Free Exchange, Round two

It’s always an honor to be noticed by The Economist.  Unlike Eugene Fama, I don’t plan to cancel my subscription to the best magazine in the world, even if they say this about me:

Mr Sumner disagrees. He seems to think it’s funny that The Economists pent much of the last decade warning that, globally, home prices were rising in a troubling manner. Contrarianism is fun and all, but this strikes me as an odd way to process the experiences that led us to this point.

A few comments:

1.  I would note that Free Exchange seemed to enjoy making fun of Fama’s views.

2.  I do think it funny that Free Exchange would claim that The Economist was exactly right in its housing bubble predictions.  Then demonstrate this by linking to an excerpt from The Economist that was 180 degrees off.  That predicted American housing prices would fall 10% over the 4 year period after May 2003, when they actually rose about 30%.

3.  I do admit to forgetting that The Economist is real people, as they don’t tend to list names of reporters.  So perhaps that made me more sarcastic than I should be.

4.  I use humor to wake people up, to try to make points more accessible.

5.  The crisis of the past year has consumed all my time.  I’d much rather be reading books or seeing movies, and my school doesn’t compensate me for this.  I am deadly serious about trying to wake people up to the incredible harm done by tight money in 2008.  Unfortunately I seem to recall The Economist advocating tighter money, on the grounds it was needed to squeeze the excesses out of the US economy.  It looks like they got their way, and it looks like that monetary policy made the housing crash prediction look even more impressive than otherwise.

I don’t want to be dogmatic about this.  I’ve never denied that the EMH is merely an approximation of reality.  Or that astute observers do sometimes have insights that the markets miss.  But that doesn’t make Fama wrong.  Social science is not about the exceptions, it is about broad principles.  I presume that “the market” does gain some value from the information in The Economist.  But here is the problem; that fact doesn’t really give the anti-EMH position any real traction.  Useful insights in The Economist are just as available to “the market” as they are to “the regulators” or to me.  If I invest based on advice from The Economist, I won’t consistently beat index funds.  And if regulators try to predict bubbles based on predictions from The Economist, they’ll do no better than they would by throwing darts at a stock page.

Here is one accurate prediction I did make.  In my previous post I showed that the 2003 Economist prediction that everyone seems to think was amazingly accurate was actually almost completely wrong.  I said I expected comments that somehow it was actually correct.  They are already coming in.  People are saying something like “yes, they explicitly predicted a 10% fall over 4 years.  And yes, prices actually rose 30%, but they rose 35% in three years and then fell 5% in the 4th. So they were right.”  Well not in those exact words, but that seems to be the general view out there.  Another argument is that they were wrong in the 4 year window, but then spectacularly right in the 5th.

Yes, but if we don’t have standards, if we aren’t going to hold people to their words, then what do we really have?  Suppose I said; “I predict a major 20% to 30% drop in the S&P500 within the next 4 years.  And if it doesn’t happen, but happens sometime later, I should still get credit.” Would you take me seriously?  People don’t seem to understand that unless a prediction is both accurate and timely, it really isn’t of much value.

The Economist seems to have wanted the Fed to do something in 2003.  But what if the Fed had tightened, perhaps we would have gone into a Japanese style deflation/zero rate trap.  Then what?  I will concede that The Economist was probably right about monetary policy in 2004 and 2005, in retrospect a bit more restraint would have helped.  But May 2003?  That is still very much an open question.

We all interact with our fellow humans.  I am sure that you observe the same things I do, our acquaintances are absurdly overconfident in their predictions in sports, politics, economics, everything.  It’s human nature.  But we all go along to be polite.  I am the same.  Obviously it’s a bit absurd for me to think that a professor at Bentley has the answer to the world’s financial crisis.  But I think I do.  I act as if I do.  I am as arrogant as you expect such a person to be.

You might ask why then do I want the Fed to adopt my policies?  The answer is that I don’t expect them to do so merely on my say so.  I think Bernanke would be foolish to adopt my ideas unless other more distinguished economists have also come on board.  The goal of my blog is to start a conversation among economists about the possibilities for unconventional monetary stimulus.  Being a libertarian with slight monetarist tendencies, I have been surprised that in recent months the conversation in this direction has been more noticeable in liberal/Keynesian blogs such as Krugman/DeLong/Yglesias.  But any news is good news.

Free Exchange says we can have confidence that The Economist’s prediction was not luck, because they gave lots of good reasons for that belief.  I agree that helps.  But consider this analogy.  Suppose you have a friend who predicts his football team will lose in the first round of the playoffs.  He cites two reasons, the quarterback is inexperienced in big pressure games, and the star running back is injured.  Now suppose they win all their playoff games and go to the Super Bowl.  The prediction was wrong.  But suppose they lose in the Super Bowl because they have no running game and their quarterback looks very shaky under pressure.  I’ll bet the average fan would say “Aha!  I knew that was going to happen.”  We remember our successes and forget our failures.  Even worse, we shape the game’s narrative to fit our predictions.  The Economist could have written articles saying:

1.  A 2007 crackdown on immigration sharply slows US population growth in the Southwest.  Housing starts to slump.  High energy prices hurt commuters with long commutes.  Home prices slump in the exurbs.

