False Profits: Recovering from the Bubble Economy

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False Profits

Berrett-Koehler Publishers, Inc.

Chapter One

Imagine if the economy were managed by people who did not know basic arithmetic, the stuff that we all learned in third grade. Imagine further that as a result of their inability to understand simple arithmetic, huge economic imbalances grew to ever more dangerous levels.

If this happened, surely the business and economics reporters would be on the job, pointing out the ungodly incompetence of the country's top economic officials and the risks that their ignorance posed for us all. Undoubtedly, thousands of economists, all quite skilled at mathematics, would be pointing out the errors. Members of Congress, especially those sitting on the committees that have major economic responsibilities, would be organizing hearings to call attention to the mismanagement of the economy.

If the media, the economics profession, and Congress somehow failed to move quickly enough, and disaster struck, certainly those most responsible for this calamity would lose their jobs and suffer public humiliation. Lengthy news stories would denounce problems in our system of governance that allowed for extraordinary incompetence at the highest levels.

Not in America.

The basic story of the economic crisis is that the top economic leaders acted as though they were ignorant of third-grade arithmetic. The fact is, they are not—these are intelligent people—but they ignored enormous imbalances in the U.S. economy that could have been easily detected with nothing more than a third-grade education and common sense. Specifically, they ignored the growth of a housing bubble that eventually expanded to more than $8 trillion. They also ignored the inevitability that this bubble would collapse and devastate the economy.

One can speculate about the reasons our economic leaders ignored this massive threat to the well-being of the economy and the country as a whole. For a while, everything seemed fine, as long as the growth of the bubble expanded the economy and created jobs. In addition, politically well-connected people in the financial sector were making enormous fortunes. Those responsible for managing the economy had real incentives to ignore a looming crisis, even if it was completely apparent to them.

Where were the business and economic reporters? They generally show extraordinary deference to the Federal Reserve Board (Fed) chairman, the Treasury secretary, and other top economic officials. In fact, in the late 1990s, a prominent Washington Post reporter wrote a glowing account of Alan Greenspan's management of the economy titled "Maestro." Few reporters are confident enough about their own analytic abilities to directly confront top officials and suggest that they are fundamentally mismanaging the economy. After all, the Fed chairman, Treasury secretary, and the rest are very smart people; otherwise they would not hold these positions.

What about the thousands of independent economists? Surely they would have sufficient confidence in their analytic abilities to raise the alarm. Simple economic analysis suggests that they are unlikely to speak up against a consensus in the profession. But even a confident and smart economist cannot be certain that she is right. After all, we all make mistakes. If Alan Greenspan says that black is white, he could be right.

Questioning the status quo becomes even more intimidating when everyone else seems to agree. When Alan Greenspan says no housing bubble exists, and all the other big-name economists more or less concur, then maybe black is white. A young economist seeking tenure, or even a more established economist looking to move up the profession's ranks, would be taking a great risk by warning about the housing bubble. The price of being wrong would be ridicule and the likely end of any hopes of career advancement. Sticking with the mainstream of the profession would be far safer.

The incentives for conformity created by the sociology of the economics profession run deep. Robert Shiller, a Yale economics professor and one of world's preeminent financial economists, began warning of the housing bubble in 2003. However, even he noted how constrained he felt he needed to be in his warnings. Shiller didn't want to be rude in pushing his view, in spite of the fact that he knew that failure to contain the bubble could lead to the sort of economic disaster that we are now experiencing.

When those within the core of the profession are constrained from raising the alarm by the positions they hold, the job is left to those at the margin. And those at the margin are, by definition, marginalized. So, if Alan Greenspan says that everything is fine, the public should not be concerned if a few economists at the margin of the profession are pointing to the storm clouds on the horizon.

As far as the hope that our representatives in Congress would raise the alarm—let's just state the obvious: politicians are rarely leaders. The most effective politicians detect changes in public sentiment and respond to them quickly. They don't get out in front and warn the public of new problems that are not yet widely recognized. Very few politicians—certainly none in leadership positions—would challenge the consensus within the economics profession.

The ignorance of those who should have known better was abetted by the fortune that the financial industry was making off the housing bubble. Top executives in the industry were offering substantial rewards to their friends in academia and politics who went along for the ride. The truth plus 50 cents may buy a cup of coffee, but most of those who could have blown the whistle were looking for something more. The top executives of Citigroup, Lehman Brothers, Bear Stearns, and other financial institutions central in providing the financing that propped up the bubble had no interest in bringing the party to an early end.

