Not a Bubble

Alex Tabarrok of Marginal Revolution has gotten a lot of (mostly dissenting) attention for his argument that there was no housing bubble (hat tip: hmm, I don't even remember, but I'll cite Paul Krugman, Jane Galt Megan McArdle, and Battlepanda, among the many who have pointed to the post). Alex Tabarrok reproduces Shiller's now-famous chart of housing prices over the past 100 years and comments:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 [culminating at an index value around 200] was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average. Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007). Prices have fallen more in the hottest markets but the run-up was much larger in those markets as well.

Prices will probably drop some more but personally I don't expect to ever again see index values around 110. Do you?

As Battlepanda points out, "Do you?" is not a very convincing argument unless you already agree with him. But I think I can make it a little bit more convincing:

Prices will probably drop some more, but personally, given the likely effect that an additional 40% drop in home prices would have on the already weak economy, I don't expect that the Fed will allow index values to fall to anywhere near 110 in the foreseeable future. Do you?

Some people will respond with something like, "OK, I don't either, but that doesn't mean it wasn't a bubble; that just means there's a Bernanke put on home prices: there was a bubble, and the Fed is now going to ratify the results of the bubble." But that's not right. The Fed is not actively causing inflation in order to bail out homeowners and their creditors. The vast majority of professional forecasts call for the inflation rate to fall over the next few years. The Fed is just doing its job -- trying to keep inflation at a low but positive rate while maximizing employment subject to that constraint. The ultimate concern of the Fed is to avoid deflation, which becomes a serious risk if the US housing market has a total meltdown. It's very much as if the Fed were passively defending a commodity standard, with the core CPI basket as the commodity.

The ultimate source of the housing boom is the global surplus of savings over investment. That surplus is what pushed global interest rates down and thereby made buying a house more attractive than renting. And that surplus is still with us. If anything, it appears to be getting worse, as US households begin to reject the role of "borrower of last resort." And it is that now aggravated surplus that threatens us with weak aggregate demand and the risk of economic depression in the immediate future -- a risk to which the Fed and other central banks will respond appropriately. Until the world finds something else in which to invest besides American houses, the fundamentals for house prices are strong -- not strong enough, probably, to keep house prices from falling further, but strong enough to keep them well above historically typical levels.

The Deficit is Good

I’ve said this before, but perhaps not in such bald terms. You can reasonably complain about the composition of expenditures or the composition of revenues under the fiscal policies of the last 7 years. But if you think the existence of a deficit – I mean a large deficit – has been a bad thing, you are just wrong. Back in 2006, I went into a lot of theoretical reasons why the deficit might be a good thing. But in the light of the housing crisis, it has become clear to me that there is a very simple reason why the deficit really has been a good thing: we have needed a fiscal stimulus this whole time (except maybe for, hmm, say February and March of 2006).

In fact we needed a much larger fiscal stimulus than what we had. Because we only had a relatively small fiscal stimulus, we had to rely on monetary policy to keep the economy going. That’s why we had a housing boom, and that’s why we are having a housing crash. Now I’ll grant you that policies such as better regulation could have reduced the severity of the boom and the subsequent crash. But that would have meant less aggregate demand arising from the housing sector (from the construction industry, mortgage equity withdrawal, etc.). And that would have meant a weaker economy. And as Paul Krugman suggests here, an economy with 63% of the population working was already nothing to write home about.

So…I’m not sure what to think about all the craziness that has been going on in the housing market. I’m not going to condone fraudulent mortgage originations or to say that it was a good thing that the bond rating agencies based their ratings on unreasonable assumptions. But all that was barely enough to keep our heads above water. I’m damn glad we’ve been running “large” budget deficits for the past 7 years. I’m glad Alan Greenspan made a ridiculous argument in 2001 about how terrible it would be to run out of Treasury bonds. It was the wrong argument, but the right conclusion.