2.  Tight money by the Fed in 2008 causes NGDP growth to slump 8% below trend.  Unemployment soars.  Nominal incomes fall at the fastest rate since 1938.  This further weakens an already shaky housing market.

But that’s not what most journalists wrote.  They wrote a narrative that fit their preconceived ideas about what happened.  Am I claiming that those other factors didn’t play a role?  Of course not.  But wouldn’t it be equally absurd to write a narrative that didn’t give prominent mention to the factors I just cited?  Especially since the fall in NGDP closely correlates to the housing crash spreading nationwide?  I think you’ll agree that it would be negligent.  But that doesn’t stop most financial reporters from ignoring those other factors.

[BTW, before you say “immigration doesn’t explain the other countries” consider that those crashes tended to occur later than the US.  And were correlated with falls in NGDP.  And the one country where NGDP didn’t fall?  Oh that’s Australia, the one country where The Economist’s prediction wasn’t even right in the long run.  They had no housing crash at all according to my commenter from down under.  I wonder how The Economist would explain that.]

One final comment.  When I ask people why a mutual fund run on their insights about fundamentals would not beat an index fund, they often dodge the question by talking about the difficulty of selling stocks short.  But again, if you really can know the fundamentals, there are plenty of profitable long positions in various markets around the world, and in the brief period when there might not be, just park the money in index funds.  I still say that type of mutual fund wouldn’t reliably beat an index fund.  And I still say the implication of the bubble theorists is that it would.  I can’t quite tell what the view is at Free Exchange:

I feel like this is the sort of critique that sounds lovely so long as one remains comfortably in the realm of abstract intellectualism. The price-to-income ratio has risen above its long-term trend, but how can we know that it’s a bubble? Fundamentals? Well, perhaps they’ve shifted. And if you’re so confident, why aren’t you ringing up your trader and telling him to short housing?

Yes, that is my question.  And the answer is that if you had shorted housing builders in May 2003 you would have gone bankrupt.  But then he seems to want to have it both ways:

Some people managed to make money off their models of the bubble despite the significant logistical difficulty in betting against housing markets.

Those would be people who ignored The Economist in 2003 and went short in 2007.  I do accept one part of this argument.  Housing is harder to short than stocks, bonds, commodities and currencies.  But that really doesn’t help Free Exchange’s argument.  You see The Economist is equally opinionated about these other assets.  Which does imply that an “Economist mutual fund” should reliably outperform index funds.  I say it wouldn’t.  Robin Hanson suggests we need to test this.  I don’t think so.  It’s like astrology.  As soon as you start suggesting to an astrologer that we do tests of whether personality types correlate with birth month, their whole attitude changes.  “It’s more complicated than that.”  There will never be the sort of test Hanson wants because no one has enough confidence in the musing of The Economist on fundamental values of stocks, bond, commodities and currencies to even lift a finger setting up such a mutual fund.

If this has been too negative, how about ending on this note.  What would make the world a better place is not people investing or regulating on the basis of The Economist’s asset price predictions, but rather governments around the world switching to the sort of high saving neoliberal economic model that The Economist advocates.  That’s what makes them the best and most valuable magazine in the world—their influence on policymakers.

I told you so! . . . Um, no you didn’t.

Talk about burying the lede!  Last night I did a post discussing how the people who say “I told you so” after bubbles are often suffering from cognitive illusion.  Only right before bed did I realize that a link in a quotation provided a perfect illustration of the phenomenon.

One of the most famous pro-bubble publications is The Economist, which likes to brag about how they predicted the housing bubble.  Here is Free Exchange:

This is truly remarkable. A bubble is an unsustainable increase in prices relative to underlying fundamentals. These fundamentals are more or less observable; those who called the housing bubble did so based on historically anomalous increases in the ratio of home prices to rents and incomes. And many people did correctly identify the bubble years before it imploded, including writers at The Economist who were worrying about rapid home price increases while the American economy was still limping out of the 2001 recession. This is the reality that Mr Fama seems unwilling to confront. How unwilling?

Only when I had finished the post did I realize it provided a link to an ad for subscriptions to The EconomistFree Exchange must have thought that was a big joke, as they had just quoted Fama as follows:

I never said that. I want people to use the term in a consistent way. For example, I didn’t renew my subscription to The Economist because they use the world bubble three times on every page. Any time prices went up and down””I guess that is what they call a bubble.

Then Free Exchange made this snarky joke (something I never do):

Obviously, we are disappointed to have lost Mr Fama’s business. But I can’t say we regret the cause.

UPDATE: An Economist correspondent notes that as a die-hard believer in the Efficient Markets Hypothesis, Mr Fama is actually being quite rational in cancelling his subscription. As all publicly available information is already reflected in market prices, there’s not much point in trying to learn anything from our paper.

But the joke is on Free Exchange.  The magazine ad he linked to says this:

Sep 11th 2003
From The Economist print edition

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? . . .

Register now and receive a 14-day premium pass.

The irony here (and ironies just don’t get any richer) is that this prediction was wrong.  And not just slightly off, but  monumentally wrong.  Biblically wrong.  Or perhaps I should say Malthusianly wrong.  Recall that Thomas Malthus and Paul Ehrlich are often (falsely) credited as predicting a “population bomb.”  Actually they (wrongly) predicted the opposite, that the “limits of growth” would prevent Earth’s population from rising to 6 .8 billion.  The Economist was not predicting that a housing bubble would occur between 2003-07, they were predicting that a housing bubble would not occur.

