Reader comments often inspire new posts, and this is a good example.  In my post on Krugman’s 2005 prediction of a housing bubble, a number of commenters pointed out that Dean Baker made the same call three years earlier, in 2002.  The clear implication was the earlier was better, and that Krugman was late to the game—just copying Baker.  I think that’s wrong.

Just so I am not misunderstood, this post is not a criticism of Dean Baker.  Commenters sent me links to bubble predictions Baker made in 2002 and also 2005.  I am going to argue that the 2002 prediction was neutral, neither particularly good nor bad, and the 2005 prediction was a good one.  All in all a decent record, nothing that deserves criticism.  Rather I’d like to focus on a narrow technical point, and argue his 2005 prediction was actually far superior, even though it came later. 

Precisely what does it mean to predict a housing bubble?  Are people predicting that one will occur in the future?  That prices will rise very rapidly?  Or are they predicting that one is already here, that prices are too high relative to market fundamentals?  I think it is usually the latter.  If the term ‘bubble’ is to have any meaning at all (other than the trite observation that prices have recently risen) there must be an implied prediction that in the not too distant future (i.e. not 100 years out) prices will fall back closer to their fundamental value.  I’ve argued this point ad nauseum, and won’t repeat it here.  My hunch is that people confuse these two issues, which is why many people assume it is easier to spot bubbles than it really is.

Here is what Dean Baker said in 2002:

This paper examines whether the increase in home prices can be grounded in fundamental economic factors or whether it is simply a bubble, similar to the stock market bubble. It concludes that there is a housing bubble. While this process can sustain rising prices for a period of time, it must eventually come to an end.

He does acknowledge prices might rise before dropping, which is of course what happened.  But that comment is so vague that I take it as one of those things you almost have to say.  After all, if prices have been rising fast, only a fool would predict an immediate and sharp decline, especially given that housing prices have a bit more momentum that stock prices.  In a nutshell, I infer that he is mostly saying that housing prices have risen above their fundamental value and that at some point the real price of housing should drop to more reasonable levels. 

In this paper from late 2005, he and David Rosnick again make a bubble prediction.  This time much more accurately, in my view.

In my Krugman post, I used this graph to think about the accuracy of bubble predictions.  I argued that those seeing a bubble in the US in 2005 were right, but in Britain, New Zealand and especially Australia they were wrong (thus far.) 

If you just eyeball the data, to me it looks like these prices occurred in the US:

2002:  200

2005:  300

2006:   350

2010:   250

So it’s fair to say that 2005 bubble predictions turned out to be accurate.  But what about 2002?  Well the actual price seems to have risen about 25% in 8 years.  That’s not too different from the overall inflation rate, and hence I’d say there hasn’t been much change in real housing prices.  So I’d call that a neutral, where lower real prices in 2010 would be a win for Baker, and higher real prices would have been a loss.

I’d like to use an analogy, to suggest why it’s better to be late than early, why Krugman actually deserves credit for being late to the bubble party.  I recall after the 1987 stock market crash that someone praised John K. Galbraith for having predicted a stock crash.  He made the prediction in January 1987, when the Dow was around 1700.  It then rose to 2700 in August, before crashing to 1700 in late October.  So was Galbraith right?   As this post shows, people seem to assume he was.  But I’d say no, as his prediction really didn’t convey useful information:

1.  If you sold stocks on his prediction, you would not have made money—even in the long run.

2.  It was an implied prediction that stocks were overvalued relative to fundamentals.  But today very few people would say the Dow was overvalued in 1987 at 1700, indeed if anything it might have been a bit undervalued.  This shows how hard it is for even a very smart person to know whether something was overvalued in real time.  I could say the same about Boston house prices in 1987, and I’m sure people living in Manhattan, London, Vancouver or San Francisco could provide similar examples of prices that once seemed insane, but now (even in this recession) actually look (in retrospect) like equilibrium prices.

I think a good prediction, a useful prediction, would be someone that predicted a stock market crash in August 1987, not January 1987.  Those are the people who deserve credit if you (unlike me) believe market predictions aren’t just dumb luck.

I can think on one counterargument.  One could argue that an early prediction might have resulted in public policy changes that prevented the worst of the housing bubble.   But I favored those public policy changes even without being able to predict the bubble.  And I’m claiming it’s not obvious there was a bubble in 2002.  I’d hate to have public policy decisions based on inaccurate bubble predictions.