I’m not glad about all the people that have died or been maimed in Iraq. Some things are clearly worse than a weak economy and a volatile housing market. But if the Iraq war hadn’t happened, I hope we would have found some other excuse to spend the money.

Falling Angels

Tanta at Calculated Risk has an interesting (but very long) post about the nature of “subprime” lending. A central idea is that, before the recent lending boom, subprime borrowers were essentially just prime borrowers whose credit had gone sour – typically people with mortgages who needed to borrow more money to keep making the payments on their existing mortgages. The availability of “traditional” subprime loans often allowed them to avoid default on their original mortgages, which kept those mortgages in the “prime” category. The increased availability of subprime credit in recent years has thus helped keep down default rates on prime loans. But now that subprime credit has dried up, the prime loans are going to start looking worse than ever: potential defaulters that would, in the past, have been caught by the subprime safety net, will now become actual defaulters.

It occurs to me that there is an imperfect but perhaps useful analogy to be drawn with the junk bond market in 1980s. Prior to the 1980s, “junk bonds” were almost all “fallen angels” – bonds that had been considered investment grade at the time they were issued but which had been downgraded. During the 1980s, through the efforts of Michael Milken and others, it became acceptable to issue bonds with low ratings, and the junk bond market as we now know it was born. As I recall, the junk bond market fell into disarray in 1990, but it eventually recovered, Michael Milken got out of jail, and “high-yield bonds” are now a permanent niche within the investment world.

Tanta is not so optimistic about the future of subprime lending for original purchases (analogous to the type of junk bond issuance that became popular in the 1980s). She seems to regard that type of subprime lending as an inherently bad idea. On the other hand, she sees the “fallen angel” type of subprime lending as being critically important, and she argues that (particularly given the type of positive feedback that occurs in the housing market) most prime borrowers are in danger of falling from grace: “We are all subprime now.”

Keynes (quoted by DeLong) on Liquidationism

Brad DeLong digs up a nice quote from Keynes, which makes a point similar to what I was trying to argue here, here, and here. I can't claim that the recent US housing boom was either quite as benign or quite as productive as the investment boom of the late 1920s, but the same general principle applies. The behavior of investors in the late 1920s appeared quite reckless in immediate retrospect, but they obviously did more good than harm (or at least, the great harm that resulted indirectly was only because of subsequent bad policies). And we do now, of course, have to be concerned about the risk of inflation, which was not (or shouldn't have been) an issue in the early 1930s. But the idea that speculators have to be severely and broadly punished by the monetary authority for taking excessive risks -- that idea, I contend along with Keynes, is foolish. It is very hard to distinguish which speculative actions were ex ante prudent and/or valuable and which were excessive. It is (as the Fed now clearly realizes) not the job of the central bank to make such judgments after the fact (or, except in its regulatory role, before the fact). The mandate is for high employment and reasonable price stability, and it is not desirable that the mandate should be broadened to include assuring the right incentives for speculators.

All for the Want of a Nail

I’m going to pick on Jeff Miron again, and in this case my only source is a couple of paragraphs in Monday’s Harvard Crimson (hat tip: Mark Thoma), so I won’t pretend that I’m really being fair to him, but I think these paragraphs are representative of a point of view that is in need of attack:

Miron...expressed less sympathy than others for the subprime lenders and borrowers, who he suggested are playing the roles of both perpetrator and victim in the current crisis.

"The subprime event is not that big a deal. It’s a small part of the economy. There will be some foreclosures, banks will lose money. That’s life. That’s capitalism. They took risks, and they lost. Policy should not bail out people for greed and stupidity, or their risk taking."

As it happens, I do think that we should have some compassion for subprime borrowers and lenders, not necessarily out of general compassion but for the reasons I discussed here. But I see that compassion as a minor issue. The fact that interest rate cuts (for example) would help these people, is one additional pebble in the balance that weighs toward my advocacy of interest rate cuts, but by itself this factor is not enough to make 25 basis points worth of difference in my opinion on the federal funds rate target. Is it possible that this factor – and the associated “moral hazard” issue – weighs 25 basis points worth (or more) against interest rate cuts for some people? It seems like it does, and that seems foolish to me, but let’s get to the main issue:

The subprime event is not that big a deal. It’s a small part of the economy.