Think about it.  In May 2003 The Economist told us that house prices were going to fall 10% over the next four years.  Time to short Toll Brothers!  Predictions just don’t get much more specific than that.  And yet housing prices actually rose nearly 30%.  How much wronger could they have been?  And for this we are supposed to believe in bubbles?  The housing bubble was “obvious” because The Economist predicted it?

From past experience with commenters who have a near religious faith in bubbles, I am expecting letters like the following:

“But, it’s like when Bush said ‘mission accomplished’ [another great May 2003 prediction.]  He was right in the long run.  Once Petraeus got the surge going in 2008 we achieved a pro-American democratic Iraq.  So he was right!”

Please read my previous post before making this sort of absurd argument.  Predicting prices will eventually fall is equivalent to making no prediction at all.

BTW, I notice one commenter dismissed my Economist mutual fund idea by pointing out that it is hard to short certain stocks.  Actually, there are plenty that can be shorted.  But even if he was right, it wouldn’t matter.  If you really know the fundamentals, then there is always some stock, bond, commodity, or currency in some part of the world that is undervalued.  So they could just invest in those “negative bubbles,” those areas of “irrational pessimism.”  Unless you seriously think an Economist mutual fund would reliably outperform an index fund (which I think is absurd) then you don’t have a leg to stand on.

Life is good.

Update:  It gets even worse.  A commenter named Michael from downunder just gave me this:

The Economist definitely seems to have gotten it badly wrong for Australia, as far as I can tell. Just had a quick look at the Australian Bureau of Statistics’ housing price stats for capital cities (couldn’t find more general prices in the minute or so I spent looking).

Within the period that The Economist forecast prices would fall 20-30%, there is a single year where prices fell…and they fell 0.1%.

The largest decrease in any year from June 2003 to the present was -1.4% from June 08 to June 09, which is outside the period The Economist forecast. And prices increased 4.2% from June 09 to Sept 09…

So prices since June 2003 are currently roughly 30-40% higher here.

Wow, The Economist track record is beginning to resemble Sports Illustrated cover stories.  When they say “bubble,” you should get leveraged and buy.

Update#2:  I just noticed that Robin Hanson already discussed many of the points that I made in my previous post.

Defending the indefensible

I love to take a contrarian position.  The more contrarian the better.  But only if I truly think I am right.  This post will be a lot of fun because these days you can’t get much more contrarian than defending Eugene Fama on the EMH.  But I also happen to think Fama is right.  Really, I do.  Indeed I think I can show that he is right, or at least much more likely to be right than most people imagine.

This was triggered by the barrage of criticism he has been receiving.  If you read posts like this one from Free Exchange, you’d think this giant of financial economics, this future Nobel laureate, is a complete fool.  Maybe he is, but if so then I am too.  Here’s the New Yorker’s Cassidy, then Fama, then Free Exchange:

(Cassidy) Are you saying that bubbles can’t exist?

(Fama)  They have to be predictable phenomena. I don’t think any of this was particularly predictable.

(Free Exchange)  This is truly remarkable. A bubble is an unsustainable increase in prices relative to underlying fundamentals. These fundamentals are more or less observable; those who called the housing bubble did so based on historically anomalous increases in the ratio of home prices to rents and incomes. And many people did correctly identify the bubble years before it imploded, including writers at The Economist who were worrying about rapid home price increases while the American economy was still limping out of the 2001 recession. This is the reality that Mr Fama seems unwilling to confront. How unwilling?

So that is the pro-bubble argument.  We can know the fundamental prices of assets.  We can know when asset prices move away from their fundamental value.  And when they do we can predict that at some point over a reasonable period of time (say a few years) they are likely to move back toward their fundamental values.  I hope that is what Free Exchange is claiming; if not I have no idea what the argument is.  But if that is the claim, it is wrong on all three counts.  I’ll come back to housing eventually, because his assertions are incorrect, but first I’d like to look at the Fidelity Latin America fund, as this perfectly illustrates my point.

You are probably thinking “why the Fidelity Latin America Fund?”  Well first of all, if you are one of those people who believes in bubbles, and you haven’t been paying attention to the FLAF, you sure are missing the boat.  It certainly looks like a bubble.  But this is also what efficient markets look like.  They are erratic.  They have peaks and valleys.  It looks like they have bubbles, but that is a cognitive illusion.  No one really knows the fundamental value of Latin American stocks.  As a result the price can move around quite a bit, even when the so-called “fundamentals” haven’t changed very much.

