 at 1:20 am

Tighter money in the US would surely have caused a recession (the non-housing sector was not in great shape, particularly after the runup in oil prices), and may or may not have popped the housing bubble anyway. Tighter money in the US would surely have caused a recession (the non-housing sector was not in great shape, particularly after the runup in oil prices), and may or may not have popped the housing bubble anyway. If your point about the Fed having other policy levers than interest rates is that it should have applied stricter regulation….then I agree completely. But again, the Fed is one of many, many regulators in the US, most of which are more directly controlled by elected government, and most of which are legally better able to target specific sectors (say, investment bank securitization rules).

I’m not sure this point by kevincure got enough attention. I’m highly sympathetic to the view that real-estate bubbles are much worse and easier to spot than equity bubbles, but is the Fed really the best place to do something sector-specific like that?

50

Concerned Economist 04.05.10 at 3:14 am

Daniel,

You wrote above that (in your professional research) you have a model which can (might?) be able to detect a bubble in real time based on price and rent data. Most economists I know don’t really have satisfactory ways of thinking about bubbles and certainly don’t have viable ways of detecting them (much less in real time).

Would you be willing to post a link or a sketch of your model / idea?

51

dsquared 04.05.10 at 10:22 am

If you have access to the Multex distribution system, you can get “As Safe As House Prices?”, which I wrote in 2004 (found UK house prices to be on the cusp of a bubble at the time) and “Even in Ireland, Trees Don’t Grow To The Sky” (found Irish prices to be in a bubble in 2006). If not, then it’s really no more complicated than above and is based on the Minsky hedge/speculative/Ponzi taxonomy. You calculate the average marginal rental yield, and you calculate the average marginal financing cost, and then you know whether the marginal buyer is covering his costs with imputed rent or is reliant on future capital gains to refinance.

It tends to be a hell of a lot of work to get an accurate assessment of the true rental yield being faced by a representative purchaser, but hell, nobody said it was going to be easy?

52

dsquared 04.05.10 at 10:25 am

The number of “innovative” (ie: high risk) products out there and the industry’s use of them took a recession causing debacle into a potentially depression causing debacle.

But the lenders didn’t construct these products out of pure cackling evil or out of a belief they were safe. The products were created because they were the only way to get people into houses because the houses were overpriced. They were a consequence, not a cause, of the bubble.

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bunbury 04.05.10 at 1:37 pm

If it was obvious that there was a bubble in house prices then surely it should have been obvious to the lenders too. The frailty of the banks is a constraint on monetary policy. If market forces were able to resist the temptation to lend into a bubble as surely they ought, then it would not be obvious that monetary policy was responsible. That is monetary policy is only to blame in so far as banks are too delicate to be left out in the rain.

The argument applies even more strongly to Steve Sailer’s CRA zombie. Even if you can believe that the CRA was an economic quivering palm where a barely noticeable action has devastating results decades later, it could only do so through the inability of markets to behave rationally. Also why only wind that clock back as far as the CRA? The link to that from Tulsa 1921 is fairly transparent.

There is a difference between the US and most European countries in that the US bubble was not simply an asset price bubble, there was a construction boom too and some places, Detroit for instance, had bust without boom.

In Europe I suspect it will be more demographically driven. I can’t wait for the day it becomes clear to Daily Mail readers that they have to choose between immigration and house prices.

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Henri Vieuxtemps 04.05.10 at 2:43 pm

But the lenders didn’t construct these products out of pure cackling evil or out of a belief they were safe. The products were created because they were the only way to get people into houses because the houses were overpriced.

The lenders don’t care; the lenders usually don’t keep loans they make, they sell them. But someone was buying them, investment companies were buying mortgages that only had value under the assumption that RE prices would keep going up. Those who were buying mortgage-backed securities kept injecting money into the bubble; they, as scathew 46 said, are the source of the problem.

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Sebastian 04.05.10 at 4:01 pm

“The products were created because they were the only way to get people into houses because the houses were overpriced. They were a consequence, not a cause, of the bubble.”

Isn’t it kind of both? They weren’t an initial cause of the bubble, but because they allowed people to get into already overpriced houses that they never could have gotten before, and because they were financed in such away as to require the assumption of stable and in some case necessarily positive housing prices, they inflated the ongoing bubble much further.

