Krugman’s lucky to be an American

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?

China, conservatism, econome-tricks, and land bubbles.

1.  China’s trade deficit.

Lots of people have linked to the most recent trade data from China, which show a deficit in March.  One month may not be that important, as China is expected to swing back into surplus.  But buried in the report is this almost mind-boggling statistic:

China’s exports totaled $112.11 billion in March, up 24.3 percent from a year earlier. Imports reached $119.35 billion, up 66 percent compared to the same period last year, the Customs Administration said in data posted on its Web site.
Den ganzen Beitrag lesen…

Poetic License

I know that I promised to stop blogging again.  But when Krugman says something like this:

One of the curious things about economic debate in the later Bush years was the conviction among many on the right that there wasn’t a bubble in housing, but that there was one in oil.

We now know the truth about housing. But what about oil?

Oil prices did spike to triple-digit levels in early 2008, then drop sharply. But think about the fact that right now, with the world economy still seriously depressed, oil is at $80 a barrel. This suggests to me that high oil prices are largely caused by fundamentals.

How can I resist?  So what’s wrong with Krugman’s assertion?  Nothing at all.  You would expect the price of highly cyclical assets like oil or commercial real estate to fall by 40% to 50% in the deepest recession since the Great Depression.  Indeed I made an almost identical argument about both assets in several posts, noting that their prices did not start falling in mid-2006 when housing began decline, but rather in the second half of 2008, when NGDP started falling.

But there’s just one problem; I have a long memory and I seem to recall Krugman making exactly the opposite argument 6 weeks ago in this post on commercial real estate.  Actually, the US recession is worse than the world downturn, so ceteris paribus CRE prices should have fallen further.  On the other hand oil prices are somewhat more volatile in response to demand shifts.  So they fell by roughly equal amounts, as you might have expected.

Why the post title?  Just yesterday Krugman called himself a poet.  In fairness, he was half-joking, and he actually is brilliant at using metaphors to get to the intuition behind economic arguments.  As far as spotting bubbles, however, he’s not so brilliant.  Like most people he calls price patterns bubbles when he can’t explain them in terms of fundamentals.  BTW, what would Hayek think if he came back today and found so many people who confidently knew when markets were overpriced?  Why do we even need markets?  If it so obvious what the correct price is, let’s bring back Soviet-style central planning.  (On the other hand, even the Soviets couldn’t have done much worse than some of our bankers.)

OK, back to my book.

Is China a bubble?

No, at least according to The Economist:

By most measures average prices have fallen relative to incomes in the past decade (see chart 1).

The most cited evidence of a bubble””and hence of impending collapse””is the ratio of average home prices to average annual household incomes. This is almost ten in China; in most developed economies it is only four or five. However, Tao Wang, an economist at UBS, argues that this rich-world yardstick is misleading. Chinese homebuyers do not have average incomes but come largely from the richest 20-30% of the urban population. Using this group’s average income, the ratio falls to rich-world levels. In Japan the price-income ratio hit 18 in 1990, obliging some buyers to take out 100-year mortgages.

Furthermore, Chinese homes carry much less debt than Japanese properties did 20 years ago. One-quarter of Chinese buyers pay cash. The average mortgage covers only about half of a property’s value. Owner-occupiers must make a minimum deposit of 20%, investors one of 40%. Chinese households’ total debt stands at only 35% of their disposable income, compared with 130% in Japan in 1990.

China’s property boom is being financed mainly by saving, not bank lending. According to Yan Wang, an economist at BCA Research, a Canadian firm, only about one-fifth of the cost of new construction (commercial and residential) is financed by bank lending. Loans to homebuyers and property developers account for only 17% of Chinese banks’ total, against 56% for American banks. A bubble pumped up by saving is much less dangerous than one fuelled by credit.

OK, but what about investment, isn’t that a bubble?

China’s second apparent point of similarity to Japan is overinvestment. Total fixed investment jumped to an estimated 47% of GDP last year””ten points more than in Japan at its peak. Chinese investment is certainly high: in most developed countries it accounts for around 20% of GDP. But you cannot infer waste from a high investment ratio alone. It is hard to argue that China has added too much to its capital stock when, per person, it has only about 5% of what America or Japan has. China does have excess capacity in some industries, such as steel and cement. But across the economy as a whole, concerns about overinvestment tend to be exaggerated.

.   .   .

Even in industries which clearly do have excess capacity, China’s critics overstate their case. A recent report by the European Union Chamber of Commerce in China estimates that in early 2009 the steel industry was operating at only 72% of capacity. That was at the depth of the global downturn. Demand has picked up strongly since then. The report claims that the industry’s overcapacity is illustrated by “a startling figure”: in 2008, China’s output of steel per person was higher than America’s. So what? At China’s stage of industrialisation it should use a lot of steel. A more relevant yardstick is the America of the early 20th century. According to Ms Wang of UBS, China’s steel capacity of almost 0.5 tonnes per person is slightly lower than America’s output in 1920 (0.6 tonnes) and far below Japan’s peak of 1.1 tonnes in 1973.

.   .   .

