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Not Everyone is Confused by Housing Bubbles

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Wednesday, 12 February 2014 06:53

Eduardo Porter tells readers about confusion among central bankers about how to deal with international capital flows and asset bubbles like the housing bubble in the United States. While there has been considerable confusion among central bankers, this appears to be more linked to their lack of qualifications than the intrinsic complexity of the subject matter.

For example, Porter notes how Greenspan was confused by the inflow of foreign capital that kept long-term interest rates low even as he was raising short-term interest rates.

"It was a wave of money that — to the confusion of Alan Greenspan, the Fed chairman at the time — the Fed seemed powerless to manage."

This was Greenspan's famous "conundrum." Of course it was not a conundrum to those who closely followed the economy at the time. It was easy to see that China and Japan's central banks were buying up long-term U.S. bonds, directly lowering long-term interest rates, while Greenspan was trying to affect long-term rates indirectly by raising short-term rates. (This was in effect a form of quantitative easing, but by foreign central banks.) Needless to say, directly acting in the market had more of an impact than indirectly acting.

The low interest rates that fuel asset bubbles should be good for the economy. The priority of the central bank should be to use its regulatory powers to prevent credit from flowing to markets that are experiencing dangerous bubbles.

It can also explicitly warn that it will take measures to bring down asset prices if they continue to grow further out of line with fundamentals. This would in effect be a form of forward guidance. While economists routinely deride the idea that such warnings could impact the behavior of investors, many of these same economists believe that central bank statements about future interest rates can have a large effect.

It is difficult to see the logic whereby central bank statements in one area will affect investors' behavior while it will have no effect in another area. It is also very difficult to see the downside from issuing such warnings. Comparing the Congressional Budget Office's projections of GDP from 2008 with actual GDP and its current projections, the collapse of the housing bubble will have cost the country more than $24 trillion in lost output through 2024 ($80,000 per person). Given the enormous potential gains from measures to stem the growth of such dangerous bubbles, it is hard to see any remotely offsetting downside risk.



Comments (18)Add Comment
Milton Friedman's solution.
written by Ralph Musgrave, February 12, 2014 7:50

Most of the damage from the house bubble collapse derived from the banks brought down as a result. Asset price collapses as such are not normally a huge problem: witness the stock market setbacks in 1987 and early 2000s. If banks were funded just by shareholders, not depositors, it would be impossible for banks to fail, as pointed out by George Selgin.

As to those who simply want to deposit money, there should be banks or other institutions catering for that need, as Milton Friedman argued. But those institutions should not lend on the relevant money. I.e. we need two types of bank. First lending banks funded just by shareholders (who carry any losses rather than taxpayers carrying the losses). Second, deposit only banks. Milton Friedman advocated that “two types of bank” idea, and he was right.
Not so fast...
written by Dave, February 12, 2014 8:45
I'd challenge someone to show me the data that proves that Greenspan was attempting to raise long-term rates to no avail. I see no evidence of that anywhere. And I'd like to see the evidence that the subprime market was primarily to blame for the bubble -- the evidence proves otherwise, which is why those monitoring the sub-prime market, believing it to be the biggest danger to the system, weren't able to predict the damage a burst bubble would cause upon the economy -- they thought the primary danger was financial because they are out of touch with the economy.

@Ralph:
All asset bubbles are not equal. Stock asset bubbles affect investors, and most people are smart enough these days not to invest hugely leveraged funds in the stock market, so this limits the damage upon the financial system from a crash. However, none of this addresses the economy vs. the financial system. The economic damage from any bubble in housing is much greater than a bubble in stocks because of who loses in a crash: in stocks it is investors, in housing it is consumers.
Correct for South America and Europe
written by Dave, February 12, 2014 9:11
Despite what I said above for the US case, this description of the problem by Eduardo does fit for South America and Latvia and many other nations that receive more foreign, long-term investment than the US does.

It is tempting to blame the US trade deficit for this, because we do have a large net inflow of capital compared to other nations, but this isn't about net inflow: it is about bank credit, which doesn't show up on a net flow analysis.

The US didn't need external bank credit to fuel its bubble. We sent the funds through Germany and back to the US. China and Japan had little to do with the US housing bubble.
I Meant Estonia, not Latvia
written by Dave, February 12, 2014 9:59
But it might also apply to Latvia.
...
written by Dryly 42, February 12, 2014 10:46
Specifically with respect to housing I'm not sure the failure on the part of Greenspan had much to do with capital flows. Any number of people were aware of the problems with housing early on. In the Fall of 2004, Chris Swecker, Deputy Director of the FBI testified about the "epidemic" in mortgage fraud and that he feared another Savings & Loan sized disaster(he was wrong-it was 40 times that). Ned Gramlich, a member of the Board of Governors privately went to Greenspan to discuss the subprime mortgage problem but "The Maestro" would have none of it. Gramlich did not formerly bring it up to the Board. But virtually everyone knew.

