Economics
Blowing bubbles
POP QUIZ: was the American housing boom based on fundamentals or was it entirely driven by speculation? A silly question, you say. Bubbles typically begin to inflate based on fundamentals-driven price signals, and they later graduate to unsustainable increases as credit expands and new buyers enter the market to speculate that prices will rise indefinitely. The answer, then isn't either-or, it's both-and. Or rather, one then the other.
Casey Mulligan seems to struggle with this concept in a new post at Economix. He writes:
Inflation-adjusted housing prices and housing construction boomed from 2000 to 2006 and crashed thereafter. Commentators ranging from President Obama to Federal Reserve Chairman Ben S. Bernanke have described that cycle as a "bubble,"? by which they mean that, at least in hindsight, the housing price boom was divorced from market fundamentals.
But maybe there was a good, rational reason for housing prices to increase over the last decade.
Or maybe there was a good, rational reason for housing prices to increase in many markets, but in an environment of rapid credit expansion and growth in new buyers the housing price boom became divorced from market fundamentals. Contra Mr Mulligan, these explanations are complementary, not in conflict with each other.
His damning piece of evidence is this chart:
Prices have not fallen all the way back to the level we'd expect if demand had remained constant from the 1990s. Based on this, Mr Mulligan concludes that fundamentals may explain "a large fraction" of the previous decade's price increases.
Now it's possible that the leveling off we've observed is due to government interventions, and prices will soon resume falling. But even if we simply take this chart and Mr Mulligan's hypothesis as they are, this conclusion seems daft:
[A]nother interpretation is that a large fraction of the housing price boom was justified by fundamentals...If so, we are probably asking too much of the Federal Reserve and other regulators to accurately disentangle bubbles from fundamentals the next time that asset prices rise.
Really? According to Mr Mulligan's own logic, the whole of the 20% increase in prices charted here involved a movement "divorced from market fundamentals" (and in the big bubble markets, values rose by 100% or more through this period). Is he really suggesting that we shouldn't expect regulators to get that something fishy is going on under such circumstances?
Mr Mulligan might respond that by that logic, the Fed might have averted the increases between 1992 and 2002, which look, according to this chart, to be fundamentals-based. But that only works if you carefully close your mind off to all the many, many other pieces of information that were available"â?like changes in the ratio of prices to rents and incomes, like massive growth in credit, like the unusual growth in homeownership rates, like the reams of troubling anecdotes from bubble markets, and so on. But why would anyone, least of all a responsible regulator, do all of that? I don't think Mr Mulligan has proven anything here except his own stubborn adherence to the idea that it's always best to trust markets.
The Economist welcomes your views. Please stay on topic and be respectful of other readers. Review our comments policy.
Sort:
My monthly income doesn't cover the cost of my interest only payment, much less fully amortized? No bubbles here, move along.
"I don't think Mr Mulligan has proven anything here except his own stubborn adherence to the idea that it's always best to trust markets." Brilliantly put!
The ability of ideologues to ignore reality in order to cling to their warped belief system is truly astounding. If there was a market for that degree of self-delusion they'd do very well.
Mr Mulligan is often daft.
I never like to encourage anyone to routinely bash another person. Particularly when bloggers mock bloggers, it seems incivil, frivolous and superficial.
So, as far as you know, I don't enjoy every time you poke fun at Mulligan, who should maybe make more of his fortunate last name.
I try to read Mulligan's blog. He does weird things like extending the generally accepted, sensible concept that unemployment insurance can extend the duration of unemployment to extremes that truly jeopardize the reputation of Chicago as a place of sensible thought. He seems to have a need to take a point that has some validity and then stretch it to the level of utter crankdom.
"But why would anyone, least of all a responsible regulator, do all of that? I don't think Mr Mulligan has proven anything here except his own stubborn adherence to the idea that it's always best to trust markets."
What reason is there to think that a regulator would be responsible? Regulators were AWOL in the financial crisis, the WV mining disaster and the Gulf of Mexico spill. This should surprise no one, as regulation is largely premised on regulators have smarter and more informed people than those they are charged with regulating -- a ridiculous proposition.
Ryan, while you throw barbs at Casey you're blogging proves your own stubborn adherence to a misplaced belief in the power of government.
Most of this discrepancy can be explained by current low mortgage rates. According to Freddie Mac (http://www.freddiemac.com/pmms/pmms30.htm), the average 30-year fixed mortgage rate is currently 5.1%. In contrast, the average rate in early 2002, when price levels were comparable to today"?s, was closer to 7.0%. During the peak-boom years of '03-'05 this rate averaged around 5.9% versus 7-8% during the late 90's. Thus, if you allow that house prices in early 2002 (near the start of the boom) were only slightly frothy, then given the lower prevailing rates of today, current price levels are probably fairly close to their fundamental levels.
