increasingly difficult for governments to keep telling their citizens that they can’t have an affordable home because of land restrictions

TO BE NOTED: From the Gulf Times Via Free Exchange Via Economist's view:

Unlearned lessons from the housing bubble

Every major country of the world has abundant land in the form of farms and forests, much of which can be converted someday into urban land

By Robert J Shiller/New Haven, US A construction worker building a new home in Hayward, California. The kinds of expectations for real estate prices that have informed public thinking during the recent bubbles were often totally unrealistic There is a lot of misunderstanding about home prices. Many people all over the world seem to have thought that since we are running out of land in a rapidly growing world economy, the prices of houses and apartments should increase at huge rates. That misunderstanding encouraged people to buy homes for their investment value – and thus was a major cause of the real estate bubbles around the world whose collapse fuelled the current economic crisis. This misunderstanding may also contribute to an increase in home prices again, after the crisis ends. Indeed, some people are already starting to salivate at the speculative possibilities of buying homes in currently depressed markets. But we do not really have a land shortage. Every major country of the world has abundant land in the form of farms and forests, much of which can be converted someday into urban land. Less than 1% of the earth’s land area is densely urbanised, and even in the most populated major countries, the share is less than 10%. There are often regulatory barriers to converting farmland into urban land, but these barriers tend to be thwarted in the long run if economic incentives to work around them become sufficiently powerful. It becomes increasingly difficult for governments to keep telling their citizens that they can’t have an affordable home because of land restrictions. The price of farmland hasn’t grown so fast as to make investors rich. In the United States, the price of agricultural land grew only 0.9% a year in real (inflation-adjusted) terms over the entire twentieth century. Most of the benefit from land for investors has to be from the profit that agribusiness can make from their operations, not just from the appreciation of the price of land. Despite a huge 21st century boom in cropland prices in the US that parallels the housing boom of the 2000’s, the average price of a hectare of cropland was still only $6,800 in 2008, according to the US Department of Agriculture, and one could build 10-20 single-family houses surrounded by comfortable-sized lots on this land, or one could build an apartment building housing 300 people. Land costs could easily be as low as $20 per person, or less than $0.50 per year over a lifetime. Of course, such land may not be in desirable locations today, but desirable locations can be created by urban planning. Many people seem to think that the US experience is not generalisable, because the US has so much land relative to its population. Population per square kilometre in 2005 was 31 in the US, compared with 53 in Mexico, 138 in China, 246 in the United Kingdom, 337 in Japan, and 344 in India. But, to the extent that the products of land (food, timber, ethanol) are traded on world markets, the price of any particular kind of land should be roughly the same everywhere. Farmers will not be able to make a profit operating in some country where land is very expensive, and farmers would give up in those countries unless the price of land fell roughly to world levels, though corrections would have to be made for differing labor costs and other factors. Shortages of construction materials do not seem to be a reason to expect high home prices, either. For example, in the US, the Engineering News Record Building Cost Index (which is based on prices of labour, concrete, steel, and lumber) has actually fallen relative to consumer prices over the past 30 years. To the extent that there is a world market for these factors of production, the situation should not be entirely different in other countries. An even more troublesome fallacy is that people tend to confuse price levels with rates of price change. They think that arguments implying that home prices are higher in one country than another are also arguments that the rate of increase in those prices should be higher there. But, the truth may be just the opposite. Higher home prices in a given country may tend to create conditions for falling home prices there in the future. The kinds of expectations for real estate prices that have informed public thinking during the recent bubbles were often totally unrealistic. A few years ago Karl Case and I asked random home buyers in US cities undergoing bubbles how much they think the price of their home will rise each year on average over the next ten years. The median answer was sometimes 10% a year. If one compounds that rate over 10 years, they were expecting an increase of a factor of 2.5, and, if one extrapolates, a 2000-fold increase over the course of a lifetime. Home prices cannot have shown such increases over long time periods, for then no one could afford a home. The sobering truth is that the current world economic crisis was substantially caused by the collapse of speculative bubbles in real estate (and stock) markets – bubbles that were made possible by widespread misunderstandings of the factors influencing prices. These misunderstandings have not been corrected, which means that the same kinds of speculative dislocations could recur. - Project Syndicate lRobert Shiller, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.

The basic story was and is the housing bubble. How could they miss an $8 trillion housing bubble?

From Dean Baker:

"Sorry Greg, This Crisis Was Completely Predictable and Predicted

Gregory Mankiw uses his NYT column today to give us an explicit "who could have known?" about the economy crisis. He tells readers that: "fluctuations in economic activity are largely unpredictable."

No, this crisis was completely predictable. The problem was that the leading lights in the economics profession completely missed the boat and are now using their platforms to tell the public that it wasn't their fault.

The basic story was and is the housing bubble. How could they miss an $8 trillion housing bubble? What were they smoking?

We have a hundred year long trend, from 1895 to 1995, when nationwide house prices just track the overall rate of inflation. Suddenly in the mid-90s, coinciding with the stock bubble, house prices begin to hugely outpace inflation.

The run up in prices cannot be explained by any obvious shifts in the fundamentals of supply and demand. Furthermore there is no remotely corresponding increase in real rents. And, the vacancy rate for housing rises to record levels.

If economists could not see this bubble, then they should look for another line of work. Sorry, this fluctuation was entirely predictable. The people whose job responsibilities including recognizing a dangerous bubble like this one just blew it completely. It speaks volumes about the nature of the U.S. economy that almost all of those people still have their jobs, unlike the tens of millions of other workers who lost their jobs or can only work part-time because of the incompetence of the economists.

--Dean Baker

Posted by Dean Baker"

Me:

I think it's fair to criticize people for missing the housing bubble, but the appearance of Debt-Deflation might well have caught many intelligent people by surprise. It certainly caught William Gross by surprise.

On the housing bubble, I don't believe that it was totally crazy from a human point of view, but it was economically crazy. I mean by that the desire to own a house was driven by fears of being impoverished during old age. For twenty years, we've heard warnings that we will not receive social security. Pensions have also been seen as less viable. Consequently, many people looked into saving more for retirement. This was sensible.

However, many people find it very hard to save for retirement. Hence, it seemed sensible to see if they could find savings from their monthly expenses. This led to the perception that renting is a sucker's game, and that the only real possible for saving for retirement was to turn rent or housing expenses, which are necessary, into an investment. This was not a stupid idea.

The bubble was dependent on this perception, and another one often heard during the bubble, which is that, if you don't buy a house now, then you never will. That was the real motivation behind the asinine theory that housing prices always go up.

I guess you can tell that I believe that people were taken advantage of in this crisis. This motivation also fed into the tech bubble.

To not understand the panic that many people feel about retirement will skew the explanations of what really caused this crisis.

I know that other countries don't fit this theory as well as the US, but I haven't seen enough data to discount it.

I could say more about this issue, but I simply want people to understand why people felt desperate to own a house.

Posted by: Don the libertarian Democrat

unlikely that the fall in mortgage interest rates during the early 2000s accounted for more than 20 percent of the increase in housing prices

From The Atlantic Business:

Richard A. Posner

A Failure of Capitalism

May 19 2009, 9:59PM

A Failure of Capitalism (IV): More on Bubbles

The housing bubble is so central to our current economic troubles, and such a mysterious phenomenon from an economic standpoint, that I want to elaborate on my brief remarks in the previous entry.