So from now on when someone tells you that Dean Baker predicted the housing bubble back in 2002, the correct response is “You think that’s impressive, well Krugman predicted it in 2005!”  Enjoy the puzzled look in their eyes, and savor the thought that you are soon about to show your superiority by setting them straight.  At least if you’re as big a jerk as I am.

PS.  Take a look at the link discussing Galbraith.  It was from 1994, and they assumed we were in the midst of another speculative bubble—when the Dow was trading in the 3500 to 4000 range.  What do you want to bet that they said “I told you so” in 2003, after the crash brought prices down to 8000?

Other bloggers have recently listed some important mistakes they made.  The trick is to decide on the number.  Pick too few and you will seem too cocky, unable to see your own faults.  But pick too many and people will think you are bragging about how brutally honest you are.  So I’ll pick 10:

1.  In the 1970s I thought we were on the road to serfdom.  I bought the whole Mancur Olson argument that modern democracies gradually became more statist, as they get captured by special interest groups.  (I haven’t read him in a while, so I am probably oversimplifying.)

2.  In the 1970s I thought communism was more of a threat than it turned out to be.  (Ditto for Iraq in 2003.)

3.  In the 1970s I thought monetary policy operated with long and variable lags, and thus fine-tuning would make things worse.

4.  In the 1970s I thought the Nordic economic model was much more seriously flawed than it really is.

5.  I used to think moral and aesthetic beliefs were ‘”mere opinion” and scientific beliefs were “objective facts.”

6.  I used to think I was smarter than other people who are just as intelligent as I am.  Actually I sort of still believe this, but at least now one half of my brain knows how silly the opinion held by the other half of my brain really is.

7.  In 2007 I thought it very unlikely that there would be a severe US banking crisis.

8.  In 2007 I thought the Fed would be able to avoid a Japanese-style zero rate trap.

9.  I predicted that aggressive QE would raise long term interest rates, a view which seemed to be refuted by the response on T-bond yields to the March 2009 Fed QE announcement. 

10.  I thought Brett Favre really was going to retire this year, after he said he was going to.  Arguably my most embarrassing error.

I’d like to talk about number 9 for a moment.  Any effective monetary stimulus would be expected to raise long term rates.  We have plenty of examples of that occurring.  My favorite is the surprise stimulus announcement of January 3, 2001, which caused long term (nominal) rates to soar.   Thus I was shocked to see long term rates fall sharply on the day of the March 2009 QE announcement. 

I don’t have a good theory for why that happened.  One could point to the fact that they quickly reversed, and soon rose far above the pre-announcement level.  So maybe markets made a mistake and I was right all along.  But that means the EMH is wrong, a theory I hold even more dearly.  So either way I’m screwed.

If I had to guess I’d say it might have something to do with the type of stimulus.  It didn’t so much raise the monetary base (indeed the Fed was correct in denying that it really was QE) rather it changed the composition of their balance sheet.  Even so, other markets (stocks, foreign exchange) reacted as if it was bona fide monetary stimulus.  So I am not really satisfied with that explanation either.

I am reluctant to form a firm opinion based on a single observation, so I will watch market reactions to other QE-type actions, to see if a pattern develops.  If I was forced to critique my own blog, the market response to the Fed’s March 2009 “QE” would be my number one weapon.

This Wikipedia entry suggests that illegal immigration is about 700,000 per year, in net terms (1,500,000 gross).   I presume this refers to the trend rate before the recession.  I also found an article in Yahoo that makes the following estimates:

The study released Wednesday estimates that 11.1 million illegal immigrants lived in the U.S. in 2009. That represents a decrease of roughly 1 million, or 8 percent, from a peak of 12 million in 2007.

The study puts the number of illegal immigrants down to about where it was in 2005. They still make up roughly 4 percent of the U.S. population.

The Homeland Security Department’s own estimate of illegal immigrants is slightly lower, at 10.8 million. The government uses a different census survey that makes some year-to-year comparisons difficult.

