A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Tuesday, December 11, 2007

Housing bubble counter factual

What would the economy look like without the debt bubble and financial dysfunction?

Only two years ago, those of us who refused to buy a house and actually turned down the free money of guaranteed house appreciation were viewed as sad relics of a bygone age. We didn't understand. What was it that we didn't understand?. That house prices always went up.

If we pointed out the historical fact that house prices did not always go up, or suggested that prices were going up now as a function of a bubble, the reply was seldom verbalized. Instead it was expressed with a simple and sad shaking of the head from side to side. The gesture used for those doomed to be eternally poor on account of addiction or stupidity.

Now it is not quite the same. But close. The shaking of the head is peremptory. How can we presume to have seen something that nobody saw or could have seen? Do we not realize the criminal culpability of [pick one] blind bankers, predatory mortgage brokers, incompetent rating agencies, lax regulators or -- the favorite -- borrowers consumed by greed-lust for houses?

It is not generally acknowledged today that the outcome was predictable in general if not specific form. It is all, to quote the noxious, a "perfect storm." Even fewer accept that there is any value in hashing over old and now very painful history.

Today we are going to look at what happened, try out a counter factual of what did not happen, and hope the result displays some targets for the future.

1. What happened.

Record low interest rates came out of the dot.com bust. They were held low for a long time and created a housing bubble, as investors professional and amateur saw the prices appreciating and money being made in solid equity year after year. The industry was sold on growth. The investment community came to rely on the gains. A corruption in the form of predatory lending to create paper for near fraudulent securities extended the bubble. Finally perpetual rises could not be sustained. The paper melted. It will continue to melt over the next five years. There is nothing to do about it, barring an impossible ignition of price appreciation in real estate. Not stabilization. Appreciation.

We are left with burdened households and a financial marketplace that insists on ever more and cheaper money, hoping that paper will turn to water and make the worthless into valuable.

2. What did not happen


A counter factual argument has to begin with acknowledging the fact that without cheap money from Alan Greenspan and the housing bubble, the recession of 2001-02 would have been much longer and deeper. Business investment over this period has been tepid and shallow and would have been no less so absent the household demand created by the bubble.


The bubble economy might have been shorter in the presence of a valid regulatory regime such as exists, for example, in all other countries in the world. Hedge funds, SIVs, CDOs, adjustable rate and low-doc mortgages are financial innovations only in the sense they figured a way past traditional and well-understood business practices and into a realm of free market that was free from legal, ethical and professional compass.


Mortgage payments would have been about the same for those who took them out. Lower interest was quickly translated to higher price.


George Bush would not have been reelected. His hallmark tax cuts would not have had the smoke of low interest rates to disguise their ineffectuality. Gaping budget deficits in precisely the amounts of the tax cuts would have exposed the scam as a simple shift of taxation from the rich of today to the children of the middle class tomorrow.

3. Targets

If a low-interest bubble economy was all that separated us from recession, What do we have to look forward to? We have the financial ruin of millions of would-be homeowners to deal with, along with a dysfunctional financial sector, and now a falling dollar. Soon we will have inflation.

The first and most obvious thing is to return integrity to the financial sector itself. A one-page summary of terms is available that could have covered every mortgage let and eliminated a large fraction of the predation that is now exposed. Prosecution of predatory lenders ought to be undertaken wherever it can be shown they violated their implied fiduciary responsibility to help people get the best deal.

The lending activity of banks. Healthy economic growth needs transparent, stable financial structures. Innovation is too often a word for illusion. Regulators need to know what is going on. Investors need to know what is going. Risk needs to be explicit, not masked. How can we run around the world preaching against corruption and allow this sort of business to go on right in the heart of the financial system?

Second, we need to find the demand that is going to pull the economy forward. When recession occurs, everybody becomes a demand sider. That is the genesis of the hullabaloo about lower rates. It is presumed that lower interest will stimulate demand.

(Ben Bernanke and the Fed may be less attuned to this. Their policy statements have focused on the "turbulence" quote unquote in the financial markets. As we noted in our last podcast, this turbulence is caused by the collapse of the house of cards, running from usurious subprime loans through shady SIVs and into portfolios around the world as bogus collateralized debt obligations.)

IF LOWER RATES ARE SUPPOSED TO REKINDLE DEMAND, EXACTLY HOW? The Fed's short-term rates have lost connection with long-term rates. Even if they were still connected, do we expect businesses to begin to invest, even at zero percent. Or perhaps another housing boom?

Obviously not.

Government deficit spending, then? We have a war. That's spending. And costing.

I will just posit two parts to a successful stimulus.

Part One: Tax financed. Taking the froth off the top will do nothing but help rebuild a sound economy.

Part Two: Transportation infrastructure, energy R&D, products that mitigate global warming -- we need these. Creating demand for them through government can be the demand engine. Please note there's a lot of work for corporations here.

Monetary policy has foundered in a chaos of its own making. If we expect a carriage out of the Fed's magic wand of short-term interest rates, we'll end up spending a lot of time looking at rotting pumpkins.