A few figures: At the beginning of 2000, the federal funds or overnight rate--the short-term interest rate that the Federal Reserve focuses on influencing through its purchase and sale of Treasury bonds--was 5.45 percent. Though short term, this rate influences long-term rates, because it is the rate at which banks borrow from each other, and the more (less) they borrow ,the more (less) they are able to lend to their customers; and the more (less) they lend, the lower (higher) their interest rates are. Also at the beginning of January 2000, the average interest rate for the standard 30-year fixed-monthly-payment mortgage was 8.21 percent.

By December 2003, when the overnight rate had fallen below 1 percent, the mortgage rate had fallen to 5.88 percent and housing prices had risen (since the beginning of 2000) by 42 percent. The overnight rate than gradually rose, to 5.26 percent in July 2007, by which time the mortgage interest rate had risen to 6.7 percent, yet housing prices had continued to increase and were more than 80 percent above their 2000 level. After that both interest rates, and housing prices, began to decline.

If low interest rates drive up housing prices, high interest rates should (and eventually do), drive them down. Yet we have just seen that housing prices continued rising after interest rates started to rise. Moreover, a leading housing economist, Edward Glaeser, has pointed out to me that, on the basis of studies of the responsiveness of housing prices to interest rates in other periods, it is unlikely that the fall in mortgage interest rates during the early 2000s accounted for more than 20 percent of the increase in housing prices.

What I think we are seeing in the numbers is the classic bubble phenomenon, a phenomenon that has been observed in a variety of markets in a variety of countries for centuries. The low interest rates of the early 2000s pushed up housing prices both directly and indirectly. Directly by reducing the cost of housing debt--and housing as I mentioned in my last entry is bought mainly with debt. Indirectly by pushing up the value of common stocks. The low interest rates, as I said, caused asset-price inflation. Common stock is an asset, and was affected by the inflation. As the market value of people's savings, increasingly concentrated in common stock (whether in brokerage accounts, retirement accounts, college savings plans, or health savings plans), rose, people felt (and were, for the time being anyway) wealthier, and this increased their demand for houses--for owning rather than renting, or for owning a bigger or fancier house than their present house. And banks, including mortgage banks, being able to borrow capital at low rates, for lending, were eager to encourage borrowing by relaxing their credit standards. So people who could not have qualified for a mortgage at any interest rate earlier were now able to borrow at affordable rates.

Once house prices started rising, moreover--and here is the bubble phenomenon at its purest--the increase acquired momentum. An increase in the price of an asset, after that increase has continued for a significant time, creates a belief that the asset is a good value. One sees other people bidding up the price of houses and assumes they know something that perhaps one does not. And when officials and economists, and not just brokers and bankers, say that housing prices are rising because of "fundamental" changes in demand and supply that are likely to continue, the belief that a house is a good value, even though it costs a good deal more than it would have cost just a year or two ago, is fortified. There is nothing irrational about such a belief, or about action on it, though there is always a risk that the apparent increase in value will turn out to be a bubble phenomenon.

That seems to be what happened, and the basic fault lies with the Federal Reserve in having pushed interest rates too far down, and kept them too far down for too long, during the early 2000s, and with the dismantling of regulatory controls that had formerly reduced the incentive and ability of banks to lend into a bubble."

Me:

Don the libertarian Democrat May 20, 2009 12:38 PM

I know that I must be wrong, but here's what I saw in the Central Valley of CA: As housing prices climbed, the wealth of the people buying the houses declined. In other words, the people in the worst economic shape were buying at the top of the market. Call me crazy, but that didn't, and still doesn't, sound right.

Now, when interest rates are first lowered, and people who have the means decide that this is a good time to buy, I can understand that. That's when people of limited means should be buying, if they have the savings and income. It should not take too great a rise for these marginal buyers to decide to wait and keep saving. That's my story.

I can, of course, concoct an asinine story for people to keep buying in such a scenario, but it doesn't have to do solely with interest rates: namely, you convince marginal buyers that, if they don't buy a house now, then they will never be able to buy a house. It's a story, a theory, a prediction, but, as Jeeves would say, it's unsound.

The interest rate story works for a bit at the beginning, but then it cannot account for what happens next. As rates started to rise, I can imagine hearing "you had better buy quick". I just don't see the evidence that anything less than a massive and quick increase would have saved us this misery, as long as people were buying into a story that had to have a bad ending for them.

Previewing your Comment

Don the libertarian Democrat May 20, 2009 7:20 PM

I want to add one more point on bubbles before you do another ten posts. For lower income people and many middle income people as well, the narrative was that you'd better buy now or you'll be out of luck. But there was another narrative that contributed to the bubble, and that was that you'll be a pauper when you retire.

There has been an endless warning that social security is iffy for people of a certain age, and that pensions are dying out. Events like Enron employees having their savings blown up contributed to this. Consequently, buying a house was considered by many to be the main option for providing for old age. Why was this so? Because you have to spend money for housing. Renting came to be seen as money down the drain, and the rest of people's wages really didn't allow for grand savings.

So people decided that, instead of paying rent, they needed to buy a house. It's hard to describe the sense of panic that many people have over retirement. I bought my house in 1991 in the Bay Area for just that reason. I did not particularly like the idea of owning a house. I sold it early last year. For me, this plan actually worked.

One reason that I'm for a guaranteed income, as proposed by Charles Murray, is precisely because I believe that it would alleviate much of this terror of a pauper's old age, by habituating people to a stable social safety net. In other words, I'm claiming that the bubble wouldn't have occurred without this life or death feeling that people had about buying a house to provide for their retirement. Being a novelist and philosopher, I've now done my part.

To understand the role of the Federal Reserve in the causation of the current depression, we must understand its influence on interest rates

From The Atlantic Business Channel:

Richard A. Posner

A Failure of Capitalism

May 19 2009, 12:09PM

A Failure of Capitalism (III)--Blame the Fed, the Government in General, and the Economists

To understand the role of the Federal Reserve in the causation of the current depression, we must understand its influence on interest rates, and how interest rates influence economic activity.

The Treasury Department borrows money to finance government activities by issuing bonds, which are bought by banks and other investors, and also by the Federal Reserve. When the Fed wants to stimulate economic activity, it buys Treasury bonds from banks and other investors, paying cash, which increases the balances in bank accounts and by doing so provides more money for lending and spending. (The process is actually somewhat different and more complicated, but I am presenting an intuitive version that will be easier for readers who are not experts to understand.) As the supply of money for loans rises, interest rates fall (the larger the supply of a good, including loans, the lower the price, which in the case of a loan is the interest rate). As interest rates fall, borrowing becomes cheaper, and people borrow more and go deeper into debt, rather than saving. With more borrowing, banks need more money to lend, so they borrow too; as it is cheaper to borrow capital than to raise it by issuing more stock (because interest is deductible from income tax and the compensation that providers of equity capital to firms receive from those firms is not) banks become more indebted too, and hence more risky. And because houses are a product bought mainly with debt (for example, an 80 percent or 90 percent or even 100 percent mortgage), the demand for houses rise. So more houses are built, but in addition, because the overall stock of housing is so durable and is therefore not replaced frequently, the increase in demand pushes up prices. If nothing else besides low interest rates is pushing up housing prices, we have a bubble, in the sense that, as soon as the crutch of low interest rates is withdrawn, prices are likely to fall, as houses become more expensive to buy, the higher interest rates are. It was the collapse of the housing bubble when interest rates rose (mainly in 2005 and 2006) that started the economic collapse, and because banks were so heavily invested in housing through their role in issuing mortgages, they came near to collapse as well, triggering the depression.