Quantitatively speaking, it’s certainly true that the volume of subprime loans is small compared to the size of the economy. But does that observation justify the conclusion that “the subprime event is not that big a deal”? To me, it seems that the question should be rhetorical, because the obvious answer is “no,” but apparently others don’t find that answer to be obvious. And (assuming that the Crimson quoted him correctly and that he intended those two propositions to be logically connected) I’d have to say that, from my point of view, Jeff Miron doesn’t seem to understand what’s going on.

I’ll allow that Mr. Miron was quoted out of context (by both the Crimson and me); that the reporter probably surprised him when he was thinking about something else, and he didn’t get a chance to think through his answer; that he probably didn’t feel he needed to be too careful about his words when he was talking to the college paper. But when we take into account indirect effects, the subprime event is a very big deal. Subprime may be “a small part of the economy,” but LIBOR – which rose about 35 basis points because of the subprime fallout (in spite of a large drop in T-bill yields at similar maturities) – is not small: as far as short-term lending is concerned, LIBOR is most of the economy.

If it were just a matter of a few institutions that made subprime loans and had to recognize some losses because defaults were higher than they had planned, that would have been a virtual non-event in the grand scheme of things. But the subprime risk is not concentrated in a few institutions – or, to be more precise, maybe it is; we just don’t know where the hell it is, and that’s the problem. Can one say that walking across a minefield is “not that big a deal” because the actual mines underlie only a small fraction of the total area? When you suddenly find that institutions in France and Germany are close to toppling because of a small problem in the US, you’ve got a big problem, because people start to lose confidence in the whole global financial system.

And that’s just the beginning. Another effect of the subprime crisis has been diminished confidence in the bond rating agencies. When investors don’t know which bonds are safe and which aren’t, it becomes hard to borrow money by selling bonds. This has not been a big problem for traditional investment-grade corporate bonds outside the financial sector, but it has been a big problem for lower-rated bonds, and it has been a huge problem for just about any kind of asset-backed security that doesn’t seem to have a government guarantee. One of the results is that it has now become difficult and expensive – even for prime borrowers – to get a mortgage for any property that doesn’t conform to the requirements of government agencies or government-sponsored enterprises. (A particular case in point is the oversized “jumbo” loans that are now required to purchase even many mid-level houses in the post-boom coastal areas.)

And then there is the liquidity crisis. With all the uncertainty about the quality of loans and institutions, the institutions themselves face increased withdrawals of capital and increased uncertainty about withdrawals. At the same time, with all the uncertainty about the quality of bonds and other assets, these assets become more difficult to sell. Leverage is forcibly unwound. Failures cascade. Many of the failures occur outside the banking system and therefore outside the direct influence of central banks. Assets deflate. Otherwise solvent institutions become insolvent. Disintermediation further weakens the financial system.

Job losses in construction, finance, and home furnishings also have multiplier effects. In the financial chaos, with even prime borrowers facing difficulties in purchasing new houses, house prices could fall below fundamental value, and households will be bound by more stringent liquidity constraints and forced to curtail consumption. Financial problems abroad can be expected to dampen improvements in the US trade balance. Damn, I’m really talking myself into forecasting a recession now. Anyhow, to reiterate my original point, even though the subprime problem is a small part of the economy, it is a big deal.

Long and Variable Lags

I wrote this in a comment to a post on Economist’s View, but it’s sufficiently critical to my world-view to deserve a post of its own in my blog. The launching point is a Vox EU piece by Tito Boeri and Luigi Guiso, in which they denominate three causes underlying the current financial crisis:

• The low financial literacy of US households;
• The financial innovation that has resulted in the massive securitisation of illiquid assets; and
• The low interest rate policy followed by Alan Greenspan’s Fed from 2001 to 2004,

of which the third is “by far the most important.”

