Bubble predictions: better late than early

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?


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30 Responses to “Bubble predictions: better late than early”

  1. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. September 2010 at 11:01

    Scott,
    You wrote:
    “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.”

    And consider this, a point I think you may have made in the past. What if NGDP had continued to grow at 5% a year from 2007 to 2010 instead of falling 8% or so below trend? Surely nominal (as well as real) housing prices would be higher than they are now.

    Not to disparage Dean Baker, as I have a great deal of respect for him, but his 2002 prediction only looks prescient because the Fed so severely dropped the ball.

  2. Gravatar of Edwin A Edwin A
    5. September 2010 at 11:01

    “But that comment is so vague that I take it as one of those things you almost have to say. ”

    Vague? It was a 22 page study. Did you notice there was a link to a pdf file under that paragraph you quoted?

  3. Gravatar of ssumner ssumner
    5. September 2010 at 12:00

    Mark, Thanks, I also respect his analysis of housing–his 2005 predictions were right on the mark.

    Edwin A. So are you just trying to be provocative, or is there something in that 22 page study that contradicts my inference?

    Claiming house prices are at bubble levels is basically equivalent to claiming that real housing prices will eventually decline. They haven’t declined from 2002 levels, even in real terms, and hence I thought I was being generous to Baker in by not claiming his assertion was wrong.

    If there are specifics dates and prices in the paper, let’s have some fun seeing how those predictions turned out.

    If he predicts (in 2002) that real housing prices will rise 75% over the next 4 years, I will withdraw my assertion, and insert a new post claiming he is the greatest Nostradomus of all times.

  4. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    5. September 2010 at 12:29

    Scott,
    My bubble definition: expected ex-ante returns over medium term (4-15 years) are too small. This means that ex-post some bubbles don’t pop if there is some random positive shock. And some bubbles just slowly deflate. If Beaker said that houses were 30% overvalued in 2002, one of the future scenarios consistent with such overvaluation is annual returns that are less than 2% below normal for the next 15 years. 2002 prediction is no less useful than 2005.

    Mark. A Sadowski,
    In 2002 Beaker said there is huge risk that policymakers will mismanage the future housing crash.

  5. Gravatar of scott sumner scott sumner
    5. September 2010 at 12:34

    123, I can’t understand your comment at all. Suppose in 2006 I had said there was no housing bubble. By your criterion I might still be right. There was that 30% shock I didn’t expect, but in 15 years things will bounce back. Who’s to say I’m wrong? I’ll tell you who, Baker and Krugman would say I’m wrong. So I don’t think even Baker himself would accept your reasoning as justifying his prediction.

    What did Baker say that policymakers would get wrong?

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. September 2010 at 12:42

    123 – TheMoneyDemand Blog,
    You wrote:
    “Mark. A Sadowski,
    In 2002 Beaker said there is huge risk that policymakers will mismanage the future housing crash.”

    That’s one reason why I remember it so well. In that sense perhaps his prediction was prescient.

    By the way his name is Baker, not Beaker. Beaker works for Muppet Labs, not CEPR:

    http://www.youtube.com/watch?v=yQj2NP25TIo

  7. Gravatar of Edwin A Edwin A
    5. September 2010 at 14:18

    “Edwin A. So are you just trying to be provocative, or is there something in that 22 page study that contradicts my inference?”

    No provocation was intended. All you quoted was the short preview statement and called it vague and didn’t refer to anything inside the paper. I wasn’t sure if you missed the pdf link because I didn’t link it directly like I linked the 2005 paper directly.

    You said:
    “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”

    In the 2002 paper, Dean Baker showed that housing prices rose 30% above the overall inflation rate not along with inflation between 1995 and 2002. This graph of his shows real prices, not nominal.
    http://i.imgur.com/vvjCX.jpg

    Baker says:
    “Since 1995, home sale prices have risen far more rapidly than the overall rate of inflation. Over this seven year period, home sale prices have risen by more than 47 percent in nominal terms, an amount that is nearly 30 percent above the overall rate of inflation.”

    So according to baker, we were already in a bubble situation in 2002. Obviously I don’t think Baker can predict the future, nor does Baker himself, but the point of the paper was just to make people aware of it. There’s no way he could have predicted in 2002 that the fed (the regulator side)would have let it grow for so long, which why he didn’t. What he did give was two possible modest outcomes of the bubble deflating more or less immediately. A big bubble and a small bubble. Being so early in 2002, his big bubble scenario ended up being too small.