The Fed had authority given by 1994 legislation to regulate mortgages. The Maestro declined to use this authority which would have been targeted directly at the problem without affecting the wider economy. Bernanke, after a fashion,did so but all of the horses were out of the barn.

I respectfully submit the real problem was Greenspan's ideology from his days as a member of the Ayn Rand cult. The Maestro actually told Brooksley Born they would never agree of fraud as he didn't believe the laws against fraud should be enforced. If an actor did commit fraud others would not do business with him. The market would solve any problem with fraudster by itself. Born, who graduated No. 1 in her class at Stanford Law, was appalled. She was aware of that provision in the Constitution that mandates the executive "shall take care that the laws be faithfully executed."
No downside risk???
written by keenan, February 12, 2014 1:10
"...the collapse of the housing bubble will have cost the country more than $24 trillion in lost output through 2024 ($80,000 per person). Given the enormous potential gains from measures to stem the growth of such dangerous bubbles, it is hard to see any remotely offsetting downside risk."

Yeah, I guess there's no downside risk if you ignore the most important economic problem of our time, which is global warming. Increased output means increased destruction of the environment. You can't discuss boosting output in a vacuum.




...
written by saurabh, February 12, 2014 2:29
Given Bernanke's recent pro-bitcoin remarks it seems like central bankers are not too interested in actually puncturing bubbles so much as inflating them.
reference for Dryly 42's comment ...
written by Squeezed Turnip, February 12, 2014 2:44
Here is a paper published by the ABA that discusses the 1994 HOPEA ("Home Ownership and EquityProtection Act of 1994") and the 2001 amendments the FRB adopted (adopted because it was already common knowledge at that time that lenders were finding ways to not classify predator loans as "high-cost loans." The FRB already knew there was a problem in the credit markets.

And Greenspan did do something: he advocated doing nothing, letting the predators go, because, ya know, the market will punish them (knowing the government nanny would rescue the poor little rich frat boys from their boo-boos).

BTW, where is the MMT "the market doesn't set the rates" crew?
bernanke and bitcoin
written by Squeezed Turnip, February 12, 2014 7:50
...
written by saurabh, February 12, 2014 3:29
Given Bernanke's recent pro-bitcoin remarks it seems like central bankers are not too interested in actually puncturing bubbles so much as inflating them.


Given that the media is no longer doing it's job, it should be no surprise to the readers of BTP that Fed Vice Chairman Alan Blinder said virtual currencies "may hold long-term promise" in 1995. Bernanke did not say this, he merely quoted Blinder. If you read pages 10-12 of this document (which contains the original letter from BB to Homeland Security), you can't find one positive thing BB said about bit coin. Once again the media fails journalism 101 and takes talking points from sources with vested interest as being reportable with no critical vigilance on the part of reporters.
Many different views of varying magnitudes of effect
written by Dave, February 12, 2014 9:46
@Dryly:

Since yours is the popular view, and since it is the most reported liberal view, I'll address the problems in this view. Not that I disagree, I don't. I agree that the fraud and Greenspan's attitude towards it brought down the financial system, and it was criminal. But nobody seems willing to separate the housing bubble from the financial collapse and this is of unending frustration for me, because they are fundamentally different beasts.

Let's focus upon the housing bubble alone for a minute: The main question is what drove prices so far beyond the Case/Shiller index (in the short term) and so far beyond historical productivity levels in the long term?

Historically since the inception of the current GSE structure, Fed easing leads to a major increase in housing activity. Such is the case in every historical case of the past. The major source of increased investment (shh -- consumption also) was housing. But in each historical case, the economy responded quickly and didn't need further housing stimulation to continue.

Such is not the case in the 2000s. Greenspan spurred housing successfully, but then he embarked upon a journey to prove the impotence of the monetary system outside of housing. It worked.

The question arises as to Greenspan's actions in lowering rates to the floor: should he have stopped the housing bubble or should he have played out his experiment?

Bernanke saw the problem the whole time and immediately raised rates sufficiently to prevent the bubble from growing further. Clearly monetary authorities saw the problem, but Greenspan blocked action until Bernanke took charge.

This is not just about fraud. It is also about shadow banking and a broken monetary system. We should fix the monetary system so it has the potency to change savings/investment opportunities, but this has to be an international effort.
which is broken?
written by Squeezed Turnip, February 13, 2014 12:29
Many different views of varying magnitudes of effect
written by Dave, February 12, 2014 10:46
...
This is not just about fraud. It is also about shadow banking and a broken monetary system. We should fix the monetary system so it has the potency to change savings/investment opportunities, but this has to be an international effort.