Chart for Fidelity Latin America (FLATX)

Anyone who believes in bubbles should have been able to make a lot of money either shorting or going long on the FLAF.  (Maybe these stocks can’t be shorted, but my point will still hold up as there are plenty of stocks that can be shorted.  So please don’t bring up that objection.)  So let’s say The Economist magazine really knows the fundamental value of assets in the various countries it covers.  It does cover a lot of countries, and probably knows more about those countries than almost any other magazine.  Also suppose The Economist started a mutual fund that invested based on its ability to spot fundamental values and deviations from those values.  That mutual fund should outperform other funds.  And not just by a little bit, but massively outperform them.  Just look at the graph.  Did the fundamentals in Latin America (a slow growth area where RGDP grows about 4%) really increase 10-fold between the summer of 2002 and early 2008?  I am almost certain they’d say no.  So there are great profit opportunities.  And not just here, The Economist covers the whole world, and all sorts of assets.  They make predictions about real estate, about commodities, about all sorts of things.  There are always some markets that are “underpriced” and others that are “overpriced.”

At this point I’m sure that people are saying “that’s not fair, they aren’t claiming to be able to beat the market.”  But unless I am mistaken, that is exactly Fama’s point.  Unless your Nostradamus-like ability to spot fundamental values does give useful predictions of where asset prices are going, with at least more than a 50/50 chance of success, then the theory of bubbles you have developed is essentially worthless.  It would have no utility, for investors and more importantly for regulators.

Now let’s ask why people have this mistaken notion that bubbles are easy to spot, and that Fama is deluded.  I believe it is a cognitive illusion.  People think they see lots of bubbles.  Future price changes seem to confirm their views.  This reinforces their perception that they were right all along.  Sometimes they were right, as when The Economist predicted the NASDAQ bubble, or the US housing bubble.  But far more often people are wrong, but think they were right.  The most famous example is Shiller’s famous “irrational exuberance” call of early 1996.  Most people still think Shiller was right.  But he was wrong, or at least it is far from clear whether the prediction was at all useful.   (Over the last 14 years there are many times when he looked wrong, and many times he looked right.)

Now suppose you were a bubble proponent and you starting watching the FLAF when it was down around 7 in late 2002.  You watch it double to 14, and say to yourself, hmm, a bit pricey, looks like a bubble might be forming.  Then it goes to 21, nearly tripling in value.  Now you are really starting to think bubble.  It’s mostly in Brazil.  But Brazil isn’t China, it grows at about 3%.  The joke is “Brazil’s the country of the future, and always will be.”  Now it goes to 28, up almost 4 times higher than the 2002 lows.  Surely no plausible amount of profit growth can justify that rise.  Now the bubble alarms are going full blast.  Sell, sell, sell.  Except anyone who took your advice would have been a fool.  It went to 35, then 42, then 49, then 56, then 63, then over 70.

Now suppose I wrote this post in the spring of 2008.  A few months later I’d look like a complete idiot.  The FLAF crashed.  The bubble theorists would have had their worst fears realized.  They’d say “I told you so” even though they would have been wrong, even though the post crash price was still near 28.  And now it’s back to 52.  What is the fundamental value?  For a Rortian pragmatist like me that question is absurdity piled on absurdity.  Or what Bentham called “nonsense on stilts.”  There is no “fundamental value.”  There are only amounts people think it is worth.  Individual people, and the market consensus.  There are no outside referees like “God” to tell us who is right.  We are all alone.  All I can say is that the price will continue to fluctuate.  I have no idea which way.  And at times the bears will make money, and at other times the bulls will come out ahead.

But there is one thing I can predict with a high degree of confidence.  Whatever happens to the FLAF over the next 50 years, the price movements will be interpreted through this congnitive illusion, this confidence that we can see patterns in graphs, even where they don’t exist.  The “mountain peaks” will look like bubbles.  In fact, you can generate a “stock graph” by just flipping coins repeatedly.  And if you show the resulting graph to the average investor he will see patterns.  It is all a cognitive illusion.

But why is Fama’s theory now in such disrepute?  Because in the past ten years the world economy has seen two very important bubble-like patterns, indeed arguably the only two such market cycles in the US during my lifetime with macro significance.  And they were both predicted by lots of experts because they violated popular theories of fundamentals.  So start with the cognitive illusion that people have that makes them see bubbles even where there don’t exist.   People think they have made accurate predictions because an upswing is always EVENTUALLY followed by a downturn.  Then add in the fact that The Economist really did make accurate predictions in two of the most important events in modern history.  Do you think it will be possible to convince them that they just got lucky?  About as likely as a husband convincing an already suspicious wife that he is innocent after twice being caught in bed with two separate women.  So I feel sorry for Fama.  He’s probably right, but I don’t see how he could ever convince anyone in this environment.  It would be like trying to convince someone that neoliberalism was the right policy in 1933.  (Come to think of it, The Economist advocates neoliberalism.)

Now let’s return to housing, and the false claims made by Free Exchange.   In fact, it is not easy to predict the fundamental value of housing.  In a previous post I pointed out that many people screamed bubble when the tight American coastal markets began to diverge from “flatland” prices.  This occurred during my lifetime, and I know that it caught a lot of people off guard.  When I moved from the Midwest to Boston in 1982 house prices didn’t seem that high to me.  By 1987 they had doubled.  By 1990 they’d fallen 15% and I recall people in Boston saying; “see, I knew all along that house prices were completely out of whack in 1987.”  Except that there is just one problem, the prices starting rising again.  By a lot.  More recently they have fallen again in the coastal markets.  But it clear to me that in the tight coastal housing markets prices diverged from fundamentals (or Midwestern prices), and never really returned.   Free Exchange suggests you can get the “fundamental” values by looking at ratio of house prices to income.  Will that work in NYC?  How about San Francisco?  Actually, if I wanted to play that game I’d estimate the fundamental value as the cost of construction plus land prices.  And land prices really don’t have any fundamental value.