So far I don’t particularly disagree, but Boeri and Guiso are then quick to paint Alan Greenspan, along with “the Keynesian sirens” whose song he chose to follow, as the villains in this matter. In my own view,

If there was a monetary policy mistake in 2002-2003, the mistake was a failure to anticipate the lag between policy action and results. When a monetary stimulus is transmitted through the housing market, the lags are apparently longer than the typical lags associated with monetary policy historically. Greenspan kept easing because he wasn’t seeing results from his earlier easing, and in retrospect, it appears that he just wasn’t waiting long enough for those results.

If that was the mistake, then Bernanke may have made the same mistake in the other direction (and if so, he is apparently still making it). The housing bust that is taking place today is more or less a deliberate result of policy: the Fed wanted to slow down the economy, and the only way they could do it was to put the brakes on the housing market. Bernanke kept tightening in the first half of 2006 because he wasn’t seeing results from Greenspan’s earlier tightening (because the housing market was still booming, or it had just begun to slow down, and the macroeconomic effects weren’t yet apparent). Starting in the second half of 2006, Bernanke got what he was looking for: the monetary tightening from 2004 and 2005 finally was affecting economic growth.

If we look at the time lag from the beginning of the tightening (June 2004) to the point where the effect was first apparent (July 2006), it suggests that about half the impact of the tightening has yet to be felt. (Apply the same time lag to the end of the tightening, June 2006, and it suggests a peak effect starting in July 2008.) The hope, I suppose, is that we haven’t yet, even now, seen the full effect of Greenspan's original loosening outside the housing market, and that the residual effect of the loosening will counterbalance the effect of the tightening via the housing market. (For example, the dollar seems to have weakened very slowly, and we are beginning to see the effects on the trade balance.) When I think about it, that scenario seems pretty optimistic. It seems more likely that Bernanke has indeed repeated Greenspan’s mistake in reverse.

From this passage, it may begin to become clear what I meant when I said, “The Fed should encourage the continuation of a housing boom (or something of that nature).” I realize that, at the peak of the boom, the stimulus was stronger than what the US economy needed, but the policy today seems to be one of keeping interest rates high enough to erase, ultimately, a large part of the boom, perhaps bringing the US economy back to where it was in mid-2004. (Even that is only if we assume no overshoot on the downside. And the current financial crisis is already laying the groundwork for just such an overshoot.).

I guess some economists were perfectly happy with 2004, but I certainly wasn’t: the unemployment rate was 5.6% in June 2004; by a typical recent estimate, that’s almost a full percentage point above the natural rate. (The Philadelphia Fed’s most recent Survey of Professional Forecasters puts the median natural rate estimate at 4.65%. Anyone who has been following this blog since the beginning will know that I put the natural rate even lower.) So, while I don’t think the Fed should try to bring back the boom conditions of early 2006, I also don’t think it should deliberately “puncture” the “bubble.” Scrape off the froth, but don’t pour half the beverage down the drain.

Did this in Housing seem an obvious bubble?

I don’t think I’m going to be continuing yesterday’s post from just where I left off, but hopefully over the course of the next few posts it should become clear why I hold such bizarre beliefs. In this post I’m updating one from last year, in which I argued two points:

1. It is still reasonable to believe that the housing boom was not a bubble; and
   
   
2. Even if one believes that, one can still be ultra-bearish on housing today.

The argument, essentially, is that the fundamental value of housing depends inversely on real interest rates, which fell dramatically between 2000 and 2005 and then rose in 2006. Since the peak of interest rates in 2006, nominal interest rates have fallen, but most of the fall appears to be the result of a fall in inflation expectations; real long-term interest rates, as represented by TIPS yields, have fallen only slightly since their 2006 peak.

