More and more I think that the entire bubble/anti-EMH approach to economics is founded on nothing more than superstition.  Superstitions are caused by cognitive illusions; we think we notice more patterns than are actually there.  You dream your son got in a traffic accident, and the next day it happens.  You forget the other 10,000 dreams that didn’t predict the future.

In economics people notice bubbles bursting, but fail to pay much attention to bubbles not bursting.  But I admit I might be wrong, so I’ll give my opponents one more chance.  If it’s not really a cognitive illusion, then bubble deniers who are right ought to be just as famous as bubble predictors who are right.  Indeed as we will see they should be even more famous.

People who actually understand finance know that if the term “bubble” is to mean anything useful, it must contain an implied prediction of the future course of asset prices.  Not a precise prediction (everyone knows that would be impossible) but at least a better than a 50/50 prediction.  If someone said in 2005 that housing prices were a bubble, but still was unable to offer more than a 50/50 odds on whether real housing prices would rise or fall over the next 5 or 10 or 20 years, then what would their assertion actually mean?  Asset prices are very volatile; we know that at some point all markets will go down.  When I read predictions from people like Paul Krugman, I infer that there is an implied prediction that real prices will fall over some reasonable period of time—say 5 years.

And of course Krugman was right in predicting that real US housing prices would fall in the 5 years after 2005, as was Dean Baker, Nouriel Roubini, and some others who became well known and lauded for their predictions.

At the same time we also know that bubble-like patterns don’t always yield reliable predictions of future trends.  The Australian housing market looked just as bubbly as the US market in 2005, but since then has soared much higher.  Some day it will fall, but the 2005 prices no longer look excessive.

If people like Robert Shiller (another person who became famous from bubble predictions) are right about asset prices being too volatile, then it should be true that US-type cases are more common than the Australian case.  I don’t think that’s true— in most developed countries real housing prices have risen since 2005, despite real upswings before 2005.  But let’s say I’m wrong and Shiller’s right.  Then the easy prediction to make is that prices will fall after a big upswing.  The much harder prediction is that prices will keep rising, even from inflated levels.  Those cases would be much rarer, and those who correctly call them when they occur (as in the Australian housing case) should be lauded as great heros of the investment world.

So who are they?

If they don’t exist, I have a theory why.  Most people are convinced bubbles exist, regardless of the data.  Hence if the prediction doesn’t pan out, then the market was in some sense “wrong.”  Traders haven’t yet woken up to the stupidity of their behavior.  When they do, prices will crash and the bubble proponents will be proven right in the long run.  So most people would implicitly think; “Why praise someone for being right for the wrong reason?”  Of course this makes bubble theory into a near tautology, irrefutable in volatile asset markets that will almost always eventually show price decreases.

Perhaps I am wrong and there are lots of famous bubble deniers out there.  But if not, that would in my mind be the last nail in the anti-EMH coffin, pretty much confirming that people are seeing what they expect to see, indeed given the satisfaction we get from seeing the high and mighty brought low, perhaps what they want to see.

One final point; I also have noticed that lots of people are given credit for bubble predictions that were wrong.  John Kenneth Galbraith saying stocks were a bubble in January 1987.  Robert 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 bubble predictions of 2003 in an ad, despite the predictions being incorrect for most of the countries listed.  That’s how strongly we want to believe in bubble predictions—we even assume that people who were wrong, were actually right.

PS.  For those interested in global housing prices, The Economist has a great interactive graph.  It helps to show the pattern from say 2000:1 to 2005:1, and then from 2005:1 to the present.  In the earlier period almost all countries showed gains in housing prices, even in real terms.  The two notable exceptions were Germany and Japan, where prices fell sharply.  If I was to use a Shiller-style model that predicts asset prices will self-correct after excessive swings, I would have predicted most housing markets to slump after 2005:1, but Germany and Japan to rise.  Instead almost the opposite happened.  Germany and Japan continued to do very poorly, while almost all other markets rose in nominal terms, and most rose even in real terms.

The two nominal decliners (in addition to Germany and Japan) were the US and Ireland—which is why people assume they had had a bubble.  But why didn’t all the other bubbles collapse?  Perhaps because asset prices are not as easily forecasted as most people naively assume.