Of course these are rough estimates, but let’s say a ballpark estimate is that since 2007 we have been losing about 300,000 illegals per year, instead of gaining 700,000 per year.   If so, then it appears population growth in the US might have slowed by about 1 million per year.  Births and deaths don’t change much year to year, and I was also unable to find any indication that legal immigration had changed much in the last three years.  It turns out the data is collected in a very confusing way, and I wasn’t able to find a reliable Census bureau estimate of the components of population growth.  The Census doesn’t show much change in US annual population growth rates, but given they were embarrassed to find 6 million more in the 2000 census than expected, I think it’s fair to say they don’t have a good handle on illegal immigration. 

So let’s suppose US population growth fell by one million after 2007, as a result of both the immigration crackdown and the recession.  Could this have caused the housing crash?  Just to get a rough idea of the magnitudes here, let’s assume a very simple model:

1.  Three people per family.

2.  Normal population growth 3 million per year.

3.  300,000,000 US residents

4.  100,000,000 US housing units

5.  Houses depreciate at 1% per year.

In this model we need a million new houses a year for new population, and another million replacement houses for depreciation.  Total construction should be 2,000,000/year, which was roughly the level of the mid-2000s.  Now assume population growth falls by 1,000,000.  This should reduce steady-state housing construction by 1/6th.  Not enough for a housing crash. 

If the slowdown was concentrated in illegal immigrant-rich areas with fast population growth (California’s Inland Empire, Arizona, Nevada, etc) it could have had a significant effect on local markets—perhaps two or three times as large as the nationwide effect.  That could have triggered a significant housing slump in the sub-prime markets.  On the other hand, some immigrants left for reasons other than the immigration crackdown and the resulting drop in housing construction jobs.  So there is the issue of disentangling the various shocks.  If the immigration crackdown contributed to the decline in housing construction, there would be some sort of multiplier effect, as other immigrants would leave because of the resulting drop in economic activity.  But I don’t want to oversell that multiplier, as most of the recession was in non-housing areas.

Let me also emphasize that I am not trying to explain away bubble-like behavior at the micro level.  None of this explains banks giving mortgages to low income farm workers so they could buy $500,000 homes, rather I am trying to better understand how at the macro level otherwise intelligent investors might have gotten caught off guard by the nationwide housing slump and fall in real estate prices.  One factor propping up prices (rapid immigration) was pulled away unexpectedly.   In other parts of the country, the early stages of the housing slump were much less severe.

Now let’s suppose that some combination of less immigration and ordinary post-bubble problems led to severe banking problems for institutions that held lots of MBSs.  The Fed mishandles this problem and lets NGDP fall 8% below trend.  Now falling NGDP causes housing prices in non-sub-prime areas to begin falling.  Ditto for commercial real estate.  We saw in an earlier post that it was commercial real estate, not subprime housing, which was the main cause of bank failures. 

I actually think immigration was much less than 50% of the initial problem.  But even if it was only 20%, because of the various ripple effects that I just described it is not inconceivable that the ultimate effect of the immigration crackdown could have been quite significant.  In 2008 there may have been a “knife edge” equilibrium, where if the economy had been a bit stronger we might have avoided the zero rate bound.  And if we had avoided that problem, monetary policy might have been able to prevent a steep fall in NGDP.  Maybe immigration is one reason Australia avoided the zero bound and steep recession.  Still, this is all speculation.  Even though I favor a high rate of immigration, the preceding story seems far too speculative to inform our immigration policy.  We are better off learning from other countries that do it better than us (yes, I mean Australia and Canada.)

PS:  There are lots of guesstimates in this post.  My hunch is that immigration slowed, but by less than 1,000,000 per year.  But births have also slowed by a few hundred thousand, which I excluded from the estimates.  Again, I am not looking for a monocausal explanation of the housing crash.  I think it likely that almost all giant economic disasters have multiple causes, whether it be the Great Depression, or the Great Recession.

In 2005 Paul Krugman called the US housing bubble.  A couple weeks ago he reminded us that he called the bubble, and implied only a fool (or a brainy right-wing ideologue?) could have failed to see it.  He presented a graph showing that housing prices in the US had been rising rapidly.  Interestingly, housing prices had been rising rapidly in lots of countries, but relatively few turned out to have housing bubbles.  Here’s a graph Tyler Cowen linked to recently:

Let’s use the archive list of months as a vertical line to estimate prices in 2005 when Krugman made the call, and compare them to today’s price:

US   2005 = 300,  2010 = 250

UK  2005 = 375,  2010 = 395

NZ  2005 = 330,  2010 = 430

Aus 2005 = 390,  2010 = 550

I don’t know about you, but to me only the US looks like a clear-cut bubble.  Yes there were some rises and falls in other countries, but it wasn’t obvious (ex ante) in 2005 whether prices in the other three countries were above or below their long run equilibrium.  Indeed it still isn’t, as Australian housing prices could crash at any time. 