The Federal Reserve pushed interest rates way down at the end of 2000 and kept them there until 2005 and during this period of low interest rates (in part of the period, the short-term interest was negative in real terms, because it was lower than the inflation rate). This was the decisive error that put too much risk into the economy, against a background of deregulation that allowed the banking industry to take whatever level of risk was profit maximizing given interest rates. The Fed was fooled by the fact that the usual indices of inflation, such as the Consumer Price Index, did not indicate a high rate of inflation. But the reason was that low-cost imports from China and other East Asian countries kept prices of most goods and services down. Inflationary pressures caused by an overheated economy flooded with lending were deflected into assets such as houses and common stocks.

The Federal Reserve missed all this. As late as October 2005, as the housing bubble was beginning to leak air, Ben Bernanke, the chairman of the President's Council of Economic Advisers--and about to be appointed the chairman of the Federal Reserve--stated publicly that the rapidly rising housing prices were not the product of a bubble. And so the finance industry, reassured, continued making risky mortgage loans and selling risky securities backed by those loans.

There were plenting of warnings of a housing bubble, going back to 2002 and found even in local newspapers. But most economists missed the bubble, and so it was easy to dismiss the few who warned as Cassandras and sourpusses. I do not fault the Federal Reserve for following the conventional wisdom. I do fault it for having failed either to take the warnings seriously enough to evaluate them in depth (the Fed has 250 Ph.D. economists), or to prepare contingency plans in the event that the ascent of housing prices proved to indeed be a bubble and the bubble collapses and brought the banking industry (so heavily invested in housing) down with it. As a result of the Fed's unpreparedness, when the banks began collapsing in September of last year the government was caught by surprise, improvised spasmodically, failed critically to prevent the bankruptcy of Lehman Brothers, and by its pratfalls deepened the downturn.

I read recently the statement by one business economist that if there is any hero in this mess we find ourselves in, it is Ben Bernanke. As far as I can judge, he has since last October managed the response to the crisis competently--perhaps more competently than his predecessor Greenspan would have done, or other possible replacements for Bernanke. But he is like a general who having been defeated in battle because of his errors manages the retreat of his army competently. He does not thereby escape blame for the defeat, and should not be permitted to shift blame to the soldiers under his command who gave way under attack."

Me:

Don the libertarian Democrat May 19, 2009 6:42 PM

"As interest rates fall, borrowing becomes cheaper, and people borrow more and go deeper into debt, rather than saving."

Are people's wages rising as well? If you think that something is cheap, why rush out and buy it unless you think that it will be more expensive later? If you think that x is cheap because of low interests rates, you must assume that they will eventually go higher. Otherwise, they're not cheap. So, two simple points:

1) How are incomes faring as compared to housing prices or even payments?
2) If rates are low, then they must at some point be high.

In other words, borrowing becoming cheaper takes place in a context. Nothing in that context necessitates lowering capital requirements, lending standards, etc. If a product keeps getting more expensive, wouldn't you expect people to be buying less of it?

Lower interest rates are an incentive for investment. They take place in a context of competing incentives and disincentives. But an incentive is just that. Raising interest rates on the entire economy seems a rather blunt instrument to stop a housing bubble. The bubble part came from housing prices going up in an extraordinary amount as against most other purchases and parts of the economy. Had down payments been 20% or based on a reasonable percentage of income, then this crisis might not have taken place. Why focus on interest rates if there are other possible cures for the disease? For all we know, raising interest rates could have also meant that many potentially valuable businesses might never come into existence.

Perhaps the Fed should have done things differently, but why not focus on the industry itself where the problem existed?

bubble would not have grown to such an extraordinary size had it not been for the banks bad practices and outright fraud

TO BE NOTED: From The American Prospect:

"The Media and the Economic Collapse: Columbia Journalism Review Edition

Regular BTP readers know that I give the media much of the blame for the economic collapse, although I give my fellow economists even more. After all, knowing the economy is all they do for a living and they were completely clueless in missing an $8 trillion housing bubble. As they say back in Chicago (my home town): how stupid can you get?

Anyhow, in its latest issue, the Columbia Journalism Review has a piece by Dean Starkman that takes the media for task for missing the crisis. While the piece makes many good points, I would argue that it is still too generous. The investigative reporting into the dealings of the Wall Street banks advocated by the piece would have been desirable, but it was unnecessary. All we needed was reporters who knew arithmetic.

The basic point is that we saw a 70 percent run up in inflation-adjusted house prices nationwide, after 100 years in which house prices had just tracked inflation. There was no remotely plausible explanation for this sharp divergence from a 100 year long trend in the largest market in the country. Furthermore, it was not matched by an remotely comparable increase in rents, which continued to largely track inflation.

The implication was that we had a housing bubble that had generated $8 trillion in housing wealth (an average of $110,000 per homeowner). This was guaranteed to end badly even if every bank had kept good books, there were no complex derivative instruments, and no deceptive subprime mortgages. The U.S. economy was being driven by this bubble and it was sure to crash when the bubble burst.

Of course the bubble would not have grown to such an extraordinary size had it not been for the banks bad practices and outright fraud, but the latter required at least some investigative work. The core problem was an $8 trillion housing bubble that was standing there in the full light of day. The fact that so many business and economic reporters somehow could not see this is even more damning than their failure to highlight the corruption of the Wall Street boys. After all, if you can't see an $8 trillion housing bubble, what can you see?

--Dean Baker

Posted by Dean Baker "

Unfortunately, we didn’t save for a rainy day: thanks to tax cuts and the war in Iraq

TO BE NOTED: From the NY Times:

"Erin Go Broke

By PAUL KRUGMAN

“What,” asked my interlocutor, “is the worst-case outlook for the world economy?” It wasn’t until the next day that I came up with the right answer: America could turn Irish.

What’s so bad about that? Well, the Irish government now predicts that this year G.D.P. will fall more than 10 percent from its peak, crossing the line that is sometimes used to distinguish between a recession and a depression.

But there’s more to it than that: to satisfy nervous lenders, Ireland is being forced to raise taxes and slash government spending in the face of an economic slump — policies that will further deepen the slump.

And it’s that closing off of policy options that I’m afraid might happen to the rest of us. The slogan “Erin go bragh,” usually translated as “Ireland forever,” is traditionally used as a declaration of Irish identity. But it could also, I fear, be read as a prediction for the world economy.

How did Ireland get into its current bind? By being just like us, only more so. Like its near-namesake Iceland, Ireland jumped with both feet into the brave new world of unsupervised global markets. Last year the Heritage Foundation declared Ireland the third freest economy in the world, behind only Hong Kong and Singapore.

One part of the Irish economy that became especially free was the banking sector, which used its freedom to finance a monstrous housing bubble. Ireland became in effect a cool, snake-free version of coastal Florida.

Then the bubble burst. The collapse of construction sent the economy into a tailspin, while plunging home prices left many people owing more than their houses were worth. The result, as in the United States, has been a rising tide of defaults and heavy losses for the banks.

And the troubles of the banks are largely responsible for putting the Irish government in a policy straitjacket.

