Tag Archives: bubble

Housing Bubble Redux

The root cause of the financial crisis was the housing bubble, going back to Clinton’s repeal of Glass Steagall and looting at FNMA, but – what was the trigger? Understanding the chain of events helps us to evaluate the policy response, and also suggests what to look for the next time.

The nadir, as everyone knows, was the S&P 500 touching 666 in March 2009, before its rescue by Chairman Bernanke. Lehman Brothers had failed in September 2008, precipitating the crash in October, but the market had peaked a full year earlier.

Crash Chart

The NBER identified December 2007 as the recession’s start, and it’s not surprising that the market peaked a few months ahead. It is generally a leading indicator for the economy. Mortgage lending, with its new ecosystem of boiler rooms and dodgy paper, had been shaking out all year. This is variously attributed to a dip in housing prices, declining demand for mortgage backed securities, and rising mortgage interest rates.

… the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not – FCIC

So, among the proximate causes, which was the trigger? Did the Fed pop the bubble by raising rates? Probably not. Fed funds had ramped steadily throughout the bubble, but had been flat at 5.25% since July 2006. That’s an indication the Fed was trying not to spoil the party.

Housing Bubble

Mortgage rates peaked in July 2006 and so, roughly, did the Case-Shiller home price index. The chart shows rates following the price trend up, and then following it back down.

It’s reasonable to suppose that the recession started and then people couldn’t make their mortgage payments, but the timing doesn’t support that. The recession was not a cause of the bust, nor was it obviously an effect. Delinquent mortgage payments, especially for Miami condos, had been on the rise throughout 2006. This chart is from the Financial Crisis Inquiry Commission.


These were flippers running out of people to flip to, like punters at the end of a chain letter, plus some poor fools actually occupying the homes and trying to make the payments. The trough of the rate trend was around 2003. If you had signed an ARM then, your interest rate had just about doubled by 2006.

  • Delinquencies start to rise in 2006.
  • Home prices peak, June 2006.
  • Mortgage rates peak, July 2006.
  • Mortgage bonds downgraded, July 2007.
  • Stock market peaks, October 2007.
  • Recession starts, December 2007.
  • Stock market crashes, October 2008.

Right up until the crash, this reads like a normal business cycle recession. David Stockman argues that main street banks were never in danger from the housing market, because they had been run out of it by big investment banks. On this reasoning, policies like TARP, ARRA, and QE were a response to Wall Street, not the recession.

If you had been alert, you could have predicted when the housing bubble would burst simply by looking at the timing of the 5-year ARMs. Stanley Druckenmiller knew that risk premiums were too low in 2004, but it took him another a year to identify the housing bubble.

When you have zero money for so long, the marginal benefits you get through consumption greatly diminish, but there’s one thing that doesn’t diminish, which is unintended consequences.

We are in a similar phase now. Everyone knows that six years of ZIRP have planted a bomb somewhere in the economy, but no one knows for sure where it is.


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Stories to Frighten Children

MedalCommentators like to exclaim about how much “market cap was lost” or “wealth was destroyed” by the latest drop in price. In a market crash, however, the drop does not destroy wealth. It merely reveals the true level of wealth. Destruction happens on the way up, as irrational exuberance leads to poor investments.

Watching the numbers on Wall Street, it’s easy to forget that investments ultimately are made in earning assets like shops, labs, and factories. It’s during the bubble phase that wealth is destroyed, by funding investments that never pay off.

The EU has had to deal with two crises … The first was obviously the global financial crisis, caused by major falls in asset values. – Douglas Flint, remarks to House of Lords October 2014

We were reminded of this popular misconception when we read it recently in Douglas Flint’s testimony before the House of Lords. This statement is an oversimplification, to put it politely. “Major falls in asset classes” did not materialize out of nowhere.   Is there anyone in the House of Lords who accepts this account of the crisis? It seems scripted – for children, perhaps, or the CNBC cheerleaders.

Masaaki Shirakawa comes off as rather better informed, but still surprised (!) to discover asset price bubbles. In fairness, the Japanese bust was the first of its kind among developed economies in the postwar era.

We have to start by recognizing this odd reality of bubbles being accompanied by price stability, yet then followed by instability of the financial system, subsequently bringing about low growth and often inflation that is lower than desired. – Masaaki Shirakawa, remarks at BIS conference March 2014

Yes, this odd illusion of stability – like ice over a flowing river. He goes on to describe a central bank misled by consumer prices into “accommodating” an asset bubble, which in turn destabilizes the financial system. The ensuing low growth, we have to say, is the true trend rate.

Our purpose here is not to single out people, like Mr. Flint, who should know better. We are intrigued, however, by the long list of trained professionals who continue to be surprised by this well understood chain of events. This prescient article, subtitled “central banks should pay more attention to rising share and property prices,” is from 1999.

U.S. house prices have risen by nearly 25 percent over the past two years … but these increases, [Bernanke] said, “largely reflect strong economic fundamentals.”

This studied “surprise” is starting to wear thin. Have America’s central bankers purposely inflated bubbles and then lied about it? That seems a little extreme. Maybe there’s another explanation. Here is an iconoclastic way of looking at our American trendline:


Maybe, without the tech bubble and the housing bubble, the S&P 500 would have run flat around 1,200. Raghuram Rajan has said that Western leaders are using credit to compensate for their citizens’ loss of purchasing power. They have a powerful incentive not to admit their economies are in decline. Boom and bust cycles, six or seven years long, are preferable to obvious stagnation – especially on an elections calendar.