Just to be clear, I’m not trying to model housing prices, I’d be the first to admit that the sharp run-ups in Vegas and Phoenix look irrational.  My point is that housing prices are usually hard to predict, because land prices are hard to predict.  Houses can become “unaffordable” in places like NYC and SF, and stay unaffordable for decades.  Of course they aren’t really unaffordable, as people are living in them.  But they appear unaffordable according to the sort of metrics used by the bubble proponents.  These bubble criers were wrong in 1990 when they thought they were right.  Housing prices in desirable coastal markets could well stay much higher than flatland markets for many decades to come.  Or they might not.

A lot of bubble proponents say that the bubble theory doesn’t allow investors to make abnormal returns.  I don’t buy that and I don’t think Fama does either.  I think you can sense Fama’s exasperation in his answers.  Reporters like anecdotes, they think in terms of specifics.  Academics like models, generalities, principles.  Fama wants to know what exactly the bubble proponents are saying.  I don’t want to put words in his mouth, but I think that he is sort of saying the following.

1.  Either you are claiming that a mutual fund run on The Economist’s predictions would reliably outperform index funds.

2.  Or you are saying something with no meaningful implications that I can understand, and you have drained the term ‘bubble’ of any useful meaning.

I think Fama would regard the first claim as delusional and absurd, and I’d agree.   So then what is the point of bubble theories, what are they suppose to tell us that is useful?  Here’s another Fama quote from Free Exchange, see if I have interpreted him correctly:

That’s what I would think it is [i.e. a bubble], but that means that somebody must have made a lot of money betting on that, if you could identify it. It’s easy to say prices went down, it must have been a bubble, after the fact. I think most bubbles are twenty-twenty hindsight. Now after the fact you always find people who said before the fact that prices are too high. People are always saying that prices are too high. When they turn out to be right, we anoint them. When they turn out to be wrong, we ignore them. They are typically right and wrong about half the time.

PS.  My “cognitive illusions” theory doesn’t explain why smart academics disagree with Fama.  Academics who have studies “proving the EMH wrong.”  These studies have even created models that can reliably beat the market, if run backward.  Sorry, I’m not impressed.  But that is another post.  Maybe I’ll call it “t-statistic illusion.”

PPS.  I just opened the link in the first quotation.  It is the funniest thing I have read in ages.  It is an ad for The Economist that brags about a spectacularly false housing price prediction made in 2003.  QED.

HT:  Dilip and rob

Orientalism: Confessions of an arrogant Westerner

Part 1  Which side are you one?

Tyler Cowen linked to this Chinese review of Avatar:

In the film, the indigenous race Na’vi on planet Pandora has to be rescued by Jake, a paraplegic former marine of the human race. Huang argues this is yet another evidence of Eurocentrism prevalent in western films:

I believe if Edward Said is still alive, when he sees that Jake is saved by the princess of Na’vi, he would think: this damn screenwriter! Are you not going to let the princess fall in love with Jake, and let Jake rescue the Na’vi ?

From Madame Chrysanthème to Last Samurai to Avatar, when could Westerners stop seeing foreign cultures as female and themselves as male? And when could they stop the cross-cultural narcissism that, no matter how unsuccessful the Western man is, he will be loved by the Oriental woman?

More politically correct nonsense from the humanities?  At one time I would have thought so; today I’m not so sure.

In recent posts I have noted how in the late 1990s we arrogantly lectured the Japanese on how they should run their monetary policy, only to make the exact same errors when we were confronted by near-zero interest rates.  Or how (according to Simon Johnson) in the late 1990s we lectured the Koreans about how they needed to shake up their dysfunctional banking system, only to make the same regulatory errors when our banking system became dysfunctional.  I still believe the Japanese and Korean policies were flawed, but I’ve lost my smug assurance that we knew how to do things better in the West.  Today I’ll talk about some more examples.

In the last few weeks a debate has raged in the blogosphere over which is better, the European high tax model or the American “low tax” model.  Many bloggers on both the left and right have snatched a few economic statistics out of the air that presumably prove their point.  I tend to agree with Tyler Cowen, who argues that it is much more complicated that it seems.  We differ from Europe in so many ways that it would be impossible to create the European system here, and vice versa.  Impossible you ask?  Yes, unless we divided up into 50 different countries, and then each adopted different languages to prevent large masses of people moving from high tax Buffalo and Detroit to low tax Houston and Dallas.

Just to be clear, I’m not saying there’s nothing to be learned from inter-country comparisons.  I do agree that European countries do a better job of providing health insurance for everyone, and that America’s smaller government plays some role in explaining our higher per capita GDP (although it is difficult to know the exact factors that are most important.)  But let’s stand back and ask what we are trying to do with these comparisons.  My question is this: if we’re looking around the world for an optimal economic system, then why focus on the highly flawed US and European systems?  How about Japan?  They are about as rich as Europe, and also have universal health insurance.  And they tend to have lower unemployment than either the US or Europe.

