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I posted a link to Bryan Caplan’s paper on Behavioral Economics and the Welfare State. Many of the comments I got from economists were predictable:

  1. Where is the formal model and existence proofs?
  2. Where is the data analysis?
  3. How is this a paper?
  4. Do you mean to tell me this is publishable?

I too was shocked initially by these features or lack thereof. However, that’s part of what made the paper compelling.

Some papers get a wonderful data set, perform magnificent identification and get a result that really changes your mind about something you care about. Most don’t.

Most are cases that are of very narrow interest or do a 90% good job at the ID but leave enough doors open that you are not really sure if  the result is meaningful or not.

On the other hand, one could as Bryan and his co-author did, attack an important question, string together some non-obvious points and in my case leave the reader thinking about whether he or she should reexamine an import view.

The profession should rightly celebrate the first kind of paper. However, what about the relative worth of the second and the third?

I submit that bringing up arguments that use the economic way of thinking matter. This is true even if the argument is not definitive, has no mathematical proof behind it and marshals no data.

Let me give a more timely example. We are now engaged in a debate over the nature of recessions and how the government should respond. There are obviously lots of models and empirical studies, none of them perfect.

However, more than any other analysis the baby-sitting coop story made me a confident Keynesian. Before then I could parrot the New Keynesian models and understood that this was more or less what a smart economist was supposed to say.

However, I didn’t know how to counter the logic of Laizze Faire except to say, “well there are sticky prices and an Euler equation and so the household will adjust consumption . . . “  This is compelling to virtually no one – not even, on a deep level, to myself.

When it really came down to it, I would have been left with “Great Depression! Want it to happen again? No? Then we need to spend more money or cut taxes! Why? Because I am very smart and I have a whiteboard. Do you have a whiteboard?”

However, a simple story about baby-sitting and it all fell into place. Paul Krugman has retold the story many times. Its about a baby-sitting co-op that uses scrip to track how many times a couple has sat for other members of the co-op and thus how many times someone should sit for them.

Because of some mismanagement in the handling of scrip the co-op at one point went into recession. There weren’t any fewer people who could babysit and there weren’t any fewer opportunities for couples to go out. The real baby-sitting economy hadn’t changed.

Bad policies by the co-op leaders reduced the number of scrip per couple. And, for lack of scrip no one went out. And because no one went out, no one sat. And because no one sat, no one got any scrip. And, since no one got any scrip, no one could go out . . .

Excess demand for financial assets led to a collapse in the demand for real good and services. Something that seemed extremely complicated was elucidated by a simple story.

Years ago that story was printed in an economics journal. I read it in the archives.

As I have mentioned before I started warning of a Japanese style scenario in early 2008, not because of a formal model, but because of that baby-sitting story.

You see, the investment banks were like a baby-sitting couple who by borrowing and lending script and carefully tracking dining out patterns with fancy computer models had assured everyone that any couple, at any time, could find a baby-sitter whether they had physical scrip or not. Just come to us, and we’ll make it happen. No scrip down as it were.

That system was about to collapse and when that happened the demand for physical scrip was going to skyrocket. If you believed the original baby-sitting story that meant a recession of epic proportions. We were going to need a lot more scrip and the Fed didn’t seem to get that.

Nor, I should mention, did may people familiar with mainstream macro-economics. Its not that you couldn’t have gotten that result out of the math models. Its that you wouldn’t have known where to look.

You would have thought about wealth effects and the distributional impact of housing. Willem Buiter, a very smart man, insisted there would be no recession because the decline in the price of houses made homeowners poorer but homebuyers richer. This does somewhere between little and nothing to the representative agents Euler equation. However, Buiter failed to consider the simple lesson of the baby-sitting economy.

Buiter, forgot about scrip.

I once had a macro professor offhandedly suggest -in between demonstrating with Hamiltonians and representative agent models how rational bubbles could exist- that one way to identify a bubble would be the the number of complete amateurs lured into an industry. Similarly, my main data point in identifying the housing bubble was Flip That House and other shows like it.

What was happening on those shows defied everything micro theory says about how a market should behave. It wasn’t just that the behaviors couldn’t be explained by neoclassical, perfect information, Chicago School micro theory. There was no amount of information asymmetries, market power, or principal agent problems that could explain what happened on those shows.  Complete novices buy a house, spend four weeks doing a shoddy remodel, and sell it for 150% what they paid for it. This was clearly Animal Spirits.