I’ve consistently argued that the bubble theory is only useful if it leads to good predictions.  Krugman did make a good prediction, that housing prices would be lower in the not too distant future.   BTW, I’d say you at least need to provide some sort of time frame—say 5 years out.  It’s not enough to say “I predict prices will keep rising, and then eventually fall.”  That’s true of any market.  Although Krugman did not provide a specific number in the post I linked to, I am pretty sure that the actual drop in the US occurred over the sort of time frame he envisioned, if he had been forced to name a date.  So I give him complete credit for a correct prediction. 

But here’s my question.  Given that the other three markets did not decline over the same time period, is it really true that we could be confident, ex ante, that US houses were overpriced in 2005?  It certainly seems so given everything that has happened since, but might that be a cognitive illusion?  Confirmation bias?  I doubt Krugman thought NGDP would suddenly fall 8% below trend in the 12 months after mid-2008.  Where would housing prices be today if NGDP had kept growing at 5%.  I don’t know.

I’m inclined to believe there was some irrationality in the 2005 housing market, but I am less confident than Krugman that price bubbles are easy to spot.  In the next post I’ll provide one reason why, despite the undeniable excesses that swept the housing market, investors with rational expectations about NGDP growth and immigration might not have spotted the oncoming collapse in US housing prices.

BTW, look at housing prices in Australia; the one country on the list that did not experience a recession in 2008, and which has very rapid immigration.

PS.  This interactive graph in The Economist shows that among 20 countries, only the US and Ireland showed a clear bubble-like pattern after 2005.  In most countries prices are now higher than in 2005, and in the few other exceptions (Germany, Japan) there had been no run-up in prices prior to 2005.  So my results don’t come from cherry-picking these four anglophone nations, bubbles really are hard to spot.  (I’m puzzled by the Spanish price graph, but even if it is inaccurate and Spain was a bubble, that just makes three clear bubbles in The Economist group of 20.)

You can adjust the horizontal scale to get different starting dates.   Many countries saw steep price run-ups prior to 2005.  If you start at 2005:Q2, it’s easy to compare current prices to mid-2005 prices.

PPS:  Compare Krugman’s mea culpa post, with these Japan predictions dredged up by David Henderson.  The second paragraph shows Krugman at his best.  What happened to that guy?

No, it’s not centers of sub-prime madness like Arizona or Nevada.  Nor is it big states like California or Florida.  It’s Georgia.  And Illinois is second.  Check out the graph in this link:

There is a good reason why most bank failures in 2009 did not occur in the sub-prime states; sub-prime loans were not the main problem.  Indeed mortgages of all types were not the main problem.  What was?  According to McNewspaper USA Today it was construction loans, often for commercial real estate: 

The biggest bank killer around isn’t some exotic derivative investment concocted by Wall Street’s financial alchemists. It’s the plain old construction loan, Main Street banks’ bread and butter for decades.

Deutsche Bank has called them “without doubt, the riskiest commercial real estate loan product.” The Congressional Oversight Panel, a financial watchdog, has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.

That’s right, everything we were told about the financial crisis in 2009 (and which I also believed for a while) is wrong.  It’s a commercial RE crisis, not a mortgage crisis.   You might argue that it was housing loans that triggered the liquidity crisis of late 2008.  Yes, but the crash of late 2008 was caused by the Fed’s failure to do level targeting once rates hit zero.  The main public policy issue with bank failures is the cost to taxpayers, not the impact on the business cycle. 

In earlier posts I argued that the commercial real estate market does not appear to have been a bubble.  It held up very well in late 2006 and 2007, even as residential housing was falling almost continuously.  Only when NGDP growth slowed in 2008, did commercial real estate begin a significant decline.  No big surprise there, commercial real estate is extremely sensitive to falls in NGDP produced by excessively tight money.  The same problem hit commercial RE in the 1930s, when NGDP fell in half.  There are stories of the Empire State Building being mostly empty after it opened in 1931.