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chris 04.05.10 at 4:21 pm

The fact is that the regulators of the financial system didn’t understand the system they were supposed to be regulating.

This is not an accident. The industry’s primary product and the reason for its explosive growth is incomprehensibility.

There’s an old joke about the postmodern mafia making you an offer you can’t understand. But that’s not just a joke anymore, it’s a business model. Making offers you can’t understand has been big business for decades now. There are professional obfuscators of great skill who know that if the other party understands the deal, they won’t take it; but if they accept the contract, they will have no legal recourse if it turns out to mean something other than they thought it meant. Thus, the deal is possible and profitable only in the absence of understanding.

I doubt if even 10% of subprime mortgage buyers understood the terms of their mortgages. And this isn’t just incidental, it’s crucial — the terms they didn’t understand would have been deal breakers if they had understood them. Obfuscation was what closed millions of sales.

Of course, a borrower who doesn’t understand that he won’t be able to make his payments after 2 years is a time bomb. Better sell that to someone else quick. But make sure they don’t understand it either, or they won’t buy.

The modern financial industry consists *mainly* of increasingly sophisticated forms of technically-not-fraud.

(P.S. The Chicago School has nothing to say about contracts that wouldn’t have existed if both parties had understood their terms. That kind of messy information problem simplifies right out of their models.)

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nassim sabba 04.05.10 at 4:36 pm

You have to be kidding here. I am a high school drop-out. Don’t know where University of Chicago is, but have been to Harvard Square twice.

As a lay, I resisted my wife’s insistence on purchasing a home (condo). With rents HALF as much as mortgage, taxes, maintenance fees, repairs, etc. even after tax deductions at our 28% tax rate. Rents are still about the same, prices have come down about 15%, but have to go a long way to match rents.

The fact that all this was due to crazy mortgage rules was very clear to me in 2006. I may have had subconscious input by browsing to sites like Mr. Baker’s, but in general, a few rules of thumb showed that it was a HUGE and unsustainable price inflation that couldn’t be justified by rent measures, or even by housing costs as a % of average family’s income in our town (65,000).

Home Depot, and Lowes were riding the wave. People bought cars twice as expensive as they could really afford, took vacations that they couldn’t have dreamed of five years before, bought boats, remodeled their homes to inappropriate levels for the location, renewing their appliances which were in perfect working conditions. Plastic and elective surgeries increased in number, major cosmetic dental works were done at twice the rate two years before (I have orthodontists who work at Tufts Univ. and have data for this).

So, GM, Ford, Toyota, Boeing, GE, Whirlpool, LC, Sony, and all the rest of the economy was riding the bubble. The minds at the Reserve didn’t see that? Pinch me. Slap me. Maybe I am dreaming. The bubble was one sector on which the whole economy was riding.

It was all ignored, if you want to be kind. The reason is obvious if you “follow the money”.

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john c. halasz 04.05.10 at 4:50 pm

@52:

“But the lenders didn’t construct these products out of pure cackling evil or out of a belief they were safe. The products were created because they were the only way to get people into houses because the houses were overpriced. They were a consequence, not a cause, of the bubble.”

No, it was the building up of the pyramiding machinery of structured securitization that caused the “wall of liquidity” behind the housing (and more generally, credit), bubble. So long as Wall St. could dump the unsaleable “mezzanine” tranches that resulted from manufacturing “AAA” tranches out of crappy loans, where the most risk was concentrated, into resecuritizations in CDOs and CDO^2s, miraculously producing further “AAA” tranches, the sky was the limit. And then, at the peak, it was precisely the shorts, soliciting deals via synthetic CDOs, that drove the credit spreads back down exactly when they should have been blowing out and shutting down any continuing activity on such “markets”.

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Antonio Conselheiro 04.05.10 at 5:30 pm

Life is good for economics nihilists these days, or it would be if that was all we were. Unfortunately, we’re also flesh and blood and have families, and since we don’t think that the worst is over yet, we worry about how many of us will get caught in the wreckage. I dearly wish that Western Civilization had collapsed 42 years ago when I wanted it to, rather than now.