“What is happening here cannot last”, I would tell people. If there are such insanely outsized profits to be had, surely professionals will put these amateurs out of business, owners of houses in need of rehabilitation will ask higher and higher prices,  and competition will drive prices down. Yet the shows went on for several seasons, with witless novices making profits that defied gravity.

The longer the show went on the more of a bubble I assumed was building. On the more professional home renovation shows they were leveraging up big time as well. And everyone knows hows it all ended.

I was reminded of all of this today by an excellent post from Mike Konczal pointing out this exact phenomenon across bubbles and industries:

In my personal opinion, in the same way middle-class people turned amateur stock analysts was the sign of a tech bubble, or middle-class people turned amateur realtors was the sign of a housing bubble, middle-class people turned amateur credit risk analysts and credit channel intermediaries was the surest sign of a credit bubble.

The amateur credit risk analysts he is talking about are the person-to-person lending websites that were once very overhyped in terms of their potential. This is an amateur market I had not considered, but it certainly makes sense.

The lesson here is beware the amateurs. Wherever they gather in huge profitable masses a bubble has surely formed, and the longer they are able to walk around blithely picking up $100 bills off the sidewalk, the bigger the bubble is.

Paul Krugman has linked approvingly to Karl’s post on Fannie and Freddie, and I want to use this renewed attention to his piece as an opportunity to disagree with it. Well, maybe not disagree, but at the very least I want to present an alternative story of Fannie, Freddie, and the bubble that is inconsistent with his, and which I have yet to see a strong argument against.

Whether or not you agree that a bubble had actually started by 2002, it’s clear that fundamentals had become divorced enough from historical levels to begin convincing some people, notably Dean Baker, that a bubble was present. To me this divergence and the subsequent uncertainty around it was a key driver of the huge and indisputable bubble that followed the debatable 2002 and 2003 semi-bubble.

Once fundamentals were potentially outside historical levels, it became unclear to market participants and economists what the fundamentals were anymore. Thus, a signal which traditionally could be used to hold prices in check was gone, and the only signal market participants were left with was prices themselves. It’s as if someone turned out street lights and the only way drivers could navigate is by looking at each others headlights and tail lights. It’s easy to see how this could lead everyone collectively far from the roads despite behaving rationally individually given the information available to them. This uncertainty and unanchoring of fundamentals set off the herd behavior that drove prices even higher, this lured private companies in who eventually crowd Fannie and Freddie out of the market.

Now herd behavior of market participants is also causal here, but that doesn’t mean that the initial divergence of fundamentals that set the herd off was not causal as well. However, this story does make Fannie, Freddie, and their enablers less negligent than typical stories that assign causality to them. This is because few could have foreseen that causing fundamentals to somewhat diverge from historical levels would set off such extreme herding behavior. This unforseeableness of the consequences means you can’t exactly call their policies reckless. In contrast, had they been the primary force continually driving the prices higher and higher to manic levels, as some narratives of the bubble hold, then one might call them reckless.

So that’s one story of Fannie, Freddie, and the bubble. Maybe it’s not the right one, and maybe Karl’s is, but I’ve yet to hear a convincing case for why it’s wrong.

I don’t have some all encompassing narrative of the housing bubble to weave you, or an airtight case that government policies caused the bubble, didn’t cause the bubble, etc. I just want to comment on a few points in the debate.

The argument is frequently made that Fannie and Freddie were minor securitizers by the time the bubble came to a full boil in 2006, therefore they didn’t “cause” the bubble. But the fact that private companies were able to push them out of the market doesn’t tell us anything about the initiation of the bubble. The fact is that as early as August 2002 Dean Baker, who many credit as having “called the bubble”, was saying that prices were becoming divorced from fundamentals. As you can see from Karl’s chart, this is still during a time period when GSEs constituted the vast majority of MBS issuance and were quickly ramping up:

So was Dean Baker identifying a bubble in late 2002 that wasn’t there, or were Fannie and Freddie the majority MBS issuers when the bubble started?

A lot of focus goes into who issued the subprime loans which are now defaulting and much less discussion occurs about what caused the initial divorce of house prices from fundamentals. I think Jim Hamilton’s explanation of the run-up in oil prices that led to the beginning of this recession has some applicability to what happened in the housing market. In short, prices skyrocketed because market participants (and academics) no longer knew the value of a key parameter. When demand did not subside even as oil prices went above historical levels, market participants began to wonder “what exactly is the price elasticity of oil at this level?”. As Hamilton put it:

Just as academics may debate what is the correct value for the price elasticity of crude oil demand, market participants can’t be certain, either. Many observers have wondered what could have been the nature of the news that sent the price of oil from $92/barrel in December 2007 to its all-time high of $145 in July 2008. Clearly it’s impossible to attribute much of this move to a major surprise that economic growth in 2008:H1 was faster than expected or that the oil production gains were more modest than anticipated. The big uncertainty, I would argue, was the value of ε. The big news of 2008:H1 was the surprising observation that even $100 oil was not going to be sufficient to prevent global quantity demanded from increasing above 85.5 mb/d.