BTW, if you can’t get a 2000:1 starting date, then white out all the country boxes and start over.  That worked for me.

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?

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?

Pay attention to the things that cause interest rates to change.

This post was inspired by a Tyler Cowen post entitled “Don’t obsess about interest rates.”  I agree, and will stake out an even more extreme position.

Before doing so, I’d like to talk a bit about the identification problem in another area—wages.  Suppose someone argued that rich country workers can’t compete with low wage countries like China.  The counterargument would be that Germany has led the world in exports for most of the past decade, and they have some of the highest wages in the world.  Bangladesh has a much bigger population, but puny exports.  The counter-counterargument is that Germany’s high wages are caused by their high productivity, and that high wages are still a disadvantage in trade, holding other things constant.  In the end, the debate is sterile unless we understand all of the underlying fundamentals, in which case wages are superfluous.

Here’s better analogy.  Massachusetts saw a big loss in jobs in industries like shoes and textiles during the 1980s.  Was the job loss due to high wages?  If so, then why didn’t Massachusetts see a higher unemployment rate?  Economists would use the good old comparative advantage model.  The booming high tech, health care, and finance sectors created lots of high paying jobs.  This raised the cost of living here, and drove out the low paying jobs.  Thus our low wage jobs weren’t stolen by cheaper labor in Mexico or China, they were literally pushed out (or crowded out) by higher paying jobs in other industries.  That’s creative destruction.

Now let’s consider the role of wages.  Although they weren’t the root cause, it is true that high wages were a sort of transmission mechanism between the high tech boom and the loss of low wage jobs.  So why do I object to people saying high wages drove out those older industries?  Because wages change for many different reasons.  They might change because the shoe industry became highly unionized and drove up wages, despite weakness in other areas of the economy.  Or they might change because of the creative destruction process I just described—a high tech boom pushing up the overall wage rate around here.  It makes a big difference which factor is behind the wage change.  You haven’t really described the reason why shoe-making jobs left the state unless you can explain why wages rose.

Here’s how this relates to interest rates.  Tyler Cowen links to a study by Glaeser, Gottlieb, and Gyourko (GGG), which finds that only about 20% of the housing price boom was due to low interest rates.  I don’t wish to contest that study, rather I want to warn people to be careful interpreting the findings.  For instance, interest rates might have fallen because the popping of the high tech bubble in 2001 led to a big drop in business investment.  With lower demand for credit, interest rates (real and nominal) would naturally be expected to fall.  Or the Fed might have cut interest rates.  Or saving rates might have risen in Asia.  If the housing industry was not directly hit by any unusual shocks, these outside factors affecting interest rates would be expected to increase housing demand, prices, and output.  The GGG study is essentially saying that 80% of the rise in housing prices was due to non-interest rate factors, i.e. factors directly affecting the housing market.  I suppose these could be changes in regulation, financial innovation, banks taking greater risks, GSEs, etc.

So why don’t I like hearing people talking about the portion of the housing boom that was due to low interest rates?  The problem is that many listeners subconsciously connect low interest rates with “easy money.”  They assume it is the Fed’s “fault.”  To their credit GGG avoid this error, referring instead to “easy credit,” i.e. low real interest rates.

Economists generally accept the idea that the Fed only affects real interest rates in the short run.  (Or at least I thought this was generally accepted, the last two years have caused me to reconsider everything that I assumed was generally accepted by economists.)  The standard view is that the so-called liquidity effect only impacts real interest rates for a few years.  In the long run, easy money will leave real interest rates unchanged, and raise nominal rates.  For instance, compare the 1970s to the 2000s.  The 1970s saw higher and higher nominal rates, culminating in 20% rates by 1980.  The 2000s saw much lower interest rates, which ended up near 0% by 2010.  The man on the street would assume that money was much tighter in the 1970s.  But economists know that this is wrong, because the 1970s saw high and rising inflation, and the 2000s saw low inflation.