On the eve of the crisis Ireland seemed to be in good shape, fiscally speaking, with a balanced budget and a low level of public debt. But the government’s revenue — which had become strongly dependent on the housing boom — collapsed along with the bubble.

Even more important, the Irish government found itself having to take responsibility for the mistakes of private bankers. Last September Ireland moved to shore up confidence in its banks by offering a government guarantee on their liabilities — thereby putting taxpayers on the hook for potential losses of more than twice the country’s G.D.P., equivalent to $30 trillion for the United States.

The combination of deficits and exposure to bank losses raised doubts about Ireland’s long-run solvency, reflected in a rising risk premium on Irish debt and warnings about possible downgrades from ratings agencies.

Hence the harsh new policies. Earlier this month the Irish government simultaneously announced a plan to purchase many of the banks’ bad assets — putting taxpayers even further on the hook — while raising taxes and cutting spending, to reassure lenders.

Is Ireland’s government doing the right thing? As I read the debate among Irish experts, there’s widespread criticism of the bank plan, with many of the country’s leading economists calling for temporary nationalization instead. (Ireland has already nationalized one major bank.) The arguments of these Irish economists are very similar to those of a number of American economists, myself included, about how to deal with our own banking mess.

But there isn’t much disagreement about the need for fiscal austerity. As far as responding to the recession goes, Ireland appears to be really, truly without options, other than to hope for an export-led recovery if and when the rest of the world bounces back.

So what does all this say about those of us who aren’t Irish?

For now, the United States isn’t confined by an Irish-type fiscal straitjacket: the financial markets still consider U.S. government debt safer than anything else.

But we can’t assume that this will always be true. Unfortunately, we didn’t save for a rainy day: thanks to tax cuts and the war in Iraq, America came out of the “Bush boom” with a higher ratio of government debt to G.D.P. than it had going in. And if we push that ratio another 30 or 40 points higher — not out of the question if economic policy is mishandled over the next few years — we might start facing our own problems with the bond market.

Not to put too fine a point on it, that’s one reason I’m so concerned about the Obama administration’s bank plan. If, as some of us fear, taxpayer funds end up providing windfalls to financial operators instead of fixing what needs to be fixed, we might not have the money to go back and do it right.

And the lesson of Ireland is that you really, really don’t want to put yourself in a position where you have to punish your economy in order to save your banks."

Bubbles are financing phenomena; depressions are financing phenomena. They are opposite sides of the same coin.

TO BE NOTED: From The Aleph Blog:

"Not All Bubbles Lead to Depressions

I enjoyed the opinion piece in yesterday’s WSJ, From Bubble to Depression? I want to clear up a few of their misconceptions. Key quote:

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

They almost get it in their later paragraphs, but the answer is simple. In the first “crash,” the losses were mainly equity-based, so there were no knock-on effects on other entities. No additional dominoes fell. With housing in the late 2000s, a loss of $3 billion happened on assets that were usually levered with debt at 5x to 30x, probably averaging 10x. And, these mortgages were held by leveraged banks that had borrowed in many other places in the overall financial system, and sometimes by even more leveraged speculators using CDOs.

Let me say it again — Bubbles are financing phenomena; depressions are financing phenomena. They are opposite sides of the same coin. The severity of bubbles differs with the amount of debt employed and the pervasiveness of the sectors of the economy affected. The tech bubble did not have much debt, and it was contained. The real estate bubble was the opposite.

The thing is, the amount of debt we have racked up as a fraction of GDP exceeds that of the Great Depression. My view is that many debts will have to be liquidated before the US economy grows robustly again, whether through payoff, compromise or inflation.

Now, we had Michael Mayo today offering his opinions on the banks, (two, three) which are not all that much different than mine. In an era of debt deflation, coming off record debt-to-GDP ratios, it is next to impossible for the US Government to make any significant difference against the deflation. Better not to try at all. An action big enough for the US Government to absorb the necessary amount of bad debt will kill the Dollar.

This last bubble has led to a depression, because of the debts incurred. We must liquidate debts, but in the process, the economy will suffer. I’m sorry, I like prosperity too, but there is no way out of this period of debt liquidation. Just as the period of debt growth pushed asset prices up, so the period of debt deflation will push asset prices down.

My advice? Avoid almost all banks, and other financial companies sensitive to the stock market or real estate, in terms of both equity and bond investments.

1. David Merkel Says:
   April 7th, 200912:09 pm at

   Logan, I’m not ruling it out. I’m saying there would be a cost attached. Some problems with collateral values could be solved through inflation, passing the costs to those who cannot hedge fully, which is most of us, but especially the elderly and foreign creditors.

   I’ve been asked about the effect on gold and other hedges — I do think that inflation will be one of the tools that the government/Fed uses to get out of this crisis, and it will have a positive effect on all inflation hedges. In the short run, though, Ben Bernanke is determined not to let any the liquidity that he is monopolizing leak out into the broader economy; I think he is trying to fight a depression without creating any inflation, which I think is an unusual intellectual conceit. I’m just not sure how long the condition will last.

   Oh, and regarding bonds — since someone else asked: I like TIPS, foreign short-to-intermediate bonds, conforming RMBS, Short-to-intermediate corporates BBB and lower but not of financials (except a few stray insurers).

It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt

TO BE NOTED: From the WSJ:

"By STEVEN GJERSTAD and VERNON L. SMITH

Bubbles have been frequent in economic history, and they occur in the laboratories of experimental economics under conditions which -- when first studied in the 1980s -- were considered so transparent that bubbles would not be observed.

We economists were wrong: Even when traders in an asset market know the value of the asset, bubbles form dependably. Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. If momentum traders have more liquidity, they can sustain a bubble longer.

But what sparks bubbles? Why does one large asset bubble -- like our dot-com bubble -- do no damage to the financial system while another one leads to its collapse? Key characteristics of housing markets -- momentum trading, liquidity, price-tier movements, and high-margin purchases -- combine to provide a fairly complete, simple description of the housing bubble collapse, and how it engulfed the financial system and then the wider economy.

In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.

The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers' losses were limited to their small down payments; hence, the lion's share of the losses was transmitted into the financial system and it collapsed.

During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.

The unraveling of the bubble is in many ways the most fascinating part of the story, and the most painful reality we are now experiencing. The median price of existing homes had fallen from $230,000 in July to $217,300 in November 2006. By the beginning of 2007, in 17 of the 20 cities in the Case-Shiller index, prices were falling. Serious price declines had not yet begun, but the warning signs were there for alert observers.

Kate Kelly, writing in this newspaper (Dec. 14, 2007), tells the story of how Goldman Sachs avoided the fate of many of the other investment banks that packaged mortgages into securities. Goldman loaded up on the Markit ABX index of credit default swaps between early December 2006 and late February 2007, as their price dropped from 97.70 on Dec. 4 to under 64 by Feb. 27. But the market was not yet in free-fall: The insurance on AAA-rated parts of the mortgage-backed securities (MBS) remained inexpensive. By mid-summer 2007, concern spread to the AAA-rated tranches of MBS.

At the end of February 2007, the cost of $10 million of insurance on the AAA-rated portion of a mortgage-backed security was still only $68,000 plus a $9,000 annual premium. Housing-market conditions deteriorated further in the first half of 2007. Case-Shiller tiered price sequences in Los Angeles, San Francisco, San Diego and Miami all show serious declines by the summer of 2007. Prices in the low-price tier in San Francisco were down almost 13% from their peak by July 2007; in San Diego they were off 10% by July 2007. Startling developments began to unfold that month. Between July 9 and Aug. 3, 2007, the cost of insuring AAA MBS tranches went from $50,000 upfront plus a $9,000 annual premium for $10 million of insurance to over $900,000 upfront (plus the annual premium).

