Markets Stopped The Madness

Eric Falkenstein:

Robert Shiller … in 2005, … wrote that in some cities “the price increases may start to slow down, and then to fall. At the same time, it is likely the boom will continue for quite a while in other cities.”  Now, compare this modest warning by a lone economist to the forces promoting home lending from all directions. It was not just a Wall Street phenomenon, but one pushed by our government, legislators, regulators, and even academics (for evidence, see Stan Liebowitzs “Anatomy of a Train Wreck“ … the Federal Housing Administration was, and is, offering loans with only three percent down, and during the boom, the Department of Housing and Urban Development promoted a program where even this minor investment could be paid for by the homebuilder. …

In light of this governmental housing exuberance, I doubt that a more powerful government would have mitigated the boom — rather, it would have made this crisis worse. Indeed, it was only the collapse of the subprime market at the beginning of 2007 as reflected by the ABX-HE subprime housing index that alerted people to the severity of this problem, and shut off financing by mid-2007, six months later. Market prices, not legislators, instigated the end of the insanity. How quickly are failed governmental initiatives usually stopped, once identified?

Human estimates are error prone; we make mistakes.  Since we listen to each other, we share our errors; we make the same mistakes together.   Our society contains many different social institutions, so those institutions tend to reflect the same estimate errors.   Thus to give credit or blame to particular institutions for a shared error, we have to look closely at who was more pushing the error to be larger or smaller, and when.

The increase in our shared housing error was slow, making it hard to say which of our institutions was pushing more for larger errors.  But the decrease in our shared housing error was fast, making it easier to assign credit there.  And according to Eric, speculative markets were the first of our institutions to clearly say we had overestimated housing values.  If we want more such error-correction in the future, we should empower such institutions more, not less.

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  • Bob

    Similarly, if you look at Construction Spending data, the private sector, which had been minting money by building houses as fast as it could during the boom, responded rapidly to downturn. Private new single-family construction spending jumped from $325B in 1995/6 (two years) to $850B in 2005/2006. That’s over $35B/month at the peak of the boom. In 2007 the number was $25B/mo, in 2008 $15B/mo, and so far in 2009 less than $8B/mo, despite residential developments being relatively long-lived and sticky projects.

  • Grant

    What a great perspective on the crisis. I’d never thought of it this way before.

    However, I don’t believe this argument directly engages the Keynesians I’ve read, who focus on the crash in housing prices (and their resulting effect on the rest of the economy, aggregate demand, etc) as being the main problem. Many seem to believe you can have the boom without the bust by implementing stimulus programs.

  • Mike

    I tend to agree that a government agency full of “hands on” regulators will not do much better and may do much worse than players in the market.

    But it seems to me there is a separate question about regulations — by which I mean laws — limiting the behavior of market players. I speak naively because I do not have an economic background, but I would guess if the Glass-Steagall Act had been in effect, the aftermath of any housing bubble would have been different than what we observe. Of course there are more and less drastic measures to consider.

  • Mike

    I should say I speak from the following perspective: the disaster of the last housing bubble, in my mind, is not so much the enormous loss of wealth (or perceived wealth), which may very well be inevitable in the most efficient realistic markets. I see the disaster as being the dramatic effect of some people’s actions on the livelihoods of others’ — in other words the contrast between who took the risks (who stood to benefit) and who bore the cost — which seems to me to be an enormous injustice.

  • Yvain

    “I doubt that a more powerful government would have mitigated the boom” – this is a bit of a straw man, isn’t it? As if the plan would be to revoke constitutional rights at random until something stuck.

    The market and government both made mistakes. But the market’s mistakes look like structural mistakes (miscalibrated incentives, privatizated gains + socialized losses, cognitive biases among the general population, completely failing to self-correct after the last time the exact same thing happened) and the government’s mistakes look like contingent mistakes (political interference spurring subsidized housing, making the correct regulations the last time this happened and then recently repealing them under pressure from deregulation-happy politicians).

    If the market’s mistakes were structural and the government’s mistakes contigent, then our best hope to solve the problem for next time is to get a smarter (not generically “more powerful”) government by decreasing things like corruption and political interference. We know it’s possible: we just have to pass the same lending restrictions that existed before and not let lobbyists convince legislators to repeal them this time.

    • James K

      Rent seeking and corruption don’t sound like contingent mistakes to me. Besides which, what regulations were removed that you think were critical? The first banks to fail were ones that would have been Glass-Steagal compliant.

  • Unnamed

    This is an interesting approach. Instead of focusing on the processes that inflated the bubble so that we can figure out how to weaken them, you suggest focusing on the processes that burst the bubble so that we can figure out how to strengthen and accelerate them. Though I don’t see any reason to choose between the two approaches – we should be doing both. And we may need to keep both in mind at once, since reforms that strengthen the bubble-popping processes may also strengthen the bubble-inflating processes (and those that weaken bubble-inflation may also weaken bubble-popping).

    This post looks like a very preliminary attempt to look at the bubble-popping forces. Even if it’s correct about what forces eventually burst the bubble, we also want to know why those forces didn’t act sooner (so that we can get them to happen sooner next time). That analysis may have a lot of overlap with the analysis of what caused the bubble to inflate.

  • Lord

    Oooo, 3% down, are we supposed to be impressed? Private lenders were offering 115% loans. Speculators work both ways.

  • jonathan

    So let’s apply this to situations. The Allies effectively ended the Nazi regime, thus alleviating the bubble of inhumanity. Sound extreme? Your argument mimics what I call “Hayekism,” the profound – and distorted – belief that what happens is what happens best and we should get out of the way and let that happen. You see this garbled nonsense in libertarian circles, offered with the usual theologist’s hubris that their philosophy is better (if only it would actually be applied to human society).

    What about the human cost of pricking the housing bubble? Does that not matter at all to you? (Hey, it’s just a bubble and bubbles grow and pop so what if the Serbians massacre the Albanians; it will work itself out in the end.) Inhumanity is inhumanity.

    And how exactly did the market function to pop this bubble in these circumstances? The housing market had turned downward a long time before the financial crisis, but the money movements were maintained and kept it alive because the government was not involved. Each of the firms involved in securitization was minting money in the short run. The individuals pocketed huge sums – and how many of them gave a flying fig about the long-term health of their companies? You MUST know the well-publicized data.

    Your point about the housing bubble self-correcting through market functions is wrong on the facts. It’s wrong because lack of regulation allowed a separate securities bubble that exacerbated and continued a housing cycle – even after housing was declining. You’re wrong on a moral basis, unless you don’t care about suffering. You’re wrong on a theoretical basis because when your idea is applied to other moral contexts it becomes sheer, immoral, inhuman insanity.