    Perhaps his 2002 paper was meaningless. If you were fed chairman, at what point do think it would early enough to simply acknowledge the bubble? Dean Baker essentially said the same thing in the 2005 paper (which you said it was a fair) that he said in the 2002 paper, but with bigger numbers. And he didn’t stay quiet between 2002 and 2005. He wrote extensively on it while it was happening in real time. One of the main points he was trying to drive at was that Greenspan could use his position as fed chairman during his testimonials with the congressional committees and show that there was a bubble in the housing market. Simply making it public like that might have stopped it in its tracks. This is just a short term solution and obviously more would need to be done, but acknowledging it would have gone a long way. Instead Greenspan and Bernanke explicitly denied there was a bubble and let it grow.

    You say today’s problem is caused by tight money and the bubble isn’t as relevant anymore. I would agree with you, but people in the US still lost trillions in housing wealth. Just like that, their savings are now gone. Even a 2005 prediction is way too late.

  8. Gravatar of Morgan Warstler Morgan Warstler
    5. September 2010 at 14:29

    Scott you are a laugh riot…

    “Claiming house prices are at bubble levels is basically equivalent to claiming that real housing prices will eventually decline. They haven’t declined from 2002 levels, even in real terms, and hence I thought I was being generous to Baker in by not claiming his assertion was wrong.”

    http://mysite.verizon.net/vzeqrguz/housingbubble/

    Of course real estate experts say home prices are easily falling another 10%…. which will put us right in there below 2002 levels.

    Which points to the OBVIOUS LOGICAL ERROR on your part, he predicted it was a bubble, it was a bubble….

    The ONLY reason home prices aren’t lower is because the Fed bought $1T+ in MBS, and continues to commit free market abuse daily.

    Predictions on home prices are not supposed to factor future QE!

    No, to see if Baker was right, we have to ask ourselves what would happen if there had be a giant liquidation.

    Answer: there was a Bubble and Krugman is partly responsible for it. Krugman called for it as basically QE from the tech bust – Krugman is not an economist, he is a liberal.

  9. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. September 2010 at 14:46

    Morgan,
    You discredit yourself when you regurgitate right wing taliking points.

    As Arnold Kling pointed out:

    “In 2002, he passed along a joke that the economy needed a housing bubble. Krugman is controversial, so the post generated comments on this blog and elsewhere, some of which are overly “gotcha” in character.

    Krugman was mainly expressing pessimism. He was not cheerfully advocating a housing bubble, but instead he was glumly saying that the only way he could see to get out of the recession would be for such a bubble to occur.”

    http://econlog.econlib.org/archives/2009/06/defending_what.html

    Spare us the propaganda. We have no need for it here. It does not advance the debate.

  10. Gravatar of Edwin A Edwin A
    5. September 2010 at 14:56

    Sumner also wrote a defense for Krugman if you haven’t seen it.
    http://www.themoneyillusion.com/?p=1620

    Even Baker thought the low interest rates were appropriate, despite screaming bubble at the time.

  11. Gravatar of John Brennan John Brennan
    5. September 2010 at 15:27

    Krugman and Baker are really both fence sitters and pikers compared to Charles Kindleberger. In 2002, In a Page One profile of Charles Kindleberger said in the WSJ (July 25th):

    “The object of his greatest fascination today is the real-estate market. For weeks, Mr. Kindleberger has been cutting out newspaper clippings that hint at a bubble in the housing market, most notably on the West Coast. Nationwide, median home prices are up about 7% from a year ago, even though the stock market has tanked and the economy has floundered. Over the long term, economists agree, housing prices can’t continue to outpace growth in household incomes. Mr. Kindleberger says he isn’t certain there is a housing bubble yet, “but I suspect it is.”

    The trick with spotting real-estate bubbles, he says, is that they don’t always spread. In 1925, for instance, real-estate prices in Florida soared and crashed, but that didn’t spread to the rest of the country. Yet he notes that something is distinctly different about the nation’s housing market today, when compared with 1925. Fannie Mae and Freddie Mac, two large government-sponsored enterprises, own or guarantee nearly $3 trillion in mortgages, helping to keep the mortgage market liquid with cash. That is a boon to homeowners, but Mr. Kindleberger says he fears that Fannie Mae and Freddie Mac’s deep nationwide presence in the market is fueling a speculative fire.