Once the cost of insuring new mortgage-backed securities skyrocketed, mortgage financing from MBS rapidly declined. Subprime originations plummeted from $160 billion in the third quarter of 2006 to $28 billion in the third quarter of 2007. Mortgage-backed security issuance fell comparably, from $483 billion in all of 2006 to only $30.7 billion in the third quarter of 2007. Other measures of new loan originations were falling at the same time. The liquidity that generated the housing market bubble was evaporating.

Trouble quickly spread from the cost of insuring mortgage-backed securities to problems with credit markets generally, as the spread between short-term U.S. Treasury debt and the LIBOR rate increased to 2.40% from 0.44% between Aug. 8 and Aug. 20, 2007. Since U.S. Treasury debt is generally considered secure, but a bank's loans to another bank carry some risk of default, the spread between these rates serves as an indicator of perceived risk in financial markets.

In one city after another, prices of homes in the low-price tier appreciated the most and then fell the most; prices in the high-priced tier appreciated least and fell the least. The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%. Moreover, housing prices have continually declined in every market in the Case-Shiller index. According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.

In an important paper in 1983, Ben Bernanke argued that during the Depression, severe damage to the financial system impeded its ability to perform its economic role of lending to households for durable goods consumption and to firms for production and trade. We are seeing this process playing out now as loan funds for automobile purchases have withered. Auto sales fell 41% between February 2008 and February 2009. Retail and labor markets too are now part of the collateral damage from the housing debacle. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006. Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy.

The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.

Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the "Bank Holiday" in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

What we've offered in our discussion of this crisis is the back story to Mr. Bernanke's analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

Mr. Gjerstad is a visiting research associate at Chapman University. Mr. Smith is a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics."

"Waiving down-payments requirements, dropping lending standards, allowing predatory lenders to flourish — that is what is the underlying cause"

Another sensible view about home ownership from The Big Picture:

"Let’s start out with a brief excerpt from Bailout Nation:

From Reagan to George W. Bush, each President of the past 25 years bears some responsibility for contributing to the belief that we can let markets govern themselves.

Of the four Presidents over that period of time, President George W. Bush is the one with the seemingly greatest culpability. Not just because this crisis happened on his watch — although that is reason enough to give him a fair share of responsibility. More significantly, the basis of his culpability is that he shared Greenspan’s and Gramm’s radical belief system — that markets could police themselves, and that all regulation was inherently bad. This philosophy colored all of the President’s appointments to key supervisory positions, as well as his legislative agenda.

That philosophy, and the executive, administrative and legislative acts, including political appointments, is where we should focus our ire at the soon the be former-President Bush. The belief system that leads to the conclusion that really bad behavior in the corporate world needs no proscribing is where you should look to place blame.

That Bush had as a goal increased home ownership is, quite bluntly, irrelevant. It is a worthy goal, and certainly one that could be achieved without forcing the collapse of the financial system.( I AGREE )

Indeed, as the chart at right shows (source: NYT), home ownership has increased every year since 1994. Funny, from that year and for each of the next 10 years, there was no collapse. You have to ask yourself why. No, the 1997 Tax Break, did not, as the NYT implied yesterday, Help Cause Housing Bubble. Home ownership was rising years before that went into effect.( TRUE )

What Bush did differently than prior Presidents was that he genuinely believed that regulations proscribing bad corporate behavior were unnecessary. It was that ruinous belief system, one he shared with other key players, that led to the crisis.( TRUE )

In fairness to Bush, many of the really bad policies that led to the boom and bust of Housing, and the collapse of credit, were in place before he was sworn into office. In particular, the repeal of Glass Steagall (Gramm-Biley-Leach Act), and the Commodities Future Modernization Act (CFMA), were both heavily lobbied for by the industry, sponsored by Phil Gramm, and passed by a Congress that didn’t bother to read them( TRUE ). They were both signed into law by Bill Clinton. That set of legislation is where you begin to find answers to The Reckoning.

Consider:

“Former Presidents Clinton, George H.W. Bush, and Reagan all have some responsibility, but far less. Bush Senior is probably the least culpable. Reagan did not reappoint Fed Chair Paul Volcker, and replaced him with Alan Greenspan. Regardless of other actions, this alone haunts his legacy, and gives the Gipper some degree of responsibility.

While some partisans have tried to paint the crisis a purely Republican debacle, history informs us otherwise. Yes, the GOP did control Congress from 1994 to 2006. However, President Clinton, a Democrat, bears a significant amount of responsibility too. He and his Treasury Secretaries, Robert Rubin and Lawrence Summers, each supported very limited regulation of free markets. Clinton, Rubin and Summers are one step behind W. in the hierarchy of proximate causes of the debacle.” (Bailout Nation) ( THAT'S TRUE. I DID TOO )

The requisite Fannie Mae/Freddie Mac discussion in the article is simply silly. Yes, FNM/FRE were cogs in the housing machinery, yes, they were corrupt organizations. No, they were not a proximate cause of the boom/bust/collapse( ALL TRUE ). For those of you who keep asking why I emphasize this, this article is why.

Increasing home ownership in America is a legitimate political goal. Waiving down-payments requirements, dropping lending standards, allowing predatory lenders to flourish — that is what is the underlying cause of boom bust and collapse.( I AGREE COMPLETELY )

Once again, we relearn that worthy ends do not justify foolish means."

"a tax break for homeowners, enacted in 1997, may have contributed to the housing bubble"

An interesting post from Start Making Sense about the power of incentives:

"Perverse satisfaction?

Today's New York Times notes that a tax break for homeowners, enacted in 1997, may have contributed to the housing bubble that (coupled with pathological defects in our financial markets) did so much to bring us to our grim current economic situation.

Specifically, Congress in 1997, acting at the behest of President Clinton, provided that up to $500,000 of home appreciation would be tax-free on sale. Clinton was practicing silly but no doubt poll-tested populism, boasting that, due to the rule, middle class Americans would never again face capital gains tax on their homes. ( WHY SHOULD IT BE TAXED? )

Now let's roll the tape forward 11 years. According to the Times:

"[M]any economists say that the law had a noticeable impact, allowing home sales to become tax-free windfalls. A recent study of the provision by an economist at the Federal Reserve suggests that the number of homes sold was almost 17 percent higher over the last decade than it would have been without the law. ( WHY DO WE WANT A DISINCENTIVE TO SELL? )

"Vernon L. Smith, a Nobel laureate and economics professor at George Mason University, has said the tax law change was responsible for 'fueling the mother of all housing bubbles.' ( HOW SO? )

"By favoring real estate, the tax code pushed many Americans to begin thinking of their houses more as an investment than as a place to live. It helped change the national conversation about housing. Not only did real estate look like a can’t-miss investment for much of the last decade, it was also a tax-free one. ( HOMES ARE AN INVESTMENT. THAT'S WHY I BOUGHT MINE, PRIOR TO THIS CHANGE IN THE TAX CODE )

"Together with the other housing subsidies that had already been in the tax code — the mortgage-interest deduction chief among them — the law gave people a motive to buy more and more real estate. Lax lending standards ( THIS IS THE CAUSE. THE OTHERS ARE SILLY ) and low interest rates then gave people the means to do so ( IF THEY COULD HAVE AFFORDED THE HOUSES, WHO WOULD CARE? ).