In this chart (an update of the earlier one), I plot an index of actual housing prices (the OFHEO Index, standardized to 1997Q2=100) and a crude estimate of the fundamental value of houses (CPI owner’s equivalent rent, capitalized at the 10-year TIPS yield plus a 2% risk premium, and expressed as an index standardized to 1997Q2=100).



My valuation method is crude, but it is not contrived. That is, I used what I considered the most obvious set of numbers, not some cherry-picked set designed to generate a certain result: I used the 10-year TIPS yield because it’s the most liquid market-determined long-term real interest rate for the US; I used 1997 as the base year because that is first year for which those yields are available; I added 2% because it’s an integer, and 1% was clearly too little, and 3% was clearly too much (at least prior to the last two weeks), and I used CPI-OER and OFHEO because those are first relevant indexes that I found for rents and house prices.

If you are willing to accept my crude approximation of the fundamental and my implicit (arbitrary but, I think, reasonable) assumption that prices in 1997Q2 were close to the fundamental, my results imply that there was no bubble this decade, but that housing prices now have to make a large downward adjustment due to a change in the fundamental. Actually, it is a conservative (that is, on the low side) estimate of how much adjustment prices have to make, because the relevant risk premium has clearly risen very recently, which would drive the fundamental values of houses down even further.

Some people have pointed out that, historically, interest rates do not explain most of the changes in aggregate housing prices, and that, in fact, if you model housing prices empirically using interest rates as one of the predictors, the results show that prices in late 2005 (where my two lines cross) were already far above the predicted value. People interpret this empirical finding to mean that housing prices must have been in a bubble. I see several problems with this argument:

1. This is one of those situations in economics where theory matters. If you want to argue that prices have moved far above the fundamental, you need a theory of what the fundamental value is; you can’t simply fit a bunch of possibly relevant variables empirically in a linear model and assume that the fitted value is the fundamental value. For example, if housing markets have become more efficient over time, then housing prices could have been deviating from the fundamental in all those past years and only now following the fundamental. And even if prices in the past did follow the fundamental, you would need to choose the exact right set of variables in order to get the correct fit, and you would need to choose the right functional form; otherwise, the coefficients on your variables will be biased, and, in particular, you may be underestimating the importance of interest rates.
   
   
2. If real interest rates are the most important variable, how do you represent them prior to 1997? There is no available series: you have to start with nominal rates and make some assumption about what expected inflation rate is applicable.
   
   
3. In an empirical fit, how do you account for the price adjustment process? Everyone knows that housing prices adjust slowly, so to make a meaningful empirical fit, you need a theory (explicit or implicit) about the adjustment process. If you ignore the adjustment process, you’re implicitly assuming that adjustment is instantaneous, which is obviously wrong. In particular, you will run into problems when there are dramatic changes in the fundamental, as for example, with the very low real interest rates in the late 1970s followed by the very high real interest rates in the early 1980s.

My approach avoids these problems because it doesn’t attempt to use historical data to ascertain fundamental values; it just asks whether the recent pattern of price changes is consistent with a theory of the fundamental. And it is. And if interest rates remain where they are, a lot of pain in the housing market over the next few years will be consistent with that same theory of the fundamental.

I come to bury the Housing Boom, not to praise it.

OK, I lied: I come to praise it. Basic macroeconomics is leading me to some unpopular conclusions:

1. The housing boom was a good thing; therefore
   
2. Far from worrying about moral hazard, the Fed should be deliberately rewarding those who participated; and
   
3. (At least according to my reading of the macroeconomy) The Fed should encourage the continuation of a housing boom (or something of that nature).

My basic argument is quite simple: without the housing boom, there would have been no economic recovery, and…recovery is good.

It’s not very controversial that the housing boom was the main reason for the economic recovery, so let’s do a thought experiment in which we re-run the years since 2001 without a housing boom. Would something else have happened instead to produce a recovery? Let’s line up the candidates.