    “Banks will make a mortgage and sell it to them. It means that the banks are ready to mortgage more and more and more and more. It’s dangerous, I think,” he says.

    A Fannie Mae spokeswoman describes the argument as “preposterous,” and notes Mr. Greenspan dismissed the chances of a housing bubble in testimony to Congress last week. Robert Van Order, chief international economist for Freddie Mac, says home prices might decelerate in the months ahead, but they’re unlikely to crash because interest rates are so low, the inventory of unsold homes is also low and the economy has proven surprisingly resilient.

    Yet Mr. Kindleberger isn’t convinced. “If I was 30 years younger,” he says, “I’d write a small book on Fannie Mae and Freddie Mac.””

    From his deep study of history, Kindleberger spotted the commodity and the contagion mechanism. Krugman still states that Fannie Mae and Freddie Mac were not part of the problem. So he won’t write the book.

  12. Gravatar of Edwin A Edwin A
    5. September 2010 at 16:25

    Here’s a couple recent blog posts by Dean Baker somewhat related to this.

    http://www.cepr.net/index.php/blogs/beat-the-press/basic-logic-for-ben-bernanke

    http://www.cepr.net/index.php/blogs/beat-the-press/house-prices-still-have-more-to-fall-deal-with-it

  13. Gravatar of Andy Harless Andy Harless
    5. September 2010 at 16:43

    A minor point: I don’t recall what Galbriath actually said, but if he was predicting a crash, you could have played it by repeatedly buying out-of-the-money puts. Downward volatility risk isn’t quite the same as fundamental overvaluation.

  14. Gravatar of Morgan Warstler Morgan Warstler
    5. September 2010 at 17:16

    Sadowski,

    You ought to read more….

    http://blog.mises.org/10153/krugman-did-cause-the-housing-bubble/

    If Mises freaks you out, you can read it here:

    http://www.businessinsider.com/actually-krugman-was-a-huge-advocate-of-the-housing-bubble-2009-6

    Mark I have good reason to remember 2001-2003, I had just gone through the hell of the tech crash… but already there were new seeds being laid in the industry, and I was greatly frustrated because I thought people focusing on housing was dumb.

    What exactly are the productivity gains in building lots of new houses? And the kind of people who were flipping houses, the kind of folks who were suddenly “entrepreneurs,” it was just plain weird.

    And by 2004, tech was coming back strong, and has been keeping it together ever since.

    Krugman WANTED low rates, he pushed for them, right in there when he should have been checking into Enron.

    Its who he is, there’s no guiding theory there except bigger government and debased currency. He really thinks the penalty for having capitalism is that when things are tight we have to fire up the printing press and screw the guys with cash. It is just the opposite: in order to have truly free markets, you have to make a commitment that when things first get bad, you eat the sandwich IMMEDIATELY… you let the hard assets flow to the winners as fast as possible.

    And Mark, if you want a simple kind of proof about what matters most to him – any good economist WHO REALLY REALLY DESPERATELY wants more QE, stimulus, etc. he’d advocate for it – even if the new funds start off in the hands of his opponents.

    If he’s still worried about WHO gets largess – he obviously doesn’t care enough about the AD.

    Think of it like King Solomon, or in business you learn when you want a deal, pay exactly what your partner asks.

  15. Gravatar of scott sumner scott sumner
    5. September 2010 at 18:41

    Mark, Again, Baker deserves some credit–at least for the 2005 call. But I’m still curious about how he envisioned policymakers screwing things up. Was it monetary policy?

    Edwin, I should have explained that blogging is so time consuming that corners must be cut here and there. I do appreciate the info you’ve unearthed, but still think my analysis holds up.

    It is true that real prices of housing had risen, but that’s exactly my objection–one can’t assume a bubble just because real prices have gone up. The real value of Manhattan is much higher than when we bought (stole?) it from the indians, but it’s isn’t going back down to those levels. That’s an extreme example, but in general real prices can change on a semi-permanent basis, and for good reason. So even though real prices seemed high in 2002, they are just as high today, and may well be just as high 10 years from now, despite Morgan’s frantic attempt to talk them down.