In all this, it's worth remembering that home valuations are very similar to bond valuations. Just as the value of a bond with a fixed coupon rate rises when prevailing interest rates fall, so too does the fair value of a home that pays a given (real or implied) rent. The only difference is that while bond markets equate rising bond prices with falling interest rates, housing markets often see rising home prices as evidence of rising rates of return on housing. This may be how the bubble started - a reasonable rise in the value of homes cause by falling long-term rates led to unreasonable expectations about further rises in home prices.
Machlup explained the futility of trying to separate fundamentals from speculation back in 1937:
"The rise in business activity is measured in money values. It may be due to increased prices or to increased volume [fundamentals], usually both. Many people take the rise in volume [fundamentals] as an absolutely healthy development and are uneasy only about a sharp rise in prices. A smaller group of economists - I am among them - extend the skepticism to the boom in business volume because they doubt that a very quick growth can be free from disproportionalities and maladjustments. Looking back to the period preceding the collapse of 1929, we find a really spectacular price rise only in the stock markets and real estate markets, while the industrial boom was almost exclusively one of increased volume. This very fact made most of the observers believe everything was sound and firm in the industrial situation. Here are a few figures from the 1929 boom:
"Industrial output rose from 1924 to 1929 by 25 per cent, or alone from 1927 to 1929 by 12 per cent. Construction contracts awarded rose from 1924 to 1928 by 42 per cent. Loans and investments by banks rose from 1924 to 1929 by 33 per cent. Bank debits outside of New York (that is, outside of stock market transactions) rose from 1926 to 1929 by 78 per cent. It was thus a time of great technical improvement and thus of lower production cost, so that the monetary expansion did not express itself in the form of increased commodity prices. Otherwise, and usually, such monetary expansion shows itself both in higher volume and higher prices."?
"All financial and industrial crises and depressions observed in the past two centuries were preceded by rapidly rising business activity, and so it was natural to take the rapidity or extent of the increase, the boom, as the cause of the breakdown."?
http://mises.org/books/can_we_control_the_boom_machlup.pdf
In other words, an increase in the fundamentals can be just as much a sign of a bubble as an increase in prices.
I think is can safely be argued that mortgate interest rates are not low, especially for people who bought before the crash.
Historically, interest rates were comparable to GDP growth plus a small premium. Right now they are several times GPD growth (taking out the direct effect of unusual increases goverment spending). Also, if you adjust past GDP, subtracting out the fictional part when it was created, GDP growth has be small compared to interest rates for a while. Consider that both property values should have been lower and interst rates should have been lower for the past several years.
Even now rates are high considering the small potential for returns anyone making capital invests can expect, yet people are stuck paying much higher rates. A fantastic amount of income is tied up in servicing bad debt and it is the secondary source of risk in our economy, following our unpredictable government. People are unable save, spend, or invest because of the money tied up in servicing debt. The debt itself would be paid down quickly if the interest cost wasn't so high compared to incomes.
What would happen if we forced banks to set all mortgages made between 2005 and 2009 to the current 3 year rate for 3 years and make principal payments on those mortgages deductable?
ToGetRichIsGlorious - there is a world of difference between competent regulators enforcing well-crafted regulations - and incompetent regulators not enforcing badly written regulations.
2000-2008 was mostly the latter, partly because the administration was led by one of the least competent presidents in American history. Yes, Dorothy, leadership matters.
Fiscalconservative: "there is a world of difference between competent regulators enforcing well-crafted regulations - and incompetent regulators not enforcing badly written regulations."
In hind sight, yes. How do we know when regulators fail and regulations are bad? We can only know it after the fact. When the Feds hire regulators, laziness isn't int the job description. They attempt to hire good regulators. In the same way, no legislator sits down to intentionally write bad regulations. Legislators always think their regulations are perfect.
The Federal Register publishes all new regulations and contains an average of 10,000 pages every year. Much of that is financial regulations. Can you point to any of those that you consider bad regulations, or to instances in which regulators failed to do their jobs?
fundamentalist - let's not waste time on an issue that is obvious to anyone who isn't desperately trying to cling to an outmoded ideology.
When Bush appointed as top regulators the same people who used to lobby on the behalf of the industry they would now regulate - can you with a straight face say "They attempt to hire good regulators."
Legislation is analyzed in great detail by people who work for think tanks, for example. And yes, obviously they do point out which parts of each bill will result in bad regulations and adverse consequences. Legislation is (again obviously) a compromise - often with clueless ideologues who deliberately influence the process so that the regulations won't work.
We've been over this already. How many more times to I have to state the obvious?
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts.
Advertisement
Subscribe to The Economist's free e-mail newsletters and alerts.
Subscribe to The Economist's latest article postings on Twitter
See a selection of The Economist's articles, events, topical videos and debates on Facebook.
Read Full Article »