Given the scale of the spending, some money is sure to have been wasted, but by and large, investment in roads, railways and the electricity grid will help China sustain its growth in the years ahead. Some analysts disagree. Pivot, for instance, argues that China’s infrastructure has already reached an advanced level. It has six of the world’s ten longest bridges and it boasts the world’s fastest train; there is little room for further productive investment. That is nonsense. A country in which two-fifths of villages lack a paved road to the nearest market town still has plenty of scope for building roads. The same goes for railways. Again, a comparison of China today with the America of a century ago is pertinent. China has roughly the same land area as America, but 13 times more people than the United States did then. Yet on current plans it will have only 110,000km of railway by 2012, compared with more than 400,000km in America in 1916. Unlike Japan, which built “bridges to nowhere” to prop up its economy, China needs better infrastructure.

OK, but aren’t the banks in trouble?

The biggest cause for worry about China is the third point of similarity to Japan: the recent tidal wave of bank lending. Total credit jumped by more than 30% last year.

.   .   .

However, too many commentators talk as if Chinese banks have been on a lending binge for years. Instead, the spurt in 2009, which was engineered by the government to revive the economy, followed several years in which credit grew more slowly than GDP (see chart 3). Michael Buchanan, of Goldman Sachs, estimates that since 2004 China’s excess credit (the gap between the growth rates of credit and nominal GDP) has risen by less than in most developed economies.

Even so, recent lending has been excessive; combined with overcapacity in some industries, it is likely to cause an increase in banks’ non-performing loans. Ms Wang calculates that if 20% of all new lending last year and another 10% of this year’s lending turned bad, this would create new bad loans equivalent to 5.5% of GDP by 2012, on top of 2% now. That is far from trivial, but well below the 40% of GDP that bad loans amounted to in the late 1990s.

But what about the Chinese stock market bubble?

Japan’s stockmarket and land-price bubbles in the early 1960s offer a better (and more cheerful) analogy to China than the 1980s bubble era does. Japan’s economy was poorer then, although relative to America its GDP per person was more than double China’s today, and its trend rate of growth was around 9%. According to HSBC, after the bubble burst in 1962-65, Japan’s annual growth rate dipped to just under 6%, but then quickly rebounded to 10% for much of the next decade.

South Korea and Taiwan, which experienced big stockmarket bubbles in the 1980s, are also worth examining. In the five years to 1990, Taipei’s stockmarket surged by 1,600% (in dollar terms) and Seoul’s by 700%, easily beating Tokyo’s 450% gain in the same period. After share prices slumped, annual growth in both South Korea and Taiwan slowed to around 6%, but soon regained its previous pace of 7-8%.

The higher a country’s potential growth rate, the easier it is for the economy to recover after a bubble bursts, so long as its fiscal and external finances are in reasonable shape. Rapid growth in nominal GDP means that asset prices do not need to fall so far to regain fair value, bad loans are easier to work off and excess capacity can be more quickly absorbed by rising demand.  (Italics added.)

Imagine that, rapid NGDP growth makes it easier to work off credit excesses.  I wonder what happens if NGDP falls during a credit crisis.  (You knew I wasn’t going to write an entire post without mentioning NGDP. )

China has lots of problems: poverty, pollution, inefficient SOEs, lack of rural property rights, political repression, and  worst of all (in my view) a dangerously unbalanced male/female gender ratio.  Bubbles are the least of their problems (although asset prices in China will continue to be highly volatile, and at times this will make it seem as if the bubble worriers were correct.)

BTW, Nick Rowe has another excellent post on bubbles.  He draws a useful distinction between the perspectives of social scientists and market participants.  I entirely agree with his post, which meshes with my earlier argument that anti-EMH theories are useless.  Anti-EMH theories are generally created by social scientists, who are wasting their time if they think they can outsmart the market.  If someone like George Soros develops a useful anti-EMH theory, I assume he would be smart enough to keep it to himself.  Once the theory is in the public domain its market value falls to zero.

What goes up . . . usually stays up

Back in May 2003 The Economist said that many countries were in the midst of a housing bubble:

A SURVEY in The Economist in May predicted that house prices would fall by 10% in America over the next four years, and by 20-30% in Australia, Britain, Ireland, the Netherlands and Spain. Prices have since continued to rise, so have we changed our mind?…

I’ve already discussed the US; in this post I’d like to examine some foreign markets.  Nick Rowe has an excellent post on bubbles, and he argues that Canada did not experience a housing bubble.  Before considering Nick’s assertion, take a look at this graph of average Canadian housing prices (you must click on the graph link on the right.)

Nick argued that if there had been a bubble then you’d expect that once prices stopped rising and began falling, then people would worry that the bubble had burst and prices would fall sharply.  Prices did fall a bit when the worldwide recession hit Canada in late 2008, but then began recovering in the second half of 2009.  So he concluded there was no bubble.  My hunch is that he is right, although as they like to say on Wall Street “past performance is no guarantee of future success.”

[Note; while working on the post I noticed that Nick’s co-blogger Stephen Gordon has a very informative post on the Canadian housing market.]