First, fiscal policy. We did have a war, two large tax cuts, and a large new entitlement benefiting the age group with the highest marginal propensity to spend. The consensus is that all these were not enough. Perhaps they would have prevented the recession from getting worse, but without the direct and indirect effects of the housing boom, any recovery would have been meager at best. OK, how about a big public works program? Not a bad idea, if you ask me, but this is where we have to begin distinguishing between thought experiment and fantasy. If your conception has a public works program that dwarfs the New Deal being passed by a Republican Congress and signed by George W. Bush, I recommend you get in touch with George Lucas about the special effects.

What about an export boom (and/or substitution of domestic products for imports) supported by a weak dollar? That is, after all, the traditional mechanism by which monetary policy is supposed to operate in an open economy with a flexible exchange rate. The first problem that arises is that the US exchange rate against many countries isn’t (and, most emphatically, wasn’t) flexible, and even when it is nominally flexible, the competing products are often effectively priced in dollars. One could imagine a mildly successful beggar-thy-neighbor policy against Europe (supposing that, in the absence of a housing boom, the dollar would have crashed against the Euro in 2002 instead of falling gradually over 5 years). At best, that gives us a mild (and somewhat stagflationary) recovery in the US and a severe recession in Europe (which, as you may recall, had its own problems in the early years of this decade). All in all, the possibilities created by a falling dollar (in place of the housing boom) are not impressive.

So what’s left? An investment boom supported by low interest rates? If it didn’t happen when the federal funds rate was at 1%, would it have happened if the rate had fallen to 0%? I tend to doubt it. An investment boom supported by “quantitative easing”? Possibly, but it took Japan years even to hit on that possibility, and the jury is still out on whether quantitative easing was the real reason for Japan’s recovery. The premise that such a policy would have been tried successfully in the US during this decade is speculative at best. Other ideas? Money dropping from the sky? Maybe, but remember, “Helicopter Ben” didn’t take over the Fed until 2006. And so on….Rather than going from the bizarre to the more bizarre, I’m just going to reassert my premise and suggest that the burden of proof is now on anyone who disagrees: Without the housing boom, there would have been no economic recovery.

The implication of having no economic recovery is that we would have slack resources the whole time – the sort of event that used to be called a depression before the term fell victim to political correctness. Thus, comparing my counterfactual world to the actual world, all the extra production that we got out of the US economy was done with resources that would otherwise have been wasted. From a macroeconomic point of view, all those extra houses and such were free – a free lunch, if you will. (I won’t abide any more TANSTAAFL: in Keynesian economics there has always been a free lunch; that was the main point of the General Theory.) So those who say that the housing boom was a bad thing are saying that we should have turned down that free lunch when it was offered.

And what of those who participated in the boom? To my mind, they are in the same category as the Iraqi Shiite rebels in 1991. They helped US policymakers accomplish their laudable goals. (I won’t apologize for being a supporter of both Desert Storm and this decade’s economic recovery.) Sir Alan even flew a mission over their region to drop leaflets touting the virtues of ARMs. And now should we leave them to be massacred? I’m not saying we should invade the mortgage derivatives market and set up a democratic regime by force. But at the very least, don’t we have a humanitarian moral duty to declare a no fly zone?

This post is already too long, and I have to get back to my real job. I haven’t even finished arguing my second point, and the third point is clearly going to be the hardest to defend. For now I’m going to have to abort, hoping to continue tomorrow. Have patience, gentle friends….


But Dean Baker says the Housing Boom was an obvious bubble:
And Dean Baker is an honorable man;
So are they all, all honorable men*…


* Yeah, OK, some of them are honorable women, I guess. Sorry, but the ART is doing Julius Caesar this season, and Shakespeare's lines already glide silently but pervasively through the New England air.

Taxes, Housing, Growth, and War

The following seem to be a standard set of tenets for anti-Bush crowd:

• The Bush tax cuts were irresponsible.


• The housing boom was unhealthy.


• Employment growth over the past five years has been inadequate.