    Regarding the Fed, they should not have tightened monetary policy in 2002 to stop the housing bubble, indeed even in 2005 (although for other reasons policy was a bit too easy in 2005.) Rather, they should have tried to tighten regulation, or convince Congress to tighten regulation, of banks and F&F.

    Morgan, You said;

    “Which points to the OBVIOUS LOGICAL ERROR on your part, he predicted it was a bubble, it was a bubble….”

    Actually, it wasn’t despite your attempt to talk housing prices down another 10%.

    Mark, Thanks for that info.

    Edwin, Thanks for finding that old post–I can’t even find my own posts, I don’t know how others do.

    John, Thanks for that great Kindleberger quotation. That raises my opinion of Kindleberger even higher. I have always been a big foe of F&F, and considered them a potential time bomb. On the other hand I missed the housing bubble, because I don’t believe in bubbles.

    Edwin: The second link is interesting, as he says we are still in a bubble, in the sense of being overvalued. That relates to the first link. Because real prices are at least as high as in 2002, in order to prove he was right in 2002, it is necessary that prices fall from current levels. If we are not in a bubble, then in 2002 we were not in a bubble. He needs Morgan to be right.

    Andy, Good point, and you might be right. But here’s what I’d say:

    1. Stocks hadn’t been all that volatile (as I recall)
    2. I am pretty sure Galbraith meant that he thought stocks were overvalued. Certainly others read it that way, which in a sense is all that matters–as I am interested in the perception people had that he was right about stocks being overvalued, when he pretty clearly was wrong.

    Morgan; You said;

    “Mark I have good reason to remember 2001-2003, I had just gone through the hell of the tech crash…”

    This shocks me. You say it’s obvious when markets are overvalued, and then tell me the tech crash was hell? It should have been heaven for you, shorting all those dot-coms (or at least NASDAQ) in 2000.

  16. Gravatar of Bonnie Bonnie
    5. September 2010 at 19:07

    I’m perplexed. I recall reading some posts here from earlier in the year about bubbles and predictions regarding them being a lucky guess at best. Imagine my surprise reading here about Krugman being given credit for predicting the “housing bubble” saying it didn’t support underlying economic fundamentals (just what fundamentals he was discussing is another matter).

    Honestly, when I look at the supplied graph with my hand over everything to the left of the 2005 mark, the rise in prices in the US look on par with the other countries listed.

    My first house was a little shoebox of a thing that was built in 1956. It had two bedrooms, a 16’x14′ living room, a kitchen that was about 10’x12′, and one bathroom that was about 5’x6′. I had a king-sized bed when I moved there and in what looked like the larger bedroom (although it was difficult to discern which bedroom was larger) I had nearly wall to wall bed, with just enough space at the foot of the bed to put a tall, shallow dresser and still have barely enough room to walk around to the other side of the bed. The big plus about it was that it was on a half acre lot. When I sold it in 1994, it went for $160k, mostly because it is in SoCal and having a place to put horses in the area I lived was a big selling point.

    In 2005, a house about the same size and age, only on a postage stamp lot in Orange County, CA, (the next county over to the northwest) went for $805k. Now it doesn’t take a rocket scientist to figure out that a house like that simply does not have 3/4 of a million dollars worth of value, unless of course it was plated in gold. But then again, property in Southern California has always been on expensive side because of high demand.

    What I’m pointing out is that much of the crazy market was in certain areas like Southern California, Nevada, Arizona, and Florida. It’s tough to just look at overall “economic fundamentals”, whatever that means, spot-check certain places and say “there’s a bubble”. Perhaps it is just real demand instead. Yes, it’s crazy to spend $805k on a shoebox posing as a house; whoever bought that house at that price was an idiot and deserves what they got, but that doesn’t mean that everywhere we look there’s a bubble or that there is one at all.

    I’m not so sure that there was a “housing bubble.” I believe that if there was a bubble anywhere it was in MBS’s because there is no way to justify lending anyone $805k for a dinky house that is kind of shabby with no land, with the exception of needing to sell more MBS product, which in my view was the coveted finished product. It was the fundamentals behind MBS’s and the mortgage process that threw the housing market out of equilibrium in certain areas where demand is already naturally high.