But it is even worse than that.  The Japanese system does not offer any dramatic advantages over the US or European models, but the Singapore system does.  Right now both the US and Europe are facing a fiscal train wreck.  We have built systems of social insurance that are increasing difficult to maintain with an aging population.  We both have tax and benefit systems that massively discriminate against savers, and this reduces investment and growth.  We both have trade barriers.  We both have incredibly wasteful health care systems where people over consume medicine because someone else is paying (or under consume because it is rationed.)

At this point someone will usually say “the Singapore model is not applicable to the US, it is a small city-state with 4.5 million people ruled by a semi-autocratic government.”  But then why is the Danish model applicable?  They are a small country of 5.5 million people, most of which live in a handful of metro areas.  Perhaps Denmark’s political system is more like ours, but that begs a deeper question.  If we are sitting around in armchairs waving magic wands and imagining turning America into Denmark or Denmark into America, then don’t we have to acknowledge that none of these grand schemes are politically feasible?  After all, if they were, why haven’t they occurred already?

Actually, I am not that pessimistic about change.  Lots of things that are politically infeasible in one decade get adopted in the next.  Indeed lots of the privatization that has occurred recently in Northern Europe (trains, airports, security and air traffic control at airports, highways, postal systems, schools, water systems, etc) would have been unthinkable in the 1970s (or in America even today.)  In 1950s America the top income tax rate was 90%; just imagine a proposal to cut it to 35%.  So here’s my point.  I am not opposed to dreaming of other systems, but if we are going to do so can be please be a bit less Eurocentric?  It’s getting rather embarrassing; after all, the rest of the world already thinks we’re pretty arrogant.

So when people ask me whether I like the American or European economic model best, I answer that I like the Singapore model best.  I like free trade and no taxes on capital and clean air and low taxes on work and paying for ordinary health care out of pocket and universal catastrophic coverage, and big budget surpluses and high rates of economic growth despite already being much richer than Europe.  Why shouldn’t we be debating that model?

I wish I could think of a good metaphor for our current debate, all I came up with was this passage from an old pop song:

Praise be to Nero’s Neptune
The Titanic sails at dawn
And everybody’s shouting
“Which Side Are You On?”
And Ezra Pound and T. S. Eliot
Fighting in the captain’s tower
While calypso singers laugh at them
And fishermen hold flowers
Between the windows of the sea
Where lovely mermaids flow
And nobody has to think too much
About Desolation Row

Part 2.  Bubble, Bubble, toil and trouble.

Darn!  My memory is faulty; Shakespeare did not invent ABCT.  Anyway, continuing on my Tyler Cowen theme, here is a WaPo story that Tyler linked to a few days ago:

“It’s definitely a bubble,” said Beijing real estate broker Xu Xiangdong, a 24-year-old former nightclub cashier. “But it won’t break because there is lots of support beneath the bubble because buying power is really strong.”

Many economists say there are good reasons for such optimism. Rapid economic growth, rising family incomes, continued migration to the cities, pent-up demand for housing, and a banking system much less exposed to residential mortgages than banks in the United States or Japan could protect China, they say, from a real estate meltdown for years to come.

.   .   .

Arthur Kroeber, a Beijing-based analyst and managing director of Dragonomics, said China’s economy is “not even close” to being a bubble like those seen in Japan, which endured more than a decade of sluggish growth after prices retreated, or in the United States, which helped bring about the current sharp global downturn.

“At some point the music will stop,” Kroeber said. But he predicted that it would not happen in China for at least 15 years, when urbanization slows.

The bigger real estate problem in China now is access to housing. For many people — especially the young or people moving to the cities from rural areas — the dream of owning a home is more and more difficult to attain. The Xinhua news agency quoted Goldman Sachs as saying that housing price increases had outpaced wage hikes by 30 percent in Shanghai and 80 percent in Beijing in recent years.

.   .   .

Now top leaders are worried. In a year-end interview with the official Xinhua news agency, Premier Wen Jiabao said that “as the property market is recovering rapidly this year, housing prices in some cities are rising too fast, which deserves great attention of the central government.” He vowed to “crack down on illegal moves, including hoarding of land and delaying sales for bigger profits.” And he said the government would do more to provide affordable housing.

Last week, the government also nudged a key interest rate higher.

Still, many economists are sanguine.

“One of the legacies of China’s prolonged stagnant growth prior to economic liberalization is an overwhelming shortage of residential property that meets its new living standards,” Koyo Ozeki said in a report published by Pimco. “It will likely take a considerable period of time for supply to catch up to demand.” That wasn’t true in the Japanese or U.S. bubbles.

Ozeki, an executive vice president for Pimco in Tokyo, noted that the total credit for the property sector in China has grown to 40 percent of gross domestic product; in the United States, it hit 80 percent in 2007. For Chinese banks, exposure to real estate is less than 20 percent of assets, much smaller than in the United States. That should reduce the chances of a banking crisis.

In addition, while property prices are soaring in such areas as Beijing and Shanghai, price increases are more modest elsewhere. Government statistics say housing prices nationwide rose only 5.7 percent last year.

Moreover, China’s homeowners carry less debt than homeowners abroad and the economy’s rapid growth can probably keep incomes rising fast enough to cover mortgage costs. Kroeber said that mortgages issued from 2002 to 2008 equaled only 40 percent of the value of housing sold nationwide.