If the Fed were not complicit in this deception, politicians would change the Fed. Consider Sen. Schumer’s famous “get to work, Mr. Chairman,” or this one from Sen. Gramm – mere weeks before the NASDAQ crash:

 “Don’t become so frightened by success that you throw wet blankets on a fire that isn’t burning.”

Central bankers aren’t stupid, and they aren’t independent. They know their political masters enjoy a rising stock market, and can easily escape blame for the inevitable crash – especially if the crash is inexplicable, and entirely unforeseen.

See also: America’s structural trap

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Mind the Wealth Gap

Bubble MachineStandard & Poor’s, God bless ‘em, have figured out that America’s rising wealth gap is responsible for our boom and bust economy. Obviously, blaming anything on a “rising wealth gap” will have a certain political appeal, but – this is to mistake cause and effect.

What Raghuram Rajan and (separately) Larry Summers have said is that the advanced economies ran out of gas in the late twentieth century, leaving us not only in secular stagnation, but with unsustainable social commitments. Since Chairman Greenspan, Fed policy has been to “jump start” the economy with cheap funds, making available – on credit – a lifestyle we can no longer afford.

Those to whom the system brings windfalls … become ‘profiteers’, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat.

So, we had an economic boom and the tech bubble in the 1990s, and then a bust. Next, federal policy joined cheap Fed funds to produce the housing bubble, and – now we are on the third bubble in recent memory.

The “rising wealth gap” is responsible for this? Quite the contrary. Our monetary policy is a trillion dollar bubble machine. Whoever is nearest the spigot is going to get rich fast even if – as Keynes observed – he’s not trying. There’s your rising wealth gap. It is an effect, not the cause, of our boom and bust economy.


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America’s Structural Trap

GMJeremiah has been raving that all monetary easing since QE1 has been overkill.  Outside of the establishment economists in Washington, this is the majority view.  Everyone from fund managers to Occupy says the Fed is not helping – the former, even as they rake in profits.  Now, we have unearthed a paper that gives a name to the problem.

But first, here is Larry Summers speaking at the IMF economic forum.  If you can’t open the FT link, watch the speech on YouTube.  Summers has the nerve to say out loud what the others now claim to have been thinking all along.

Four years ago, the financial panic had been arrested … but, in those four years, the share of adults who are working has not increased at all.  GDP has fallen further behind [its] potential …

This may be why Summers was dropped from the short list for Fed Chairman.  He says there should have been a rebound after the crisis.  Summers goes on to suggest that our equilibrium interest rate may be negative, and he draws a parallel with secular stagnation in Japan.  The implication is that we only have full employment during a bubble, and – we may have been in this structural trap since the 1990s.

About ten years ago, Robert Dugger studied the situation in Japan.  Recently, people have taken new interest in his work.  We found this on Minyanville, and the original paper is here.  The charm of Dugger’s paper is that, reasoning from Japan’s experience, he was able to predict exactly how such a situation would unfold in America.  The details are uncanny.  You would think he had just written it last week.

In a structural trap. extremely loose monetary policy perpetuates deflation and low GDP growth, because unproductive but politically important firms are allowed to survive and capital reallocation is prevented.

A structural trap looks like a liquidity trap, except that the Fed can’t generate a credible expectation of inflation – because everybody knows the real economy is flat on its back.  What it takes to revive the economy is that you have to let old line companies go bust, so that workers – mostly young workers – can get new jobs in new industries.

TrapThat’s a lot of pain, but it would be over by now.  The alternative is that we languish in this weak recovery, possibly forever.  Larry Summers actually said forever.  Japan is going on twenty years.

Dugger recognized that no politician has the nerve for this, and that’s where an independent central bank comes in.  Remember Chairman Volcker tightening the screws in the 1980s?

Now that he is not facing another election, President Obama can afford to be bold.  He should appoint a monetary hawk as Chairman, and pursue a policy of structural reform.  That may be a stretch for the man who bailed out GM, but we can hope.

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The College Bubble

Another of Jeremiah’s wacky ideas has gone mainstream.  Here is the Pope Center’s George Leef discussing the “college bubble” on Bloomberg.  He makes the same analogy as here, that government policy helped inflate both the college bubble and the housing bubble.

Any degree, from any place, at any cost [was] going to be a great investment

This contrasts with the view of College Board’s David Coleman that “a college education is the best investment a young person can make.”  It’s worth four minutes to watch Mr. Leef.  He is lucid, and sympathetic to the cause.  He allows that college is a good investment for some people, but not all – just like buying a house.

The rest of the story, as you know from Amanda Ripley and Angel Gurria, is that many American students leave public school unprepared for college, and then they sit through four years of an overpriced diploma mill before finally settling down to work at Starbuck’s.

The whole process is reminiscent of Soviet factory production, in which products are churned out – college graduates, in this case – with no attention to quality or market demand.

See also:  Poder a los Estudiantes

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First Rule of Tax Policy

Jeremiah was so pleased with the Chile post, he has us ransacking tax policy around the globe.  This nugget is from Canada:

Interest on a loan secured by your home is NOT tax deductible, UNLESS you use the money for a profit making investment.

This is one reason Canada didn’t experience the housing crash – although pundits say it could still happen.  Canadians pay tax on government bonds, but not their savings accounts.  To an American investor like Jeremiah, Canada is “through the looking glass.”  Run, don’t walk, to put your money in a Canadian bank.  They’re offering 1.1% APR.

You may have noticed that our national economy staggers from one bubble to the next.  Jeremiah is not the first to make this observation, but he is the first to coin a general rule:

If government policy favors some good or service, then the price of that good or service will become a bubble.

This simple rule explains the housing bubble, the dot com crash, the student loan crisis, municipal bankruptcy, and even the high cost of medical care.

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