Thursday, October 16, 2008

All The World Loves a Bubble


As if you need to be told, I'm not an economist. But at the same time, I haven't had a great deal of difficulty identifying the two big "bubbles" of our time - the "dot com bubble" and the "real estate bubble". With the dot com bubble, I "knew" that the moment I tried to "cash in" would be the moment people figured out that it was largely a house of cards, so I didn't try to cash in - silly me, overestimating the intelligence of the financial community.

For the more recent bubble, I wasn't trying to get a loan to buy a house I couldn't afford, and don't want a McMansion, so I wasn't aware of how absurd the housing market had become, but it wasn't lost on me that housing inflation had reached absurd levels in parts of the country or that a lot of new construction was priced well above the reasonable means of a lot of people who seemed to be buying it. And for the last two years, a growing number of voices have been warning laypersons about the impending problems of the housing market and mortgage industry - those warnings could not have escaped the attention of industry professionals. If we are to assume that there is value to the field of economics, I find it difficult to believe that an economist who was truly studying the housing market wouldn't have seen this coming.

The other day on Marketplace, I heard an economist, Susan Lee, give a simplistic explanation for how the government is responsible for... well, everything that goes wrong with the economy:
Just take a look at monetary policy. Back in 1998, when the giant hedge fund Long Term Capital Management went under, the Fed rushed to the rescue. Tons of unnecessary dollars were pumped out. Those dollars generated the dot-com bubble. When that bubble burst in 2001, the Fed again threw dollars at the crisis, generating the housing bubble. And when that bubble burst last year, the Fed once again shoveled out more dollars which will, eventually, create another crisis somewhere else.
A similar argument is raised in the Washington Post today, by Peter Schiff: Don't Blame Capitalism.
Yes, many Wall Street leaders were irresponsible, and they should pay. But they were playing the distorted hand dealt them by government policies. Our leaders irrationally promoted home-buying, discouraged savings, and recklessly encouraged borrowing and lending, which together undermined our markets.
Schiff tells us how government policy has stripped people of the fear of losing their investments,
But over the past generation, government has removed the necessary counterbalance of fear from the equation. Policies enacted by the Federal Reserve, the Federal Housing Administration, Fannie Mae and Freddie Mac (which were always government entities in disguise), and others created advantages for home-buying and selling and removed disincentives for lending and borrowing. The result was a credit and real estate bubble that could only grow - until it could grow no more.
That's nonsense. Nobody made a private lender participate in this scheme. Nobody said, "Hey - don't pay any attention to that ginormous bubble that's completely unsustainable and could wipe us out if it bursts." If we're supposed to believe that the financial industry "wizards" who get paid between tens and hundreds of millions of dollars per year couldn't see this coming, or did but chose to do nothing, they don't even deserve minimum wage.

With all due respect for the distorting effects of tax policy, subsidies, and government guarantees, it's not as if any of those distortions are a mystery. They're among the best known, most obvious, and most predictable aspects of the housing market. When people like Schiff tell us, "Market forces would have kept out unqualified buyers and prevented home-price appreciation from exceeding the growth in household income," they're both overstating the responsibility of those policies for the bubble and are grossly understating the responsibility of financial professionals. For goodness sake, Schiff argues,
Prominent among these wrongheaded advantages are the mortgage interest tax deduction and the exemption of real estate capital gains from taxable income. These policies create unnatural demand for home purchases and a (tax-free) incentive to speculate in real estate.
Those policies make it possible for people to afford "more house" than they could in their absence, but they are far from "prominent" in the current financial crisis. They have existed for many decades without causing a bubble. Nobody - nobody - is proposing that it's necessary to repeal them in order to prevent a future bubble. And I doubt any sensible person, economist or otherwise, would suggest that now is the time for a repeal resulting in downward pressure on home values and a further reduction in the amount prospective homeowners would be able to borrow. Removing those distortions may well be an appropriate long-term goal, but would be short-term stupidity.

Schiff provides a similar argument to that heard on Marketplace,
Artificially low interest rates invigorated the market for adjustable-rate mortgages and gave birth to the teaser rate, which made overpriced homes appear affordable. Alan Greenspan himself actively encouraged home buyers to avail themselves of these seeming benefits. As monetary policy caused houses to become more expensive, it also temporarily provided buyers with the means to overpay. Cheap money gave rise to subprime mortgages and the resulting securitization wave that made these loans appear safe for investors.
Who says the "loans" appeared safe for investors? They were combined, sliced, diced and securitized, and certified as high grade securities, all by financial industry professionals - with the apparent goal of making it impossible for investors to figure out what they were buying or make an accurate assessment of risk. The accounts from inside the mortgage industry suggest two primary lines of thought: First, the absurd notion that housing inflation could continue at 10-20% per year, indefinitely, and second that it was more important to buy up garbage mortgages, securitize them, and turn a profit than it was to let somebody else do so and grab the "profits".

Schiff notes, correctly in my opinion, that "Real credit can be supplied only by savings", and suggests that nonetheless "the government cannot abide solutions that ask for consumer sacrifice". But it's not just the government that can't stand the idea of consumer sacrifice - our economy is built on consumer largesse. What happens if you reign in consumer spending, some 2/3 of the economy, as part of your effort to shift the economy back to savings and "real credit"? In the long-term we're likely to be better off, but boy does that short-term picture get rocky.

I respect the consistency of Schiff's argument, which appears to be a form of free markets purism where the government shouldn't create tax or fiscal policies that affect the markets, and also should let markets self-correct in times of crisis.1 And I respect the fact that government actions that distort the markets will have unintended consequences. But the markets have an atrocious record of self-regulation, and the unfettered capitalism of the industrial revolution has little appeal.

Schiff implies that "fear" will cause self-regulation in the absence of government regulation, but that's presented as an article of faith, and seems contradicted by the fortunes lost in these market corrections.2 If Lehman Brothers truly saw no risk and had no fear of failure, again, its principals didn't deserve so much as minimum wage. Beyond that, how far does even Schiff truly wish to roll back worker rights, workplace safety requirements, environmental regulations, and other regulations of business and industry in the name of "free markets"?
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1. Schiff writes,
By refusing to allow market forces to rein in excess spending, liquidate bad investments, replenish depleted savings, fund capital investment and help workers transition from the service sector to the manufacturing sector, government is resisting the cure while exacerbating the disease.
Now, I've not seen any great evidence that the markets are interested in training or retraining workers, except as made necessary by labor shortages. But what transition from service to manufacturing is he talking about? Granted, I'm in Michigan, so my perspective may be skewed, but I see a continued bleed of middle class manufacturing jobs with retraining directed at moving people into office or service jobs.

2. I don't want to overstate this. I find truth in the quip that, had current government policies been in effect in the 18th century, we would still have (heavily subsidized) neighborhood blacksmith shops.
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Update: Recession-Plagued Nation Demands New Bubble To Invest In (via Paul Krugman).

1 comment:

  1. I love this stuff. But you'll probably get more comments if you show of your "expertise" by simply giving links with commentary like "Heh" or "Indeed".

    ReplyDelete