What about after the fact? Once the bubble burst and the damage had been done, we would expect the people who failed at their jobs to be held accountable. Maybe somewhere, but not in this country. The basic story is that the people who failed to warn of the housing bubble are the people in charge of repairing the damage.

The people reporting on finance today are for the most part the same people who ignored the bubble in the years 2002–2007. They have little interest in admitting how easy it was to both recognize the bubble and predict the resulting damage from its collapse. The economists who either didn't see the bubble, or didn't want to stick their necks out by discussing it, are the same ones charting the economic path going forward. They don't want to call attention to the difficulties they seemed to have with third-grade arithmetic. And the politicians are still listening to the bankers, who still have lots of money for campaign contributions.

So, instead of inquests and exposes, we get cover-ups. Almost all discussions about how we failed to see catastrophe coming focus on the financial aspects of the crisis, many of which are complicated, and ignore the fundamental cause: the huge overvaluation of the country's housing stock. Once the topic moves from bubble-inflated house prices to credit default swaps and collateralized debt obligations, nearly everyone following the news is safely lost.

In this financial crisis story, the crisis is talked about as if it were a rare and highly unlikely event—a black swan—rather than one that could be predicted with absolute certainty, even if the timing and exact course of events could not be known. Instead of firing all the people who didn't do their jobs, Washington's policy elite has instead focused on creating a new agency—a "systemic risk regulator"—responsible for detecting such "unlikely" events in the future.

The "systemic risk regulator" is the ultimate joke on the country. We already have a systemic risk regulator. It's called the Federal Reserve Board. At many points it has staged extraordinary interventions whenever it felt that events in the financial sector were spinning out of control and threatening to seriously harm the economy. Alan Greenspan's efforts to shore up the stock market after the 1987 crash and his intervention in the unraveling of the Long-Term Capital Hedge Fund in 1998 provide the two most obvious examples.

The problem was not that we lacked a systemic risk regulator but rather that we had one that failed catastrophically at its job. Rather than holding our failed regulators accountable, we are pretending that their job descriptions were the problem. This response is akin to creating a new government agency to rescue people from burning buildings after an especially deadly fire. The more obvious solution is to dump the head of the fire department.

The assumption would be that if people died in burning buildings, it was because the fire department hadn't done its job. When the economy suffers a collapse like the housing crash recession, failed economic management is the culprit. The way to improve economic management is to hold the managers accountable for their performance, thereby giving them an incentive to buck the consensus opinion and say what they believe to be correct. Covering up failure is a recipe for more failure.

Regulators and others in policy positions certainly face risks by stepping out of line. But these people must come to know that they face comparable risks by not stepping out of line when the situation demands it. In other words, if we want good policy, we must let those in policy positions know that they will be fired if they don't warn us about an enormous housing bubble.

Those who ignored the housing bubble messed up horribly and should be fired. Instead, it appears that they will escape virtually any sanction. Left in place, they will do more damage and set the worst possible example for regulators and policymakers in the future.

The Story of the Housing Bubble

The basic story of the housing bubble and its collapse is simple. For 100 years, from 1895 to 1995, nationwide house prices in the United States tracked the overall rate of inflation. This trend meant that, on average, house prices rose at the same rate as the price of other goods: food, cars, clothes, and so on. Differences in the rate of price increases among geographic areas were large. House prices in places like the New York suburbs or San Francisco did rise far more rapidly than the overall rate of inflation. But rapid price increases in these areas were off set by prices that trailed the rate of inflation in areas like Gary, Indiana, or St. Louis, Missouri. These areas of falling house prices were large enough to keep nationwide house prices just even with the overall rate of inflation.

Some price variation by year was also common. During some years, house prices did rise more rapidly than the overall rate of inflation, sometimes for four or five years in a row. But even in these cases, the cumulative increase in house prices was only slightly greater than the rate of inflation, in the range of 10 to 15 percentage points. Eventually these run-ups would be off set by house prices that rose less rapidly than other prices.