So here is my suggestion.  Never reason from a price change.  Don’t ever say “oil prices will be high next year; hence I expect oil consumption to decline.”  That’s bad reasoning.  And don’t ever talk about high or low interest rates causing some sort of change in the economy.   Instead say something like “I believe the high tech bust helped boost the housing industry.”  That sort of reasoning is consistent with the central idea of economics—scarcity.  If less resources are devoted to making one type of capital good, then you’d expect more resources to be devoted to making other types of capital goods.  Interest rates are merely the transmission mechanism that facilitates the “recalculation.”

Of course I am not suggesting that the tech bubble bursting caused the housing boom.  GGG find only about 20% of the boom is explainable via interest rates, and the tech bubble bursting is just one of many variables that can affect real interest rates.  High Asian savings rates are another factor, and Fed policy is a third. However, the liquidity effect is less significant than usually assumed, as interest rate changes far more often reflect economic conditions than exogenous changes in Fed policy.  So even if low interest rates had caused the housing boom, you would still not be able to claim that a Fed easy money policy contributed to the housing boom.

PS.  BTW, also avoid talk about disinflation/deflation, which could be due to either less AD or more AS.  If you are worried about too little AD, then talk directly about falling NGDP.  And yes, I am at fault here as well, as Bill Woolsey has noted on occasion.

PPS.  I will be travelling a great deal in August, so I won’t be able to do much blogging.

In the 1930s the right had to choose between a modest amount of inflation (returning prices to the pre-Depression levels) or more socialism.  They weren’t thrilled with big government, but their strongest opposition was reserved toward policies of inflation.  So we ended up with deflationary policies between 1929 and 1933.  Of course the voters wouldn’t accept 25% unemployment, so we got big government instead of the inflation.

As this video shows, we are essentially facing the same choice today.  We could pump up the economy through monetary policy, or we can have Fannie and Freddie continue to throw $100s of billions down the drain, socialize the auto industry, extend unemployment benefits to 99 weeks, etc.  And if that isn’t enough there are also calls to move away from free trade policies.  And then there’s the higher taxes we’ll pay in the future to cover the costs of debts run up in a futile attempt to stimulate the economy.

Just as in the 1930s, the right seems to have decided that a little bit of socialism is better than a little bit of inflation.  What do I mean by a little bit of inflation?  I mean enough so that the post-September 2008 trend rate of inflation is the same as the pre-September 2008 trend rate of inflation.  Apparently even that little bit of inflation is more distasteful than massive government intervention in the economy.

And the irony is that many of the policies I describe, such are Fannie and Freddie propping up the housing market, unemployment insurance extensions, and trade barriers, are themselves slightly inflationary.  But they don’t just raise the price level, they also cause all sorts of distortions—they move prices away from their free market equilibrium.   (I’m looking at you Morgan.)

The even greater irony is that this isn’t even one of those pick your poison cases.  The inflation I am calling for would be nothing more than a continuation of the inflation that occurred in the previous two decades.  We’d want it even if we hadn’t had a housing crisis and recession.  I don’t recall conservatives complaining loudly that 2% inflation was a disaster when Clinton was president.  So why the sudden and hysterical opposition to 2% inflation?  Is that really a fate worse than socialism?

The still greater irony is that the more the conservatives win today, the more inflation we’ll get in the long run.  The conservatives got their way in the early 1930s, but it so discredited their ideology that it opened the door to much higher inflation over the next 40 years.

Part 2.  A few more “whiffs” of racism directed against Fannie and Freddie.

As you know, some fearless bloggers have exposed the “whiff” of racism in attempts by conservative economists like Raghu Rajan to blame the government for the mortgage fiasco.  Here for example, is Edmund Andrews:

Of all the canards that have been offered about the financial crisis, few are more repellant than the claim that the “real cause” of the mortgage meltdown was blacks and Hispanics.

Oh, excuse me — did I just accuse someone of racism?   Sorry.  Proponents of the above actually blame the crisis on “government policy” to boost home-ownership among low-income families, who just happened to be disproportionately non-white and immigrant.  Specifically, the Community Reinvestment Act “forced” banks to make bad loans to irresponsible borrowers,  while Fannie Mae and Freddie Mac provided the financial torque by purchasing billions worth of subprime paper.