"Referring to the special treatment for capital gains on homes, Charles O. Rossotti, the Internal Revenue Service commissioner from 1997 to 2002, said: 'Why insist in effect that they put it in housing to get that benefit? Why not let them invest in other things that might be more productive, like stocks and bonds?'” ( WHY SHOULD ANY INVESTMENT BE TAXED? HELLO! )

I happen to know a couple of people who got into the business of buying fixer-uppers, doing renovation work, and then selling for tax-free capital gain, thus achieving exemption for their labor income. There, at least, there was productive activity - but still distortion of economic choice by the tax incentive. ( THE TAX INCENTIVE WASN'T AN INCENTIVE. THE TAX WAS A DISINCENTIVE THAT WAS TERMINATED )

One further idiotic incentive effect was that, as soon as your home begins to approach $500,000 of appreciation, you have an incentive to sell it immediately and buy a new home for the current market price, so that you can run the exemption from zero all over again. Happily (?), however, that is no longer a problem in today's market.

Whenever something like this comes out about special tax breaks that don't merely create perverse incentives ( WHAT'S PERVERSE ABOUT IT? ) but seriously aggravate major economic problems, I have to admit to feeling a twinge of, well, perverse satisfaction that the rules I spend some of my time studying are at least important. Plus I duly note that the problems come from failure to heed the recommendations (e.g., for a relatively broad-based and neutral tax ( WHAT DOES NEUTRAL MEAN?) ) that nearly 100 percent of the experts in my field would make. An unworthy sentiment, to be sure, but I'm only human.

Another big example is the role of the tax system in overly entrenching employer-provided health insurance as the dominant mode of provision ( THAT IS BAD ), to the degree that, while few would advocate building on employer-provided insurance if we were starting fresh, many believe that at this point we need to just accept it as an entrenched feature. Thus, for example, one of the big criticisms of Senator McCain's healthcare plan was that it would have undermined employer-provided insurance without sufficiently putting something else in its place.

The home exemption story is admittedly a bit more complicated than just being a case of stupid Clinton-era populism. Prior to the 1997 enactment, people could generally roll over gain when they sold one home and bought a new one (for at least as much money) within a two-year period. Plus, gains on home sale were otherwise taxable ( WHY? ) while losses were nondeductible ( WHY? ), creating apparent (and some actual) tax bias. The underlying problem is that a "correct" approach would have treated gains and losses symmetrically (leaving aside the issue of taxpayer choice whether or not to sell) when they resulted from market swings, while disallowing recovery only for declines in home value that resulted from home use. Richard Epstein, before he became a libertarian icon, actually wrote an article on this, suggesting that the basis of homes be reduced by depreciation (which would not, however, be deductible since it reflected personal rather than business use), with gain or loss relative to the adjusted basis being equally recognized. That is actually a pretty logical approach, within a standard income tax accounting framework, and the failure to do it, meaning that in some cases properly deductible investment losses were being disallowed, may have helped contribute to the 1997 silliness.

Still, the predominant message here remains: stupid tax breaks interact with other defects in our economic system to help create the current horrific circumstances we face. It's happened before, and it will happen again."

How did it do so? There is no connection between tax breaks and fraudulent or ill-advised loans. None. Why was the sale of the house taxed in the first place? It's a terrible idea that causes a disincentive to buying and selling. Why? The idea that it lead to the current crisis assumes a mechanical view of human behavior, which is clearly false. Under a Human Agency Explanation, it is the committing of fraud, negligence, fiduciary mismanagement, and collusion, along with idiotic loan terms that caused the crisis, not any incentives.

"I think we're in a bad state of the world when we rely on theorists."

Justin Fox has an interesting post:

"I've done a lot of bashing here of those who think the 1999 repeal of the Glass-Steagall Act separating banking from the investment business is to blame for all our troubles. I've also argued that securitization—at least fancy-pants securitization—has been partly at fault. So it was interesting to hear an economist I admire make the opposite arguments Thursday. The occasion was a Columbia Business School symposium on on Preventing the Next Financial Crisis, and the economist was MIT's Bengt Holmström.

Holmström is a theorist, and he has charming habit of reminding people that his theories are just, you know, theories. But at the same time he has ample experience with real-world economic phenomena. He's been on Nokia's board of directors for a decade, and he once briefly served on the board of a Finnish investment bank. ("Never go on the board of a bank, because you will never know what goes on there.") Most important, he was back home in Finland (at the Helsinki School of Economics) during the Scandinavian financial crisis of the early 1990s."

It's a good sign when a theorist knows what a theory is in relation to the world.

"That Scandinavian financial crisis--a favorite topic of this blog--was similar in so many ways to today's crisis: There were lots of real estate loans gone bad, sharp drops in house prices, bankrupt banks, and government takeovers of the various national financial systems. "But there was zero securitization," Holmström said."

That's a very important point.

"Holmström's theoretical contributions mainly have to do with the economics of information, and that's where he located the problem in both Scandinavia in the early 1990s and the U.S. now. There are low-information assets--cash, bank deposits, money-market securities--where, most of the time, nobody really needs to know anything about their underlying value. Then there are high-information assets--stocks are the best example--where the value is highly uncertain, and every investor assesses it differently.

"The key is who should hold what," Holmström said. Complex, high-information assets don't pose big financial-system risks in and of themselves. Earlier this decade, "the Nasdaq fell 90% and nothing happened." The problem is when leveraged liquidity providers (a.k.a. banks) end up with lots of high-information assets on their books. "When you're in the liquidity providing market and rolling over 25% every night, you don't have the luxury of wondering whether you can trust somebody."

I disagree with this. I agree with the Steve Hsu post that Banks do deal in and need to engender trust. This should not and cannot be overlooked. Trust and Negligence don't necessarily go together.

"A financial crisis happens when market participants suddenly realize that what they thought were reliable low-information assets are really risky high-information assets. And that usually happens after an extended period during which market participants become willing to accept almost anything as a low-information, liquid asset. Holmström: "If you come to the phase of the cycle where everybody thinks everything's liquid, you're going to have a problem."

You do if it's false.

"Holmström said he doubted government could ever regulate away that occasional tendency. "How do you prevent people from considering equity to be the same as Treasuries? You can't legislate that." But he did think was something to the idea of treating liquidity providers differently from other financial players."

Besides regulations, there are legal and ethical standards of business that should necessitate giving people a clear picture of what they're buying. Obviously, since there's crime, you can't just legislate against that either if you mean by regulate or legislate totally prevent.

"During the Q&A, an audience member who said he was at Salomon Brothers when Citicorp and Salomon's parent Travelers merged in 1998 ("I watched those nice stodgy Citi bankers try to boogie like the Salomon Brothers investment bankers") wondered if Glass-Steagall repeal wasn't part of the problem.

Replied Holmström: "I'm for going back to some separation between liquidity providers and the rest of the market. I don't think it's coincidental that this happened after Glass-Steagall repeal."

A couple of other people on Holmström's panel then chimed in with the argument I've made--that the issue was letting investment banks and other market players (it all began with money market mutual funds) grow into a liquidity-providing shadow banking system, an evolution that began long before Glass-Steagall repeal.