My theory all along has been that the US housing bubble was widely misunderstood, and that if NGDP had kept growing at a 5% rate after mid-2008 then the US housing bust would have been far milder.  More specifically, in heartland markets like Texas there would have been no housing bust at all.  Most of the damage would have occurred in 4 key sub-prime states, and even in those states the price declines would have been far smaller.

One implication of my hypothesis is that in most other countries the housing crash should have occurred later than in the US, and should have been far milder.  The Economist, which ironically is the publication that I most strongly disagree with on this issue, has published a graph that strongly supports my hypothesis.  If you click on the link you will see an interactive graph that shows global housing trends since 1990.  I found it easier to read by moving the starting point to 2000:1, and go up to 2009:3, the last observation.  And I used real housing prices, which should make it easier to spot bubbles in countries that have inflation.

Many countries experienced no unusual increases (Germany, Switzerland, Japan, Hong Kong, China, Netherlands, etc.)  Other countries like France experienced a sharp increase, but only a very small decline.  Australia and (to a lesser extent) Canada also fit this pattern.  Furthermore the timing of the decline is clearly associated with the 2008-09 recession, which reduced NGDP in the US, Europe and Japan.  Also note that where housing downturns eventually did occur, they were generally more severe in countries that had severe recessions (UK and Ireland) and relatively mild in countries where the recession was much milder (Australia and Canada.)  So it looks like we can say there was (at best) a housing bubble in the US, and to a lesser extent a few other countries like Spain and Ireland.  But no global housing bubble.

I believe that portions of the US market, and perhaps to a lesser extent the Irish and Spanish market, became overvalued in early 2006.  The other English-speaking countries also saw large increases in real housing prices, just as in the US.  But because they experienced much milder declines, and because those declines were closely associated with the severe global recession, I don’t see how you can call them bubbles.  A severe recession is a fundamental factor that would be expected to reduce housing prices even if the EMH explained 100% of house price changes.

While my falling NGDP story explains most foreign downturns, The Economist’s bubble story seems inconsistent with these inconvenient facts:

1.  Prices in most other “bubble” markets did not decline when the US market turned down in 2006.

2.  The declines in other markets were generally much milder, even when the preceding price increases had been just as rapid as in the US.

3.  Housing prices turned up recently in places like Australia and Canada, despite their being “overvalued” according to The Economist.

So you shouldn’t believe people who tell you that we are in a bubble, and who defend that hypothesis by merely pointing to fast rising prices.  Ex post, people like Krugman and Shiller were right, but only about the US.  In many other countries large price increases did not lead to a major collapse, and prices are still quite high in early 2010.

Of course if you wait long enough prices will eventually fall in any country, that’s how markets work.  But it turns out that it is much harder than most people imagine to predict which prices are “obviously overvalued,” and hence bound to fall sharply.  We all know about confirmation bias.  Because most elite economists live in the US, and pay little attention to countries like Australia, they tend to assume that recent events have provided decisive support to their bubble hypotheses.  Yet from a global perspective bubble theories haven’t done well at all.  Indeed they performed quite poorly over the past 10 years.  Outside of the US and Ireland, you would have been better off if you had ignored The Economist’s bubble warning of 2003, and instead had gone out and bought a house.  But what about those who base their forecasts on fundamentals, and not merely the rate of price appreciation?

If you look at the specific countries cited in The Economist’s famous prediction, the results are far worse than even for the US.  Recall that in May 2003 The Economist predicted 20% to 30% prices declines in 5 foreign countries.  If you set the starting point at 2003:2 and use nominal prices, then you will see that prices rose by more than 10% in the Netherlands, and by anywhere from 30% to 55% in other 4 countries.  Not exactly the 20% to 30% price drops they expected.  Some of my commenters claimed that The Economist was right in the long run, because prices did eventually fall.  I don’t think that argument is right—surely you must be held to the terms of your prediction, otherwise there is no way to ascertain how good you are at forecasting.  But even with those very generous assumptions, they were still far off base.  Even today the Netherlands continues to show a greater than 10% gain.  Spanish, British and Australian housing prices are still up by 30% to 50% over 2003 levels.  Only Ireland is even remotely close, with its price appreciation having fallen to about 10%.  But even that prediction is far from the 20% to 30% price drop forecast by The Economist.  The most generous assumption of all would be to use real housing prices.  But even in that case none of the 5 showed price declines over the following 4 years, and only Ireland experienced a tiny decline between 2003 and late 2009.

So The Economist’s predictions of 10% to 30% price declines over 4 years were spectacularly off base.  Even over a 6 1/2 year time frame, only the US (the country they thought was the least overvalued) experienced a significant decline in house prices.  And then only in real terms.  So in all 6 countries their predictions were wildly inaccurate for the 4 year time window they specified.  And even under the most generous assumptions, using real housing prices and a 6 1/2 year time frame, The Economist’s predictions were still highly inaccurate in 5 of 6 countries.  What an awful record of forecasting housing prices through the use of “fundamentals.”  This shows just how difficult it is to identify bubbles in real time.