    You might think that I’m splitting hairs here, but the difference is the fact the losses in those areas were huge which caused the MBS market to take a nose dive and triggered the crash in the housing market when the loans started to dry up. If we were to assume that all the loans made were good and foreclosures did not rise, one could make a reasonable assumption that the housing market would have kept going with demand.

    Perhaps the other countries represented in the graph that have not had any real indication of a “housing bubble” but do show a rise in real estate prices similar to that of the US had a better handle on the home finance process/markets than we did here in the US, leaving them in much better shape when the woes started to spread.

    Of course I could be just full of garbage, in which case, the real estate bubbles in those other countries are about ready to burst.

  17. Gravatar of Bonnie Bonnie
    5. September 2010 at 19:09

    Sorry about the graph, I mean my other left — holding my hand over everything to the RIGHT of the 2005 mark.

  18. Gravatar of Morgan Warstler Morgan Warstler
    5. September 2010 at 19:59

    Scott if housing prices go down another 10%, before the market stabilizes, will you agree that that their price was headed to all along, or will you say guys like me talked prices down? Interested in your answer here.

    What bothers you about the idea that housing for the masses isn’t an investment, that it is a consumable that basically should grow with inflation, just like rents…

    When the average home is owned for 5-7 years depending on the state, and has a ton of upfront loan costs, why do you insist on acting like it is on par with stocks or gold?

    You said before we need more renters, what do you think happens to home prices as that shift occurs?

    Ya know Scott, yes I did know when markets were over-valued, in the tech boom it was when C++ computer programmers were demanding $200K a year, Cuban was shorting Yahoo, and tech conferences were no longer full of geeks. In the housing market it was when a guy sat down and told me he’d bought 3 houses in three months with no money down and had taken $50K out as closing on each one, and was starting to advertise on craigslist to find unemployed people with credit scores over 720… it wasn’t when Krugman wrote a column.

    I really do think you skip over the important part of Fisher – it’s really about keeping people from becoming heavily indebted in the first place… and if you aren’t doing that part – the second part (reflation) isn’t worth much.

  19. Gravatar of Edwin A Edwin A
    6. September 2010 at 00:03

    “It is true that real prices of housing had risen, but that’s exactly my objection-one can’t assume a bubble just because real prices have gone up. ”

    This is why I wanted to make sure you read the 2002 paper. At the very least the executive summary of the paper. Seeing how you’re arguing it’s impossible to see a bubble in 2002, I would think it’s only fair to give his paper a better read. The real prices was only part of his argument. He went through several possible reasons why the high housing prices could be permanent and justifiable, but none of them survived close scrutiny. (Demographics, growing income, interest rates, population growth, consumer preference) All signs pointed to bubble even in 2002. The same arguments he used in that 2005 paper still apply to home prices before 2002. For over a hundred years housing prices moved more or less with inflation, but in 1996 that stopped being true. There was no sound fundamental reasons why housing pricing would just suddenly jump like that other than a bubble.

    You said:
    “Regarding the Fed, they should not have tightened monetary policy in 2002 to stop the housing bubble, indeed even in 2005 (although for other reasons policy was a bit too easy in 2005.) Rather, they should have tried to tighten regulation, or convince Congress to tighten regulation, of banks and F&F.”

    This is what Dean Baker said what the fed should have done to pop the bubble:

    “I argued that the weak economy caused by the crash of the stock bubble demanded stimulatory policy. Low interest rates were the right policy — we needed them to recover from the stock bubble.

    Let’s see, my policy prescription was to have every last staffer at the Fed devoting all of his/her time to documenting the evidence for the bubble and the dangers it would cause to the economy. I would have had Alan Greenspan use his congressional testimonies and other public speaking engagements to warn of the risks of the bubble. This doesn’t mean mumbling “irrational exuberance,” it means carefully showing with charts and graphs how house prices have followed an unprecedented and unsustainable path. He also should have warned explicitly what would have happened to the banks that had made big bets on the bubble when it burst.

    In addition, they should have made full use of their regulatory power (including working with other regulators) to crack down on the issuance and securitization of junk mortgages. The “who could have known?” line is crap. These loans were being issued by the million, there is no way Greenspan could not have known about them.

    Would this have worked? Brad for some reason is very confident it would not have. It certainly would have been nice if the Fed had tried (what was more important?), then we would both know for sure.