The argument has been discredited time and again, shriveling up almost as soon as it’s exposed to sunlight.  But it keeps coming back, mainly because the anti-government narrative gives Republicans a way to deflect allegations that de-regulation allowed Wall Street to run wild.   It’s the financial version of Sarah Palin’s new line that “extreme environmentalists”  caused the BP oil spill.

Paul Krugman caught a whiff of it in a recent commentary by Raghuram Rajan in the FT, and quickly denounced it.

Now Bloomberg.com seems to be making those sorts of racist accusations:

June 14 (Bloomberg) — The cost of fixing Fannie Mae and Freddie Mac, the mortgage companies that last year bought or guaranteed three-quarters of all U.S. home loans, will be at least $160 billion and could grow to as much as $1 trillion after the biggest bailout in American history.

.   .   .

The companies’ liabilities stem in large part from loans and mortgage-backed securities issued between 2005 and 2007. Directed by Congress to encourage lending to minorities and low- income borrowers at the same time private companies were gaining market share by pushing into subprime loans, Fannie and Freddie lowered their standards to take on high-risk mortgages.

Many of those went to borrowers with poor credit or little equity in their homes, according to company filings. By early 2008, more than $500 billion of loans guaranteed or held by Fannie and Freddie, about 10 percent of the total, were in subprime mortgages, according to Fed reports.

It seems even the Fed is peddling those vicious racist lies.

Even worse, they assert that Fannie and Freddie’s heavy involvement in sub-prime lending continued even during the height of the housing bubble:

The composition of the $5.5 trillion of loans guaranteed by Fannie and Freddie suggests that the surge in delinquencies may continue. About $1.98 trillion of the loans were made in states with the nation’s highest foreclosure rates — California, Florida, Nevada and Arizona — and $1.13 trillion were issued in 2006 and 2007, when real estate values peaked. Mortgages on which borrowers owe more than 90 percent of a property’s value total $402 billion.

That doesn’t seem to mesh with what I’ve been reading in Krugman’s blog:

He [Schwarzenegger] asserted, as a simple matter of fact, that “government created the housing bubble”, because Fannie and Freddie made all these loans to people who couldn’t afford to pay them.

This is utterly false. Fannie/Freddie did some bad things, and did, it turns out, get to some extent into subprime. But thanks to the accounting scandals, they were actually withdrawing from the market during the height of the housing bubble “” the vast majority of the loans now going bad came from the private sector.

Yet it’s now clear that the phony account of the crisis “” that it’s all due to Fannie, Freddie, and nasty liberals forcing poor Angelo Mozilo to make loans to Those People “” is setting in as Republican orthodoxy

If you are wondering what the phrase “it turns out” refers to, perhaps it is this earlier post by Krugman:

But here’s the thing: Fannie and Freddie had nothing to do with the explosion of high-risk lending a few years ago, an explosion that dwarfed the S.& L. fiasco. In fact, Fannie and Freddie, after growing rapidly in the 1990s, largely faded from the scene during the height of the housing bubble.

Partly that’s because regulators, responding to accounting scandals at the companies, placed temporary restraints on both Fannie and Freddie that curtailed their lending just as housing prices were really taking off. Also, they didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.

So whatever bad incentives the implicit federal guarantee creates have been offset by the fact that Fannie and Freddie were and are tightly regulated with regard to the risks they can take. You could say that the Fannie-Freddie experience shows that regulation works.

Just to get serious for a moment; when I get upset at “Those People,” I am thinking about the Congressmen who created Fannie, Freddie and the CRA.  And yes, I know that the CRA was only a minor factor in the crisis, but everyday it becomes clearer that Washington’s attempts to enlist Fannie and Freddie into their crusade to make every American a homeowner lies at the center of this crisis.  Indeed the misdeeds of the “too-big-to-fail” banks (and their associated bailout with TARP funds), now comes in a distance third (or fourth if you include the Fed), far less costly to taxpayers than even the misbehavior of smaller banks that exploited the incompetence of the FDIC.

The experts say we can’t eliminate F&F right now, and I suppose they are right.  But only because we don”t have a monetary policy that stabilizes NGDP growth expectations.