I agree, it's not just the poor management of mortgage fraud that was the problem, it was also a fundamental misunderstanding of derivative construction (a theorem doesn't apply if its hypotheses aren't met). Bernanke and Blinder found a slight insight into the problem back in the 80's ("Credit, Money, and Aggregate Demand"). There were, to my mind, three useful points in that paper: first, market-based credits are of two distinct flavors (auction-market ("bonds") vs. customer-market ("loans")); second, that money and credit have a (relative) symmetry that needs be respected; and third, recognition of the importance of intermediaries in the provision of credit. Shadow banking in some sense is dead by self-implosion (derivatives of derivatives won't and shouldn't reappear), but market-based credit is not and will not be (necessity is the mother of invention), but you're right, the system evolved beyond the scope of the current regulatory system. In some sense, it might be like Gödel's incompleteness theorem: no matter what system you come up with, there will always be some bubble that you can't prevent AND someone is going to inflate the bubble (since a previously unnoticed system inefficiency might be exploitable as an arbitrage)
Best I've seen yet...
written by Dave, February 13, 2014 1:11
A complicated thing... I have an answer, but I'll give it tomorrow...
Where is the political strength to pop financial bubbles?
written by John Wright, February 13, 2014 9:06
A question to ask is where are the USA institutions or Very Serious People heading up USA institutions who will courageously pop financial bubbles in the USA?

There is no powerful group (Fed, SEC, Congress, news media ) that has an institutional interest in finding and deflating financial bubbles.

It appears the VSP’s in Government, the news media, and financial industry are focused on benefitting from an inflating bubble (share price profits from financial institutions, employment opportunities, lobbying opportunities, share options profits, book writing (see Greenspan)) and have little to gain from popping a bubble.

For example, if Greenspan DID identify an Internet company equity bubble, and raise the margin requirement on stock purchases, and the stock market dropped as a result, that would not have been viewed positively by American politicians or the populace.

The same applies to the housing bubble, history might be very kind on a bubble popper, but initially they would be viewed harshly.

And our current President apparently thinks highly of regulators who don't see bubbles (Geithner) or economists who lobby for weakening financial regulation (Summers).

And I would have expected little oversight from former financial engineer Romney, if elected.

Bubble poppers are similar to whistle blowers, and, whistleblowers seem to be unwelcomed ("traitors") at first and only vindicated with the passage of time.

Hence, there is little risk of the Fed “taking away the punchbowl” before the partiers get very drunk.

The Fed takes away the punchbowl when it is bone dry and the liquor cabinet is empty.

If the costs of a bubble are eventually thrown on the great unwashed population, while the profits are grabbed by the well-connected before the bubble deflates, I don’t see what will drive the USA to de-bubble the USA economy.

The watchdogs are not there, for example the USA Congress quietly gutted its own Insider trading law, claiming security concerns, about a year after initially passing it.

I believe the VSP LIKE bubbles as they offer hope to the middle class/lower middle class during the inflation phase.

Whether this is hope offered by the “must incur large debt to get a college degree to succeed” or “must get a large mortgage to build equity in a home”.

And in this morning's news came:
"FORMER TOP S.E.C. ENFORCER SWITCHES SIDES George Canellos, the former co-chief of enforcement at the Securities and Exchange Commission, announced on Wednesday he would be returning to the law firm Milbank, Tweed, Hadley & McCloy."

"With the move, Mr. Canellos becomes the latest Wall Street regulator to switch sides,"

I simply do not the powerful closed loop feedback system that will effectively control financial bubbles in the USA.
Correction to the last sentence of my previous post, missing a "see"
written by John Wright, February 13, 2014 9:10
I meant to write:

I simply do not see the powerful closed loop feedback system that will effectively control financial bubbles in the USA.
aphorism
written by Squeezed Turnip, February 13, 2014 5:20
written by John Wright, February 13, 2014 10:10
I meant to write:

I simply do not see the powerful closed loop feedback system that will effectively control financial bubbles in the USA.


Things are worse than they appear. They are also better than they appear. For example, it was the FRB itself that made the amendment in 2001 to its HOEPA mandates so that regular mortgages could be targeted if necessary. So, while there is no evidence, we may dare to hope (or, may I quip, HOEPA) that sometimes the political system gets things right enough for things to lumber on. That said, your points are important to recognize as, at the very least, that it will take a lot of work and a committed cadre to prod reluctant VSPs to do what is not in their self-interest.
...
written by jm, February 14, 2014 1:03
The real underlying problem was the failure to take action against China's mercantilistic pegging of the yuan at, initially, only about a quarter of its true value vs the dollar.

It was this that created the huge US trade deficit, which the Chinese could support only by the most enormous 'vendor financing' fraud in history. The only thing the Chinese government could do with the mountain of dollars they had bought at four times their true value in yuan was to lend them back to the US. The result was the 'savings glut' that financed the housing bubble -- the Chinese were major holders of MBS.
THE problem?
written by Squeezed Turnip, February 14, 2014 10:10
written by jm, February 14, 2014 2:03
The real underlying problem was the failure to take action against China's mercantilistic pegging of the yuan at, initially, only about a quarter of its true value vs the dollar.


Didn't help, but that was not really THE underlying problem, but rather one of many factors that came together. Have you read this?
what happened?
written by Squeezed Turnip, February 16, 2014 10:40
This bit by Gorton and Metrick is a decent summary, but it's 2 years old.

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Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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