    As a last resort I would have raised interest rates. I hate to throw people out of work (except Wall Street bankers and economists), but it would have been better to preemptively burst the bubble rather than let it run its course and be where we are today.”

    His main beef with the fed is that they failed at their regulatory job, not monetary policy. I’m not sure how much I agree with raising the interests even as a last resort, but it would have never gotten to the point if the fed had tried option A. (talk) and B. (regulate) first like he suggested. The number one thing the fed could have done is simply acknowledge the existence of the bubble instead of dismissing it.

    You said:

    “Because real prices are at least as high as in 2002, in order to prove he was right in 2002, it is necessary that prices fall from current levels. If we are not in a bubble, then in 2002 we were not in a bubble. He needs Morgan to be right.”

    Morgan is probably right in that house prices will continue to fall. Baker argues the bubble hasn’t fully deflated yet because of the home buyer tax credit.
    http://www.cepr.net/index.php/data-bytes/housing-market-monitor/hmm-2010-08

  20. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    6. September 2010 at 00:48

    Scott, you said,
    “I can’t understand your comment at all. Suppose in 2006 I had said there was no housing bubble. By your criterion I might still be right. There was that 30% shock I didn’t expect, but in 15 years things will bounce back. Who’s to say I’m wrong? I’ll tell you who, Baker and Krugman would say I’m wrong. So I don’t think even Baker himself would accept your reasoning as justifying his prediction.”

    A big part of this 30% shock should have been anticipated ex-ante and is a sign of market inefficiency. The remaining part is just a bad luck and could have been avoided (for example if Greenspan was still the chairman). Your recent post about Australian housing prices is relevant for determining the relative contributions of bad luck vs market inefficiency.

    You said:
    “What did Baker say that policymakers would get wrong?”

    Baker said:
    “In the late eighties Japan experienced a simultaneous bubble in its stock market and its real estate market. The collapse of these bubbles has derailed its economy for more than a decade. A similar collapse in the United States, coupled with a poor policy response, could have similar consequences here.”

    Mark,
    Thanks :)

  21. Gravatar of Morgan Warstler Morgan Warstler
    6. September 2010 at 06:32

    Scott, seriously if prices fall another 10% before we see the bottom of the curve…. will you:

    1. say prices are correct – who are you to argue with the market?
    2. say guys like morgan talked the value of homes down?

  22. Gravatar of scott sumner scott sumner
    6. September 2010 at 07:33

    Bonnie, I agree things looked a bit crazy in 2005. I gave Krugman credit for an accurate prediction, but then later claimed it was luck.

    Morgan, You asked:

    “Scott if housing prices go down another 10%, before the market stabilizes, will you agree that that their price was headed to all along, or will you say guys like me talked prices down?”

    Neither, I’ll say it was a lucky guess on your part. Just as if you win a bet on the Super Bowl, I’ll say that was a lucky guess too.

    You said;

    “What bothers you about the idea that housing for the masses isn’t an investment, that it is a consumable that basically should grow with inflation, just like rents…
    When the average home is owned for 5-7 years depending on the state, and has a ton of upfront loan costs, why do you insist on acting like it is on par with stocks or gold?”

    Just the opposite, the average house lasts for 100s of years, which is much longer than the average company. Of course owners will change occasionally, just as with stocks. But new homes are much more an investment than new factories, as they are much more durable.

    I’m one of the most pro-saving economists out there, so you don’t have to convince me about that.

    Edwin, You said;

    “This is why I wanted to make sure you read the 2002 paper. At the very least the executive summary of the paper. Seeing how you’re arguing it’s impossible to see a bubble in 2002, I would think it’s only fair to give his paper a better read. The real prices was only part of his argument. He went through several possible reasons why the high housing prices could be permanent and justifiable, but none of them survived close scrutiny. (Demographics, growing income, interest rates, population growth, consumer preference) All signs pointed to bubble even in 2002.”

    I assumed he had lots of reasons, that’s not the issue. The point is that he was wrong. Telling me all the reasons he believed something that was wrong doesn’t change my views on iota.

    You said (my comment and your response):

    [Me]
    “Regarding the Fed, they should not have tightened monetary policy in 2002 to stop the housing bubble, indeed even in 2005 (although for other reasons policy was a bit too easy in 2005.) Rather, they should have tried to tighten regulation, or convince Congress to tighten regulation, of banks and F&F.”