Once the ratio of house prices to rents and other fundamentals became indisputably divorced from historical levels, market participants had to wonder what are the new underlying parameters were. Dean Baker said from the start that the historical levels were correct, and nothing has changed. Economists overall were agnostic. But from 2002 until 2007, those who bet optimistically were rewarded and those who bet pessimistically were punished or ignored as prices increased quickly.

If Fannie and Freddie drove the initial divorce of prices from their historical relationship with fundamentals, than they are an important causal factor. Yes, markets that myopically rewarded the most optimistic assessments of the new parameter values were a necessary condition for us to arrive at the hugely frothy markets of 2006, but so too was some first mover to push prices above historical levels.

Perhaps some of that divorce from fundamentals was real, in the sense that the equilibrium price to rent ratio grew as a result of a change in capitalization rates driven by income growth. If this is the case, then those who want to claim that the bubble was “called”, especially by Dean Baker, or that bubbles are identifiable, have a harder story to tell about when you know that a bubble has formed. What level of divorce from historical values is acceptable as real and at what level do you call it a bubble?

The post-housing-bubble narrative has been that the unsustainability of prices was obvious ex ante, and so we should be able to call them in the future. This to me seems to be a bit of hindsight bias, but it is always difficult to make a case that claims which turn out to be ex post false were nevertheless ex ante reasonable. Kristopher Gerardi, Christopher Foote, and Paul Willen have a new paper out that I’ve been waiting for someone to write. They go through pre-collapse claims of the housing pessimists, optimists, and agnostics, and evaluate not just who was write and wrong but which beliefs where obviously right and which were debatable. This is a fun and accessible paper starring a well-known cast of characters, with prominent roles for Paul Krugman, Dean Baker, and Robert Shiller, and a quick cameo by The Economist, Calculated Risk, and John Cassidy. I strongly recommend it.

Rereading the cases of the optimists and the agnostics should be a reminder to those who claim to have identified the bubble, and also argue for the identifiability of future bubbles, with a high degree of confidence. The burden of proof on those making those claims is to argue convincingly against, for instance, Himmelberg, Mayer, and Sinai who argue that you can’t just look at price to rent ratios, but must consider changes in the user-cost of housing.

Even more prominent than the housing optimists are the housing agnostics. Rosen and Haines argued that the academic consensus on the issue was that the relationship between prices and fundamentals was sound, and that overpriced markets, if they existed at all, were limited.  The authors find that the beliefs of agnostics can be summarized in this quotation from Davis, Lenhart, and Martin:

If the rent-price ratio were to rise from its level at the end of 2006 up to about its historical average value of 5 percent by mid-2012, house prices might fall by 3 percent per year, depending on rent growth over the period.

There is a tendency to call anyone who bought a home during the late stages of the bubble “irrational”, because prices were obviously unsustainable. But as the authors point out, the consensus of economists gave no indication that this was the case, and so behaving as if it wasn’t was quite reasonable for non-experts. Of course, pointing out that current prices were justified by fundamentals does not rationalize a 120% LTV negative amortization mortgage.

To those who simply point to lower lending standards as sufficient proof for a bubble, the authors offer this:

Did lax lending standards shift out the demand curve for new homes and raise house prices, or did higher house prices reduce the chance of future loan losses, thereby encouraging lenders to relax their standards? Economists will debate this issue for some time. For our part, we simply point out that an in-depth study of lending standards would have been of little help to an economist trying to learn whether the early-to-mid 2000s increase in house prices was sustainable. If one economist argued that lax standards were fueling an unsustainable surge in house prices, another could have responded that reducing credit constraints generally brings asset prices closer to fundamental values, not farther away.

I believe the case for humility about the obviousness and knowability of bubbles is underappreciated. Many, I’m sure, will simply point to the pre-bubble agnostic consensus of economists as more evidence that economists are rational expectations obsessed, over-mathematized fools who don’t know what they’re doing. I think they would benefit from a close reading of this paper.

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