"Investment banks led the way, but commercial banks decided they liked it too," retorted the ex-Salomon guy in the audience. "The abolition of Glass-Steagall put this kind of behavior in the hands of people with much bigger balance sheets."

See, this isn't yet a very well thought out theory. A followed B in time.

"Holmström's summation: "I'm a theorist. I'm allowed to speculate. I think we're in a bad state of the world when we rely on theorists."

He is absolutely correct. Below, he also is, sadly, correct:

Update One more nice Holmström quote from my notes, on nationalizing banks:

One of the things governments can do very easily is take over banks, because they're very bureaucratic. It's much harder to take over institutions where imagination is required."

"how do we explain an increase in optimism? "

Here's another take by Lawrence H. White on Casey Mulligan's notion of Optimism causing the Housing Bubble:

"If I understand him rightly, I don’t much disagree with Professor Mulligan. We agree that Federal Reserve policy acted to promote the housing price boom by lowering real interest rates. The difficult question is: what share of the boom can we attribute to monetary policy, and what share to other independent sources? Applying Professor Mulligan’s way of computing the impact of lower real interest rates alone on the present discounted values of houses, correct anticipation in 2002 of real T-bill rates — which were about to go 200 basis points lower for the next three years — can account for only around a six percent rise in house prices. Thus the milder-discounting effect by itself accounts for only a fraction of the actual run-up in prices observed, assuming correct anticipations. The present-value calculation is straightforward.

We can get a bit more impact out of lower interest rates by noting that the lowering of mortgage lending standards implied an even larger drop in risk-adjusted mortgage rates than in risk-free Treasury rates. Market participants did not have any clear basis in historical time series for anticipating that this drop would reverse itself soon.

Still, I agree that the joint hypothesis “real interest rate anticipations were correct and they alone fully explain the rise in house prices” is untenable. Of course, we already knew that anticipations of house prices could not have been correct, given that nobody would pay $300,000 for a house in 2006 that he knew would be worth only $200,000 two years later. "

I agree with this. No Spigot Theory.

"Professor Mulligan reasonably proposes to attribute the bulk of the rise in house prices to some kind of ex-post-mistaken (but not necessarily irrationally exuberant) anticipations, offering the hypothesis that “it was optimism that raised housing prices, not much of anything tangible during the boom. Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble.” Optimism about “tastes” here includes optimism about the future growth of demand in particular local housing markets. Something like that would seem to be required to explain why the house price boom was so highly concentrated in a few states. We can’t explain such concentration by appealing only to optimism about technology or national economic policy variables.

An appeal to optimism, of course, doesn’t really explain events but simply gives us a reframed question: how do we explain an increase in optimism? I suggest that optimism (regarding whatever) during this period was not independent of the rising rate of aggregate nominal income growth that was being fueled by Fed policy. Expansionary monetary policy may have (at least cyclically) effects on relative prices and real variables, like the real demand for houses, through income channels, not only through its effect on the real interest rate. I anticipate, and agree, with Professor Mulligan’s likely response that more needs to be done to quantify these other effects."

There seems good reason to believe that their was such an overabundance and overly magnified aspect of Wishful Thinking in this current situation. However, for the explanation, we need to understand the presuppositions, assumptions, and context of this explosion of Wishful Thinking. I believe that a lot of it comes down to an overestimation of what government can do, and simply thinking of the actors in this drama as free market adherents misses the true nature and assumptions of their belief system, which includes plenty of government intervention when it's in their interest.

"that it was optimism that raised housing prices, not much of anything tangible during the boom."

I often find myself agreeing with Casey Mulligan, although I'm not sure why. But once again, I agree with his basic point:

"Professor White showed that one-year real interest rates were low during the housing boom. That’s a good starting point because, if the Fed can affect anything real, it is the short-term interest rate. Now let’s use that information to demonstrate that the impact on housing prices is minimal.

Since I will demonstrate that the housing-price impact is small, I will assume that the supply of housing is fixed; an elastic supply of housing would only reduce the price impact below what I calculate here.

Each house in place today produces services for a number of years. To a good approximation, we can assume that each house lasts forever, except that it depreciates exponentially (but slowly). The market value of the house is the present value of those services. Low interest rates can raise housing prices (although not much), because future services are discounted less.

Suppose that annual real interest rates were going to be one percentage point (100 basis points) lower for a year. Then the cost of buying a house, holding it for a year, and then selling it would be essentially one percent less. The low one-year interest rate would not affect the selling price at the end of the year because, by assumption, the reduction lasted only for a year and the next buyer will be back to normal interest rates. So the source of benefit from the low rate is that the initial buyer reduces the carrying cost for a year.

A 100-basis-point-lower interest rate for one year would justify paying about $202,000 for a house that would ultimately be worth $200,000. A 100-basis-point-lower interest rate for two years would raise purchase prices by about two percent. (Actually, it would be less, because of the discounting of the second year, not to mention the supply response.) A 200-basis-point reduction for two years would raise purchase prices by less than four percent, etc.

Thus, interest-rate reductions for a short horizon do raise housing prices, but not much by the standards of this recent housing boom when housing prices were tens of percentage points higher (according to Case-Shiller, practically 100 percent higher). A house that would ultimately be worth $200,000 was actually selling for something in the neighborhood of $300,000.

Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years. If so, he is on shaky ground. First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom. It’s not hard to find commentary from those years recognizing the low short-term rates were not expected to last."

I agree with this. The low interest rates do not explain this crisis. At best, they are a necessary condition.

"Second, such a claim gets closer to my hypothesis: that it was optimism that raised housing prices, not much of anything tangible during the boom. Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble."

What does optimism mean?

1.	a disposition or tendency to look on the more favorable side of events or conditions and to expect the most favorable outcome.

2.	the belief that good ultimately predominates over evil in the world.

3.	the belief that goodness pervades reality.

4.	the doctrine that the existing world is the best of all possible worlds.

It would seem that it is 1 that he means. The most favorable outcome in:
1) Interest Rates
2) Future Tastes
3) Future Technology

I prefer "wishful thinking":

interpretation of facts, actions, words, etc., as one would like them to be rather than as they really are; imagining as actual what is not.

I prefer this phrase because I believe that people knew that they were taking risks, but chose to ignore them. There was a real disposition to ignore reality and history and even common sense.I'm not quite sure that they were optimistic. There was too much uncertainty in the world and too little faith in the Bush Administration for optimism. I hope that I'm making the difference clear.

I believe that much of this malady has to do with a general belief in the incompetence of the Bush Administration. So, my views, they don't qualify as a theory, predict that there will be a major change in the perception of our situation after we have left President Bush behind. The swearing in of President Obama should lead to more optimism, if you will, than we see now. I don't like how many predictions I've given on this blog. Perhaps it's time to sign off.

"I could be wrong, but this strikes me as an attempt to simply unglue a market which has become utterly stuck."

Free Exchange yesterday posted about the attempts to drop the interest rate on mortgages and get home buying moving, thereby stabilizing the prices of houses:

"MANY commentators have attacked the Treasury plan to use Fannie Mae to help bring mortgage rates down on the grounds that reinflating the housing bubble is the last thing we ought to be doing. Serious analysis of the programme, like this, from Felix Salmon, has also proceeded on the basis that the goal of mortgage rate reductions is to help homeowners by stopping and reversing home price declines. I'm not sure this is the case."