    [You] This is what Dean Baker said what the fed should have done to pop the bubble:”

    Fine, but I never accused Baker of opposing tighter regulation—so how does that relate to my comment? I was responding to something you said.

    Basically, all your quotations show that I was 100% fair in how I characterized Baker’s view, and did not even slightly misrepresent anything he said in the 22 page paper.

    I believe there are home price futures markets, what do they say about a 10% price drop?

    123, You said;

    “A big part of this 30% shock should have been anticipated ex-ante and is a sign of market inefficiency.”

    I don’t know what this means. I doubt whether in all of world history a 30% fall in asset prices has been anticipated ex ante. Indeed the term “shock” implies it is unanticipated. If price changes are anticipated (as under high trend inflation), they are not shocks.

    Your last comment makes sense–Baker anticipated that policymakers would fail to keep AD growing, just as they failed in Japan.

  23. Gravatar of Morgan Warstler Morgan Warstler
    6. September 2010 at 11:36

    “Neither, I’ll say it was a lucky guess on your part. Just as if you win a bet on the Super Bowl, I’ll say that was a lucky guess too.”

    Of course, one just has to look at housing prices and trend based on inflation since 2000 to see where they are likely to pause and turn northward.

    Scott, you are aware that only a certain kind of guys set the lines in Vegas, and they are not eggheads, they are not economists, they are “boots on the ground” types.

    Thats the thing, when I read the boots on the ground guys (Denninger, Mish, etc.) they are so much closer to the line than you are. And the fact that you don’t read them is what makes me nervous.

    If you actually ran your stuff day-to-day up against the guys calling your ideas idiotic, instead of playing in the shallow end with DeKrugman – it’d be far more compelling.

    To me it looks like you are hiding. I shouldn’t be having to bring this stuff here, to get you to throw down the gauntlet. If you really trust your stuff, then call out the serious deleveraging austerity guys and look for a fight.

  24. Gravatar of scott sumner scott sumner
    7. September 2010 at 06:18

    Morgan, It’s impossible to argue with some people, as their worldview is too different to even engage in a debate.

  25. Gravatar of Morgan Warstler Morgan Warstler
    7. September 2010 at 09:45

    Ok, Scott – try this one:

    http://www.acting-man.com/?p=4741#more-4741

  26. Gravatar of scott sumner scott sumner
    7. September 2010 at 18:05

    Morgan, He said:

    “Consider for instance the fact that a large percentage of today’s preeminent economists failed to predict an economic crisis that anyone with a smattering of common sense could detect well in advance.”

    Actually, the EMH says crashes are unforecastable. If people knew it was going to happen, it wouldn’t happen.

  27. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    8. September 2010 at 04:56

    Scott, you said:
    “By your criterion I might still be right. There was that 30% shock I didn’t expect, but in 15 years things will bounce back. Who’s to say I’m wrong?”
    There are two causes of 30% crash in housing prices:
    1. Market inefficiency – housing markets did not reflect all available information and houses were too expensive before crash.
    2. Unforecastable variation of fundamentals.
    My guess is that market inefficiency is responsible for 20 percentage points and unforecastable variation of fundamentals is responsible for 10 percentage points.

  28. Gravatar of ssumner ssumner
    9. September 2010 at 06:58

    123, I keep going back to my argument that the anti-EMH view has no practical implications. There is no outside observer to profit from market inefficiency (or at least very few of them.)

  29. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    10. September 2010 at 02:47

    Scott, for me a combination of pro-EMH and anti-EMH views had very positive practical impact. I have saved a lot of money by renting as I was afraid of the bubble (anti-EMH), yet I was calm that I am not making any big ex-ante mistake, as according to EMH, expected risk-adjusted return on housing investment should be equal to other assets.

  30. Gravatar of TheMoneyIllusion » Who are the famous bubble deniers? TheMoneyIllusion » Who are the famous bubble deniers?
    8. December 2010 at 05:49

    […] saying stocks were a bubble in January 1987.  Rober Shiller saying stocks were a bubble in 1996.  Dean Baker saying US housing was a bubble in 2002.  The Economist magazine touting its successful housing […]

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