As far as naming the guilty goes, it’s impossible for there to be too much of that. As far as I’m concerned the whole economics profession is guilty either of fraud, collaboration in fraud, or cowardly silence — but we all knew that. (The finance profession of course is much worse, since economists were seldom directly guilty of crimes). They’ll be held harmless by tenure and their own prudent investment practices, so we needn’t worry our heads about retribution of any kind. Two wrongs don’t make a right, you know.

Free-market cargo-culters in academia, government, the media, and the two political parties have by now succeeded in turning the American body politic into a raging mass of angry, fearful morons, the loudest fraction of which thinks that deregulation, lower taxes, and immigration restrictions are what we need now. They no longer trust the Republicans and are looking for someone worse.

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chrismealy 04.05.10 at 5:45 pm

What’s the Galbraith line? Something like every generation thinks it’s a genius for inventing a new kind of debt?

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Martin Bento 04.05.10 at 5:47 pm

Daniel, so then what did cause the bubble? I think saying overvalued real estate does not push the causal chain back far enough to tell us anything useful. Further, I do think the loan products did push the prices up, more than the other way around. First of all, people estimate what they can “afford” based on the payments short-term. These loans increased what people could afford and thereby increased demand: that’s what drives up prices. If not this, what was driving up the prices? Further, for all the scolding from Obama et al about people buying homes they could not afford, these loans made perfect sense for both borrower and lender if one assumes house prices will continue to escalate quickly and for neither otherwise. So long as house prices were going up, the buyer could sell out or refi to a better loan before the payments escalated. Otherwise, the buyer would default, which the lender presumably does not want. So the lenders were offering loans that only made sense with steadily-increasing prices and that also caused prices to escalate by increasing demand through deferment of ownership costs (through no down payment, interest only, and similar devices). And the chronology supports me on this: zero down payment, interest only, and ARMs all originated in the 90’s, before the bubble got going.

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szara 04.05.10 at 6:00 pm

I don’t see how anyone can defend the Fed’s failure to use it’s unique powers under Regulation Z of the HOEPA act. It can ban practices made by any kind of lender, just by following a standard regulatory review and comment process. This is a unique regulatory “superpower”. The late Ed Gramlich on the Fed Board was arguing for precisely this action and was ignored. The Fed eventually did act, banning some of the most egregious lending practices for subprime loans (stated income loans, qualifying borrowers based on teaser rate, prepayment penalties, non-allowance for tax and insurance payments) in July 2008. It was too late, of course, but still a good thing. They currently have a proposed regulation out for review to restrict abusive yield spread premiums (paying a bonus to the mortgage broker based on how nasty a loan he can coax you into). Again, too late, but still a good thing. Had the Fed taken these actions in 2004 or 2005, it would have had a definite effect in reining in the most abusive loans and cooling off the overheated markets driven by these predatory loan products. Of course, nobody would have thanked them for their efforts, but that’s why you have an independent Fed.

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ANNMARIA 04.05.10 at 6:50 pm

What caused the bubble? A Ponzi scheme, overvalued homes, credit decisions with little relationship to actual data, valuing of securities with little reference to underlying asset value and generally all those people who thought they’d never need math and would believe in magic instead.

We didn’t buy a house despite the large numbers of friends and colleagues telling us we were missing out. We live in a neighborhood where the average 3-bedroom condominium sold for substantially over a million dollars. Our real estate agent qualified us for a loan for over a million dollars. We have good credit and good jobs but we also had four kids to put through college and didn’t want to live like paupers. No problem, we were told, just pay interest only and sell at a profit later.

Doing the math, we looked at the average income of people in the country and tried to estimate how many of them could actually afford the homes in our neighborhood if they really had to pay for them. At SOME point, the Ponzi scheme comes crashing down and someone has to pony up the dough.

We also missed out on the dot-com bubble, selling out stocks before the crash on the exact same principle, i.e., there is no way those companies are worth that.

When I read about how Wall Street has to pay millions in bonuses to “retain talent” , THAT is the part I can’t figure out. What exactly is the talent these people have?

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dsquared 04.05.10 at 7:01 pm

Martin: I think my official answer on the ultimate cause of the bubble (apart from the low interest rate environment) is the same as the thread we had a couple of years ago: “the general tendency of complicated systems to have complicated and unpredictable dynamics”. Nowt more, nowt less.