I actually do believe that they're trying to stabilize housing prices.

"I could be wrong, but this strikes me as an attempt to simply unglue a market which has become utterly stuck. Fear of housing as a sector has (understandably) become quite common, and as a result, buyers have exited the market in droves. This has made housing markets very illiquid, which is problematic. A dearth of buyers makes it difficult for markets to clear. Prices may come down too far, too fast, and homeowners willing to accept something like a market price on their home may still be unable to sell. This illiquidity produces immobility, which has its own economic costs, as well as unnecessary defaults. Falling prices with lots of buyers is healthy, in other words, while falling prices with no buyers is not."

I do agree with this as well, but the question is how to best unglue the market. I've said that we should let home prices fall a bit more before doing anything, but I understand the economic and political concerns of why this is being done.

"So what to do? Well, nothing grabs a potential buyer's attention like an eye-popping interest rate (as we learned, to our great detriment, during the early part of the decade), and 4.5% is an eye-popping interest rate. And there is evidence that this just might work. Interest rates came down after the Federal Reserve announced a plan to purchase $600 billion in agency debt, leading to a 38% increase in last week's Mortgage Bankers Association index of applications for loans for purchase."

I do agree that this might work well. I certainly agree that it will help. I do not agree on a target rate, and I would let the Fannie/Freddie infusion be tried first.

"Under normal circumstances, there is no reason to subsidise homeownership or to work to excessively lower mortgage rates, but at the moment housing markets are simply broken. If this plan brings buyers back, it just might be worthwhile."

It might work, and I've made my case.

By the way, when he says: "Serious analysis of the programme" : Does he mean to demean average citizens such as myself trying to voice an opinion. Who is he talking about?

"Ezra Klein argues that people -- with their fancypants synthetic CDOs -- are making the financial crisis too complicated."

Publius on Obsidian Mirror takes a look at an Ezra Klein post:

"Ezra Klein argues that people -- with their fancypants synthetic CDOs -- are making the financial crisis too complicated. At heart, the basic problem is still the housing market:

[A]t the heart of all this was a fairly simple dynamic. The subprime market -- which is to say, the market of loans sold to high-risk individuals -- exploded. The banks invested in those loans. Other people bet on their safety. And the loans collapsed. The mistakes, in retrospect, seem quite simple, and quite stupid.

Well, yes and no. In theory, the larger meltdown shouldn't have happened strictly because the loans were more risky. In a functioning market, risky loans would simply have been priced more appropriately -- investors would have paid required more for the increased risk, and so on."

In general, I agree with Ezra Klein, as far as his point goes. The subprime aspect of this crisis is just low or fraudulent standards and poor loans. There's no reason to make this more complicated than that, except you might want to try and explain why it happened.

Publius, however, also makes a good point, which is that the horrifying uncertainty of how much money was wagered out there was a result of these more complex financial products, and that terrifying uncertainty was a major part of this crisis.

"The problem, then, was the lack of information. Banks, investors, credit agencies -- no one seemed able (or willing) to value these things appropriately. And that blindness, it seems, stemmed in very large part from the sheer complexity and Enronness of the instruments constructed on top of the housing market."

Yes, well, at some point, you could argue that, once the government got involved, they were no longer willing to value their products. The basic problem was that, at least as far as CDOs go, no one could price them, so that it wasn't possible for anyone to buy or sell them. This takes a bit more examination, but let's leave it for now.

"The housing market, admittedly, was the sandy foundation upon which everything was built. And it was an important cause in that respect. But the complex infrastructure built on top of the sand obscured the fact that it was in fact sand -- rather than magic money-spewing concrete -- below the surface. And so more infrastructure got added on top of the shaky foundation, furthering blinding everyone."

It's very true that you didn't need to actually have anything to do with the house or mortgage, say, to have a CDS, but I don't agree that this was a matter of reality being obscured by complexity. I don't agree with Publius about that.

"As for which one of these causes was the "proximate" one, who knows. But it seems like it required more than stupid housing loans. It required something that blinded people to the value/risk of those loans."

I don't accept that any blindness was involved. Sorry.

"The reason all this matters is that preventing the next crisis requires understanding what exactly went wrong this time."

Based on our learning curve after the S & L Debacle, I'd expect another rupture in the finance/government continuum in about five years. But, what the hell, let's pretend we can actually learn something and prevent futures crises. For all I know, it might well work this time.

Anyway, I don't agree with Publius in one very important matter. I'm studying these products precisely to prove that an aboveboard, decent, honest, mildly intelligent, investor or realtor or whatever, could have explained these products quite simply to anybody, at least as far as to their risk. I can understand quite a bit about the risks of driving without being an automotive engineer. I don't buy the complexity, obscurity, etc., line of explanation, which I believe has an exculpatory angle to it. So, if you want to learn what went wrong, then don't accept these protestations of befuddlement at face value.

As to Klein's point, it has the ring of indifference or annoyance to it, as if some daft professor had assigned him Swinburne and Mallarme in order to understand Ogden Nash. He doesn't know enough, it sounds like, to pronounce what the crisis all boils or reduces down to. I know he likes to cook, but this is one area where he's not a chef.

"As far as I understand the situation, at the heart of all this was a fairly simple dynamic. The subprime market -- which is to say, the market of loans sold to high-risk individuals -- exploded. The banks invested in those loans. Other people bet on their safety. And the loans collapsed. The mistakes, in retrospect, seem quite simple, and quite stupid. That's not to say that the instruments involved weren't very complicated, but the complicated nature of the instruments seems to have been a key player in obscuring the fundamentally hollow nature of the loans. It keeps coming back to the subprime loans. To the fundamentals of the housing market. In 2003, John Talbott wrote a book called The Coming Housing Crash. Talbott was a former Goldman Sachs banker, which is to say, he worked for Rubin. He was seeing something. He wrote the book "after hearing that a friend—a teacher in San Diego who earned $45,000 a year—had just refinanced his condominium and borrowed $255,000 against its rising value." These loans weren't secret.

In 2004, Dean Baker sold his house. "Houses have something similar to a stock's price-to-earnings ratio: their rental value. In a sane housing market, Baker says, a home's annual rent is roughly one-14th of the home's value...The annual rent he pays on his condo is roughly one-17th of its value -- and that's not taking into account high property taxes. Add those to the equation, plus condo association fees, and the ratio is closer to one-20th."

Baker didn't have insider knowledge. He just had a contrarian personality and an abiding faith in the fundamentals. Rubin did not. Somewhere in the gap between the two of them lies Rubin's mistake. This stuff is complicated. But this effort to suggest that no one could have been more prescient is really weird."

Again, I don't disagree with his points, as far as they go, but he seems indifferent or uninterested in fraud, negligence, fiduciary mismanagement, and collusion, as well as to the system of backups that many of the highest members of our financial establishment were assuming. This story is basic to understanding the way our system really functions, and what the beliefs and expectations are that people base their decisions on in our actual system. Believe me, they're not Cato Fellows, and they have an abiding love and faith in government largess. They wouldn't have lowered capital requirements without making assumptions of how things would go for them if this all went sideways.

So Klein is terribly wrong. The only way to uncover what actually caused this crisis is to understand all of these investment decisions well enough to judge truth and real misunderstanding from BS and CYA and IDWTGTJ. I Don't Want To Go To Jail.

I'm not saying I can, but I don't see any point in not giving it the old college try. Go Bears!