Liu Renping, a 30-year-old construction engineer originally from the countryside of Inner Mongolia, is typical of many first-time Chinese home buyers. After deciding to get married, he hunted for four months before buying a two-bedroom, 900-square-foot apartment on the northern edge of Beijing last March, even though it won’t be completed until this October. He paid $162 per square foot and took out a mortgage out for half the money needed. The other half came from his mother, friends and his savings.

About 30 percent of the couple’s pay will cover mortgage payments. “And my salary will increase in the near future. So I don’t feel big pressure from my mortgage,” Liu said.

Since he bought the apartment, prices in that development have jumped more than 50 percent. “I am lucky to have bought it early,” he said. “If the price was this high when I bought the apartment, I wouldn’t buy at all because it would have been too expensive and I wouldn’t have been able to afford it.”

Here is much more.

So what do you think?   Prices have risen 5.7% in the last year in a country where nominal incomes have been averaging double digit increases for decades.  A country with a billion people who still lack adequate housing.  Does that sound like a bubble?  You’re thinking; “Aha, but what about Beijing and Shanghai, where prices are rising much faster, surely that is a bubble?”  Maybe, but I suppose it depends how you define “bubble.”  Most people simply define it as a fast price run-up followed by a price retreat.  By that definition the NYC housing market has had several bubbles in recent decades.  But more sophisticated bubble theorists like Robert Shiller talk of price run-ups that are obviously excessive, where the future price will be predictably lower than the present.  But by that criteria NYC has had no bubbles, after all at no time in the past 30 years has it been possible to forecast with any confidence that NYC condos would become cheaper over the next 3 or 5 or 7 years.

I have the impression that many people get confused over this point.  How often have you heard “I knew NYC condos were a bubble when everyone started talking about them at cocktail parties.”  The smug assumption is that the speaker was able to predict the crash.  But this isn’t right.  NYC condos never crashed, and still haven’t.  Rather they have had tremendous price appreciation, interrupted by occasional modest downturns.  As a result the real price of condos (even in this slump) is far higher than in the 1970s—the boom turned out to be permanent.  Our minds trick us—we think the modest pullbacks after huge price gains confirm the bubble theory, when in fact they refute it.   And of course this is true for many other cities like Boston and San Francisco.

But not Vegas and Phoenix.  In those cities average houses suddenly rose from $200,000 to $400,000, despite a huge supply of cheap land and a nearly constant cost of production for building new houses.  In 2006 an economist like Shiller might have said: “I confidently predict that in 5 years Phoenix and Vegas houses will be much cheaper, as new supplies come on the market.”  And he would have been right.  What is the difference?  In the NYC case all we knew is that markets with huge run-ups are susceptible to occasional pullbacks.  Indeed according to the EMH it must be so.  Otherwise investing in a highly volatile market would be “heads I win, tails I’m even.”  But we didn’t know when the correction would occur, so this knowledge was not particularly useful.  In Vegas and Phoenix we could (if you believe Shiller) be fairly confident that between 2006-11 real estate prices would fall, as the fundamentals could not support the high prices for long.

Which model is more applicable to China?  The simplistic cocktail party “bubble” theory, or Shiller’s more sophisticated version?  I say the simplistic version.  But even if I am right it will be bad news for me, because most people don’t understand the distinction I am making.  Thus once prices start falling (and they will at some point) some future blogger like this one will put me on a Hall of Shame list of people who were oblivious to the China bubble.  In the probably forlorn hope that I can avoid this public shaming, one last attempt to explain this distinction:

1.  Beijing and Shanghai prices will fall at some point in the next 10 years.

2.  I have no idea whether Beijing and Shanghai prices will be higher or lower over any particular time scale (one year, two years . . . ten years.)

Why do I think these two cities are more like NYC and SF than Vegas and Phoenix?  Because the current average price is about $1700 per square meter, or $170,000 for an 1100 square foot condo (spacious by Chinese standards.)  Just imagine what that apartment would cost in NYC or London.  I think that Beijing and Shanghai will increasingly become two of the great world cities (along with NYC, London, Paris, Tokyo, etc.)  And when that happens people will say “remember when you could buy an 1100 square foot apartment for only $170,000.”

[By the way, if we have degenerated to the point where we are judging public intellectuals by their ability to out-guess markets, then I fear for the future of my profession.  What’s next, judging statisticians by how often they win at Powerball?  Comparing the 403b accounts of salt and freshwater economists?  Are we on the same level as carnival fortune-tellers.]

The article raises another interesting issue when it mentions how the Chinese government is reacting to the “bubble” by encouraging the construction of new apartments to hold down prices.  I imagine some ABCT-types might be horrified by this response; doesn’t it just make the post-bubble adjustment out of housing even more painful?  But I am less concerned.  If they end up building “too much” it will just mean that a few people get to live in nice modern apartments a bit sooner than optimal, and a few other people get some other nice modern good like a car a bit later than would be optimal.  Right now the Chinese need lots more of almost everything.  Theories of “reallocation” are not much use in countries where there is a massive flow of unskilled workers from the countryside to the cities, and if one industry gets a bit ahead of itself, it doesn’t decline, rather it simply absorbs unskilled workers at a slower pace whereas some other industry (like autos) absorbs unskilled workers at a faster pace.