I’m no fan of W myself, but I’m puzzled by this triplethink. What macroeconomic policies were people hoping for? What policies would have increased employment without exacerbating either the budget deficit or the housing boom?

Let’s look at an alternative path in which the tax cuts hadn’t taken place. The tech bubble would have burst anyhow. (It started to burst long before the first tax cut.) Without the 2001 tax cut, the recession would have been deeper and lasted longer. Without the 2001 and 2003 tax cuts, the painfully slow recovery would have been even slower. Quite possibly the Fed would have cut rates all the way down to zero. (That’s only one percentage point away from what actually happened.) The housing boom – as the only major source of demand facilitating a recovery – would have been pushed to an extreme that would make last year’s experience look mild. (Exercise for the reader: calculate the present value of a perpetual stream of housing services discounted at 0%.)

If anything, the tax cuts were not irresponsible enough. Instead of tax cuts on capital income, designed to encourage virtuous activities like saving and investment, what we needed were sleazy, Keynesian tax cuts to encourage Joe Sixpack to switch to high-quality microbrews. (Fortunately, the tax cuts were entirely ineffective at encouraging saving.) Or perhaps, instead of tax cuts, we should have built a lot more bridges to nowhere back when we were facing an excess of unbroken windows.

The only alternative economic stimulus would have been a weaker dollar. You may recall, though, that Europe and Japan were facing inadequate growth at the same time, and the other Asian countries had plenty of unexploited potential. A deliberate weak dollar policy, back in 2001-2004, would have fallen into the classic “beggar thy neighbor” category. And with the rest of the world playing the same game, it’s implausible that ordinary fiscal, monetary, and “talking down” policies could have made the dollar so weak as to substitute for the stimulus of the tax cuts. That would have required dramatic intervention against the dollar, on a scale never even imagined, and with the explicitly aggressive intent of forcing the Asians (under threat of bankruptcy) to give up their own intervention policies. I don’t recall anyone advocating such actions at the time.

If you want to blame Bush for the economic problems of this decade, don’t blame his economic policies; blame his foreign policy. Whatever its ex ante merits may have been, the Iraq war, along with the atmosphere of tension it induces in the region, has clearly been partly responsible for the rising price of oil, which is exactly what has placed such a tight limit on the current recovery. (Try this thought experiment: assume the actual path for the cost of non-energy value added in the US, and suppose that the price of oil had risen much less. What would the inflation rate be? Would the Fed have kept tightening so long?)

Bubble? No. Crash? Yes.

Listen closely to the US housing market. At first, you may think you hear a hissing sound, but what I hear are the wheels of a moderately efficient market grinding out a new equilibrium price. By my very rough estimate, the fundamental value of the average US house has fallen by about 15% over the past year.

A house represents a stream of housing services, and the value of the house depends on the rate at which you discount those services. Since housing services can also be purchased with money (rent), the discount rate for housing services has to maintain some relationship with the discount rate for money (the interest rate, which, as you may have noticed, has been rising lately).

In a post last year, James Hamilton goes into more detail on the basic mathematics of house pricing and ends up with the formula H = s/(i-g), where H is the house price, s is the value of housing services (rent), i is the interest rate, and g is the growth rate in the value of housing services. In my calculations, I assume that the growth rate is equal to the inflation rate, so the formula simplifies to H = s/r, where r is the real (inflation-adjusted) interest rate.

What real interest rate, in particular? There is no easy answer, but to make things simple, I just take the (easily observable) 10-year TIPS yield and add a 2% risk premium. 2% corresponds roughly to the typical spread between 30-year mortgage APRs and 10-year treasury yields. A subtle housing economist would also account for a lot of other details, such as maintenance costs and tax deductions, but I just want to look at the big picture, so I’ll assume that those things net out to zero.

Using the CPI for Owner’s Equivalent Rent, I calculated the path of this “fundamental value” (H) since 1997 (when TIPS were first issued) and compared it to the path the OFHEO house price index. (Both numbers are indexed to start at 100.) The chart below shows the result.