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Gareth Rees 04.05.10 at 7:21 pm

Surely the chain of causation goes: low interest rates—property price rises—widespread expectation that rises will continue—increased desire to “get on the ladder”—exotic financing—further price rises—and so on round the loop.

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dsquared 04.05.10 at 7:25 pm

yes, but there’s no particular reason why the chain doesn’t go low interest rates – property price rises – lack of affordability – stagnation of house prices, and usually it actually does. The system has both positive and negative feedback in it, and it’s not the usual case that the positive feedback will run away.

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Elijah 04.05.10 at 7:37 pm

“My god, by the way, does he ever name the guilty men. One of the very attractive characteristics of Dean Baker’s economics writing, shared with the best bits of Paul “Krugman and Doug Henwood, is that he is a left-liberal writer about economics who completely lacks the ‘cultural cringe’ common to the species. He doesn’t feel the need to call people like Martin Feldstein “really smart” and he doesn’t waste time giving house room to the normal platitudes of market theism or pretending that his view of the world is really properly considered quite close to orthodoxy. In general, he doesn’t crawl around seeking the approval of the economics profession.”

Alas, for some — within and without economics — if all they were after was approval, it would make it easier to understand, if not to excuse or justify. It would also make it easier to correct (not to mention, easier to sift through comment threads ). But what of the narcissist whose only goal is to quiver with pleasure at his own self-approval? He after all, in his majestic equality, forbids rich and poor, academic and non-academic, left and right, from calling enablers of bubbles, torture, and endless war “apologists.” What if, in a manner of speaking, it wasn’t so much “cultural cringe” as a pathological, over-engorged cultural tumescence?

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dsquared 04.05.10 at 8:28 pm

If this is a first attempt to turn this thread into a secondary theatre of “Kerr vs Greenwald”, then kindly turn it in.

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chris 04.05.10 at 9:28 pm

Otherwise, the buyer would default, which the lender presumably does not want.

What lender? There’s a mortgage originator and there’s the eventual buyer of the securitized and multiply-sliced loan. They are different people with different incentives. The first one has the ability to refuse to make loans to buyers who are obviously going to default in a couple years, but doesn’t give a rat’s ass because they are long gone in a couple years. The second, for the most part, didn’t know what they were buying.

The fact that “the lender” was not an identifiable single entity with a single set of incentives seems to me to be a major factor in the current crisis and why it was driven by financial innovation.

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scathew 04.05.10 at 9:39 pm

@dsquared

“The products were created because they were the only way to get people into houses because the houses were overpriced. They were a consequence, not a cause, of the bubble.”

Honestly I think you’re actually supporting my argument. If houses were overpriced, people shouldn’t have been able to afford them then they wouldn’t have joined on to increase the frenzy. In that case, things should have cooled off by natural market forces (ie: supply without demand).

However, because of the unregulated nature of the market, banks were able to create “innovative” products that brought more people into the market, people who ordinarily shouldn’t have been in the market. That not only increased the balloon, but also the associated risk (because there were more high risk members making up leveraged products, thus increasing the risk of devaluation).

Without this later input, the market might have quietly, though still somewhat painfully, self deflated. But with these products, particularly since they were designed to mask risk, they made it much more likely that the market would “pop”, and “pop” it did.

I’m not saying preventing balloons is not important, but they will happen, in the same way that car accidents happen. Certainly preventing accidents are important, but usually the difference between life and death is whether regulated things like speed and safety equipment are involved. Now I will admit in this metaphor the Fed kept their foot on the gas through artificially low interest rates, but the complete lack of airbags and seat-belts (all removed by regulatory “reform”) took it from an everyday fender bender, to a 200 car blood soaked pile up.

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mpowell 04.05.10 at 9:48 pm

It’s a pretty good thesis that the important thing is for the fed to identify property bubbles and use monetary and other means to deflate them reasonably early on. But there is and was some funny business in the mortgage market all the same. I took out a home loan recently and I learned that whether you are getting a 30 year IO mortgage or a 15 year mortgage, they use basically the same formula to determine what your ‘affordable’ monthly rate is. That is insane. It denies the existence of people who have good credit because they understand how to work out their finances soundly (and if they don’t exist, why give them better rates?). I don’t know what drives mechanisms like these, but it sure seems like the people putting these packages together are playing tricks on both the people they are loaning money to and the people that ultimately hold the debt. And that’s not good.

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