The big challenge for China is to become much more efficient at everything so that they can produce lots more of everything.   The much smaller challenge is to produce much more of everything in the right order.  They are probably making some mistakes.  Some of the high speed rail projects are too fancy for a country at China’s stage of development.  But once people have enough food and clothing and TVs and cellphones, the biggest unmet need is a nice place to live.  So I’m not going to second guess the Chinese housing market without a bit more evidence than is provided in the WaPo article.

[BTW, if you read Tyler’s post and mine back to back, you might note a subtle jab at Tyler’s editorial decisions.  I don’t have the heart to attack him more directly, because he is always so much more polite than other bloggers.]

What does part 2 have to do with Western arrogance?  Well I wonder if people in the West (including me) are well-placed to judge whether Chinese apartments are overpriced.  After all, the Chinese investors who buy these units are pretty sophisticated, and understand local conditions far better than I do.  And this leads me to the reason I am so optimistic about China (although I am a raging pessimist compared to Fogel):

1.  The Chinese people generally think their government is doing a good job.

2.  The Chinese people favor a free market system, indeed they (and Indians as well) like the free market system much more than do Americans or Europeans.

3.  There is grumbling in China that the government is not moving fast enough toward a free market system.  The press and the public have been critical of recent trends toward more lending to SOEs.

I think those three attitudes bode very well for the future, despite the very real and massive problems that China faces today.

So what can China learn from the West?  They should develop some of our arrogance, and look to other Asian countries like Singapore for their economic model.

Tight money causes bubbles

Of course I should have said “is associated with,” not “causes.”  But if you are trying to be provocative, why stop halfway?

I’d rather not talk about bubbles at all.  I find them boring, misleading, and I don’t “believe in them.”  (I don’t disbelieve in them either.)  But my commenters force me to continue talking about them.  So here is something designed to enrage everyone.

The Fed was created in 1913.  Let’s throw out the decades when there were World Wars, which (according to Krugman) were hopelessly distorted by rationing and price controls.  Here I will divide up decades into those with easy money (indicated by high and/or rising inflation) and tight money.

Easy money:  1960s, 1970s

Tight money: 1920s, 1930s, 1950s, 1980s, 1990s, 2000s.

Yes, I know the 1980s had more inflation than the 1960s.  But the rate trended sharply lower in the 1980s, and most economists think that is what really matters in terms of the real effects of inflation.

Now let’s look at bubbles of major significance.  This is subjective, but I will exclude bubbles that apply to individual stocks, commodities, or local real estate markets.  I want bubbles of macro significance.  I will also list the bubble peak, and whether there seems to be a rational explanation.  Note, according to some definitions of ‘bubble,’ if there is a rational explanation that is consistent with economic theory, it isn’t really a bubble.  But I am not interested in debating that issue here, I just want price spikes generally regarded as bubbles:

September 1929, stocks, fundamental explanation

Mid-1937, stocks and commodities, fundamental explanation

August 1987, stocks, deeply mysterious

April 2000, stocks, partly explicable, partly mysterious

Early 2006, housing, fairly mysterious (especially Vegas and Phoenix)

Early 2008, commercial real estate, fundamental explanation

Mid-2008, commodities, fundamental explanation

What do you notice about the pattern?  None of the 7 bubbles occurred in the easy money decades of the 1960s and the 1970s.  Why then this almost universal belief that easy money causes bubbles?

1.  People often misinterpret the stance of monetary policy.  As Milton Friedman observed, low interest rates are not easy money, they are a sign that money has been tight.  Tight money can depress rates in two ways, the Fisher effect and the income effect.  Thus tight money can lower inflation and real growth, and both of these effects tend to reduce nominal rates.

2.  People confuse easy money and easy credit.  Easy credit can co-exist with tight money.  Easy credit may contribute to bubbles (I don’t have an intelligent opinion on this question.)

3.  More sophisticated observers will point to real rates.  But not all bubbles are associated with low real rates.  The best example is 1937, when rates were very low because the economy was still very depressed.  Another example is the two 2008 peaks, when real rates had fallen due to weakness in the economy.  In other cases observers blame low real rates during the formative stages of the boom (say 1927, or 2003), not at the peak.

Do I really believe that tight money causes bubbles?  Given that I don’t believe in bubbles; that would be kind of silly.  But I do believe that “bubbles” are just as likely to form during decades when inflation is low, or falling, as during decades when inflation is high or rising.  It’s something to think about.

PS.  Many readers may find my views on bubbles confusing.  Last March I explained why I don’t think the debate over the EMH is very interesting.  The question isn’t whether the EMH is “true” or not (social scientists don’t even agree on what “true” means.)  Rather the question is whether the EMH or the anti-EMH position is more useful.  I have found the EMH to be very useful, but I haven’t seen any uses at all for the anti-EMH position.  That is what I mean when I say I don’t believe in bubbles.  I do not mean that I think Fama’s models can explain any and all market fluctuations.

PPS.  Austrian readers; please give me a few minutes to put my hands over my head and go cower in the corner before you respond.