Housing prices did roar ahead of the fundamental during the economic boom of the late 1990s, but with the decline in interest rates starting in 2001, the fundamentals caught up with prices and then pulled ahead. From 2003 to 2005, actual prices were catching up with fundamentals. By the first quarter of 2006 (the last data point from OFHEO), prices were just slightly above the fundamental (not what I would call a bubble!), but in the subsequent two quarters, with interest rates rising, the fundamental has dropped dramatically. As a fundamentalist who never bought the bubble story, I won’t be at all surprised to see housing prices drop (in real terms, certainly, and perhaps in nominal terms as well) over the coming months and years.

A Point of Agreement

In an earlier post, I noted that I seem to disagree with Dean Baker more often than I agree. Today, though, he made a point about rent inflation that echoes one I made last month. (Somehow I don’t think either one of us was the first person to think of it, though.)

Positive Feedback

Having established in my previous post (not to everyone’s satisfaction, I realize) that Bernanke is actually a hawk, let me now turn my attention to how the Man with the Helicopter should react to the latest inflation report. If you follow the news at all, you will recall that Wall Street reacted with great dismay to Tuesday’s report of a greater than expected increase in the Consumer Price Index. Ostensibly, the reason for the dismay was the expectation that more monetary tightening would be necessary to combat the newly revealed inflation.

Let’s take a closer look. It wasn’t the large increase in the energy component of the CPI that troubled Wall Street: this wasn’t a surprise to anyone who drives. What troubled Wall Street was the unexpected increase in service prices. But in fact, there was no broad increase in service prices. The CPI for services excluding rent of shelter has risen by 0.0% over the past 3 months – hardly the stuff inflationary spirals are made of. The whole problem was with rent (especially “owner’s equivalent rent” for homeowners)..

Housing costs are important, and we certainly shouldn’t ignore them when evaluating the overall inflation situation, but we have to consider today’s rent increases in the context of recent experience. We need to consider the reasons that rents are increasing and the dynamics of any Fed response.

A few years ago, when interest rates were very low, renters began to find it economical to buy houses of their own, demand for rental housing went down, and rents – which might otherwise have risen – were kept in check. That dynamic helped keep the overall inflation rate extremely low. Today, the opposite dynamic is taking place: interest rates are higher, homeownership is uneconomical, rental demand is up, and rents are rising, contributing positively to the overall inflation rate. When you smooth out these cyclical fluctuations, though, the trend rate of increase in rents is neither dramatically high nor dramatically low. We can anticipate that interest rates will eventually reach a peak, housing markets will eventually stabilize, and rents will eventually settle into some equilibrium growth rate not too far from their historical trend.

But what will happen if the Fed responds to rising rents by raising interest rates? The answer is pretty clear: interest rates go up, so rents go up, so interest rates go up, so rents go up, and so on. (Arguably, this is, in reverse, part of what happened on the way down.) Eventually, interest rate increases will deflate the rest of the economy and put an end to the vicious circle, but at the cost of an unnecessary slowdown. If the Fed has a policy of responding to rent increases with interest rate increases, that is a positive feedback mechanism that will tend to amplify the business cycle. Of course, part of the Fed’s job is to dampen, rather than amplify, the business cycle.

So, as a first cut, the answer to how Bernanke should react to the inflation report is that he should ignore it. Unfortunately, he can’t ignore Wall Street’s reaction. The spread between TIPS yields and nominal bond yields indicates increased inflation expectations, and, as a new Fed chairman, Bernanke cannot be seen making excuses not to raise interest rates – even if they later turn out to have been good excuses. On the other hand, with the stock market down, there is more reason to worry about a weakening economy, so perhaps this offsets concerns about credibility. All in all, it’s hard to say what Bernanke should do, but in any case, Wall Street’s reaction seems a bit excessive.