A 100-year trend is an extremely long trend in economics. Over this same period, the U.S. economy experienced huge changes, including the massive immigration wave at the beginning of the 20th century, two major wars, and the Great Depression. A trend that persists through all these changes, especially one that occurs in the largest market in the world, should be taken seriously. Prices in smaller markets, for example, the market for a mineral like gypsum or quartz, may be subject to erratic forces that lead them to fluctuate in unusual patterns. But the housing market in the United States was a $10 trillion market in 1995, even before the bubble sent prices through the roof.

In short, given the enormous size of the market and the history of house prices, economists had good reason to take notice when, in 1995, those prices began to outstrip the overall rate of inflation. When I first wrote about the housing bubble in the summer of 2002, house prices had already outpaced the overall rate of inflation by 30 percent, creating more than $3 trillion of housing-bubble wealth. Even by that point it should have been evident that the housing market was in a seriously expanding bubble. Absolutely nothing on either the demand or the supply side of the market—that is, in the fundamentals of the market—could have explained this unprecedented increase in nationwide house prices.

On the demand side, the two main factors are income and population. If income grows rapidly, people may want bigger and better homes, or even second homes. Other things being equal, a more rapidly increasing population will lead to more rapid growth in the demand for housing, especially if the growth rate is high among people in their 20s, who are forming their own households for the first time.

Neither of these factors offers an explanation for the run-up in house prices during this period. Income growth had been healthy during the late 1990s, but it was not extraordinary. The rate of growth of median family income over the four years from 1996 to 2000 was no more rapid than the growth rate over the long boom from 1947 to 1973. Yet, in that era, house prices did not even keep pace with inflation. Furthermore, the country had fallen into a recession in 2001, and family income had begun to decrease. Income growth remained weak right through the rest of the bubble period, even though some modest gains occurred in 2005 and 2006. Income growth alone could not explain the extraordinary increase in house prices during this period.

Population growth is an even less plausible explanation. Although Alan Greenspan once cited immigration as a factor pushing up prices, the reality is that the inflow of immigrants in the 1990s and the following decade was a relatively minor phenomenon compared with the demographic bulge created by the baby-boom cohort. (In addition, not many immigrant families would have been able to afford the $400,000 homes that were standard in bubble markets like Los Angeles, San Francisco, and Washington DC.) The rate of household formation was far more rapid in the 1970s and early 1980s, when the baby boomers were first forming their own households, than in the bubble years.

By the mid-1990s, the overwhelming majority of the baby boomers who would ever be homeowners already owned a home. These families were watching their children finish school and leave home. By the end of the housing bubble, the oldest baby boomers were already in their 60s. If anything, the baby boomers would be looking to move into smaller homes. A population-driven increase in the demand for homes could not explain the extraordinary run-up in house prices either.

Economists should have been well aware of the country's demographics; the future of Social Security was one of the main topics of economic policy debates throughout this period. The main (and not very accurate) story line for the Social Security "crisis" was that the program would soon be overwhelmed by the retirement of the baby-boom cohort, which would lead to a large increase in the ratio of retirees to workers, resulting in benefit payments vastly exceeding tax revenue.

The real story of Social Security was less frightening than the claims of those who wanted to privatize the program; but the basic fact that the ratio of retirees to workers was rising should have immediately told any economist that attributing the run-up in house prices to demographics was nonsense.

Neither income growth nor population growth, the two main factors on the demand side, could explain the run-up. The supply side of the market offered no better explanations. Alan Greenspan once suggested that environmental constraints on building were one cause of the run-up in house prices. This explanation should have immediately prompted derision.

Despite certain environmental restrictions on building during the era of the housing bubble, that era was hardly the high point of the environmental movement. The Republican takeover of Congress in 1994 would have constrained any environmentalist excesses at the national level. Moreover, the Republican takeover of many state legislatures and governorships in the same election would have curbed environmentalist drives at the state level as well. The belief that environmental restrictions were imposing more constraints on the supply of housing in this period than in prior decades had no basis.

Greenspan also suggested that the limited supply of buildable land in desirable urban areas was a factor pushing up house prices. Land in urban areas is limited, but this reality was not new to the mid-1990s. This constraint had not led to a run-up in house prices over the prior hundred years, so why it would have made these prices suddenly rise nationwide in 1995 is difficult to fathom.

(Continues...)

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Excerpted from False Profits by Dean Baker Copyright © 2010 by Dean Baker. Excerpted by permission of Berrett-Koehler Publishers, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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