Why were all those bad commercial real estate loans made?  After all, shouldn’t banks take into account the risk of recession?  Well nobody could have expected NGDP to suddenly fall 8% below trend.  But even so, there clearly is a problem here.  Indeed it appears that our current banking crisis, which was initially thought to be very different from the 1980s S&L fiasco, was almost an exact replay of that earlier crash.  Initially we were told that the big banks were the problem this time–it was all about “Too-Big-to-Fail.”   But they have been quietly repaying their TARP loans.  Even the worst banking fiasco in nearly 80 years will not result in taxpayer money being permanently transferred to big banks.  Even if you include the AIG bailout as an implicit bailout of the big banks, the small banks are still the main problem.  Our government insurance company let’s smaller banks run wild, just as in the 1980s (i.e. before the so-called “regulatory reforms” that were supposed to fix the S&L problem.)  The cost to FDIC of all these smaller bank failures in places like Georgia will be many times larger than the net cost of AIG plus the banking part of the TARP bailout.  And let’s not even talk about the cost of bailing out the GSEs.

It’s not about big banks and it’s not about derivatives:

It did not end well. Construction loans started blowing up when the real estate market collapsed and the economy tumbled into recession. The 10 biggest banks, facing problems of their own with subprime mortgages, were largely immune to the deterioration in construction loans, which accounted for just 2% of their assets in 2007, according to the Federal Reserve. By contrast, construction loans accounted for more than 10% of assets at banks that didn’t rank in the top 1,000. “What’s causing the problem is Main Street America, the construction loan made by the bank down the street,” says Bill Bartmann, who owns a debt advisory firm. “They built, and nobody came.”

Making matters worse: Community banks never sold the construction loans to investors the way banks unload auto loans and residential mortgages. “Most construction loans are so unique, so different, so non-homogenous, that you can’t securitize them,” Bartmann says. “They were kept on the books of the banks that originated them.” And there, many of them started to turn rotten.

Here’s an example of what banks did in Georgia:

Rollo Ingram witnessed one spectacular flameout up close. He was chief financial officer at Atlanta’s RockBridge Commercial Bank, which opened in 2006, backed by other members of the city’s business elite.

RockBridge told banking regulators it planned to specialize in business lending. It didn’t, plunging instead into real estate and construction loans. The bank told regulators in 2006 that construction loans would account for 5% of its portfolio. By the end of 2007, they accounted for 42%. Business loans, which were supposed to make up 50% of RockBridge’s lending, came to just 28%, according to an after-the-fact autopsy by Federal Deposit Insurance Corp.’s inspector general.

Nor did RockBridge recruit veteran loan officers with enough experience to safely assemble its risky portfolio, the inspector general concluded. “They hired younger, less-experienced ones, and didn’t hire enough of them,” Ingram says. He says he was forced out in 2008 when he complained about the risky direction the bank was taking.

Those on the left complained the banking crisis resulted from “laissez-faire,” forgetting that the federal government effectively nationalized most of the liabilities of the banking system in 1934.  That’s right; when you deposit $100 in your bank account you are actually lending the money to Uncle Sam, who re-lends it at the same rate to the bank.  FDIC is effectively a government institution, and the fees on banks are effectively taxes, which of course are passed onto the public.  The government didn’t seem to care that wildcat banks in Georgia colluded with property speculators and ran wild with government loans made at risk free rates.

But some on the right were arguably even worse, not paying enough attention to this problem and constantly harping on the need for “deregulation,” aka the doctrine of “business should be free of regulations that inhibit their ability to loot the Treasury.”

I’m amazed that after the S&L fiasco of the 1980s our government wasn’t able to figure out the problem.  Or maybe they do understand the problem, but are in the pocket of property developers. 

And of course now if someone proposed a crackdown, there’d be complaints about how it would “starve the economy of capital, and slow the recovery.”  Just one more side-effect that results when hawks at the Fed prevent an adequate recovery in NGDP.

Update:  I just saw an example of the “blame it all on laissez-faire” meme discussed in Arnold Kling’s blog.  And Barry Eichengreen isn’t even very left wing.