On Bubbles and Depressions 20 comments
- Profile & More Articles
- Tim's blog: The Mess That Greenspan Made
- Subscribe to Iacono Research
an article to
-
Font Size:
-
Print
- TweetThis
In this commentary in Monday's Wall Street Journal, economists Steven Gjerstad and Vernon Smith offer a theory about why we could again be going from a bubble into a depression.
Over the years, there have been quite a few bubbles, but not all of them cause the sort of economy-wide damage that was seen in the 1930s or over the last year or so. Why?
Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.
Most people forget that it wasn't just a stock market bubble in 1929 that led to America's last lost decade. There was an enormous housing and credit bubble in the mid-1920s during which Groucho Marx and others lost a good deal of money on Florida swampland. During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.
As has been the case thoughout history, you can't get a really good bubble going until you get broad participation from the public - preferably lots of people at the lower end of the socio-economic scale levered up courtesy of a banking system that is gushing with easy money.
That pretty much described the situation in the 1920s and in the 2000s.
The entire piece is worth a look as they go through the recent history of financial bubbles in the U.S., a sequence that really accelerated about 20 years ago when you-know-who started sitting in the big chair at the Federal Reserve
boardroom.
Interestingly, they touch on one of my all-time favorite subjects since this blog began a few years ago - how owners' equivalent rent duped the Fed.
Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!
By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.
How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.
With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.
Yes, "an important component of inflation remained outside the index" - that sort of thing almost always ends badly as noted here on many occasions before.
After years of writing on this subject, yours truly still comes out high in a simple Gooogle search on the phrase owners' equivalent rent - right there in second place, behind the Bureau of Labor Statistics with "How owners' equivalent rent duped the Fed" and then again in fifth place with the memorable "The complete and utter failure of owners' equivalent rent".
Related Articles
|
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largestSee all
increase in followers
in the last 7 days
Fastest Climbers » -
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most active
Instabloggers.-
1
David Fry
-
2
TraderMark
-
3
Don Dion
-
4
Cliff Wachtel
-
5
Joseph L. Sha...
Top Instabloggers » -
1
-
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
or was this what we have pretty much gone through?
On Apr 06 09:39 AM kelm wrote:
> It is amazing to me how changes to what we measure, unemployment,
> rental equivalent rates etc, can have such adverse consequences on
> the macro level. I recognize that some measures must change over
> time as the economy changes and hence he needs of the data gathering
> change but there really needs to be a lesson;s learned conducted
> and everyone really made aware of the unintended consequences of
> changing how and what data is gathered and interpreted.
My wife was a real estate agent when they increased the allowable percentage of your income for your house payment to over 50%.
We knew something was fishy and, meanwhile, still pay $1,600 a month rent for a $525k house.
On Apr 06 11:50 AM User 180763 wrote:
> The gov't could not afford to have inflation rise 6.5% in one year
> when they have to adjust all the Social Security payments proportionately.
> Thus they had to fudge the indexes ahead of the data to keep the
> real gov't debt covered up. The data from "Shadow Government" is
> the correct data and should be used by all of us make our finanical
> decisions.
I suggest those who want to look further into the how and why of such long-term bubbles Google "fourth turning", "kondratieff wave" and "generational dynamics".
This was all very predictable, timing is always the issue and I have yet to see a bursting of a bubble this large that wasn't easy to spot if you simply deal with reality and stay away from the pollyanna mindset.
But I'd like to take a different view from the majority here. The country can't afford for all the baby boomers to go on social security. Some of us have protected out nest egg and may not need the benefits. We may have earned it, yes. But I'll be damned if that seems like a good enough reason to saddle my kids with even more debt. I know plenty of people, who will have pension income over $80,000 - $120,000 per year per household (in today's dollars) and who have stashed away several hundred thousand dollars in savings (and they still have some left even after the market crash). They could "get by" without social security just like I could. But will they? No.
You see, I think that part of the problem in America today is that we all have an entitlement attitude, to a greater or lesser degree. Even the wealthy will file for social security benefits. Yes, they did earn it. But when did doing the right thing go out of style?
I'm not a liberal. Actually, I lean to the right on most issues. I want less government for the most part. I want government to be more efficient and to regulate only industries that really need it, like banks. I'm a small business owner. I don't want the government to keep putting up more and more barriers making harder for people like me to start their own business. Small businesses are the backbone of this nation!
But I keep hearing complaints, well-founded in my opinion, that when the government keeps helping the poor it lessens the incentive to get an education, work hard, and climb out of poverty. The complaint usually continues to say that we, as a nation, have created an entitlement attitude. Too many people expect the government to step in and take care of their problems. I agree whole heartedly.
But when it comes down to it, I think this attitude has gone way beyond the poor. It has grown to encompass the middle class and even the wealthy, to some extent. Let's face it, social security was established to be a safety net for those who had no other means of support in their old age or when they were disabled or otherwise unable to work. It was not created to be the universal retirement plan that it has evolved into.
No one really wants to fix the looming social security problem. If we did, it would affect all those that could afford to live comfortably without it but are not willing to forgo an "entitlement."
On Apr 06 09:39 AM kelm wrote:
> It is amazing to me how changes to what we measure, unemployment,
> rental equivalent rates etc, can have such adverse consequences on
> the macro level. I recognize that some measures must change over
> time as the economy changes and hence he needs of the data gathering
> change but there really needs to be a lesson;s learned conducted
> and everyone really made aware of the unintended consequences of
> changing how and what data is gathered and interpreted.
Anyway. So it goes.
SOB.
Two years ago I fell into the greatest housing situation I have ever experienced. I now rent furnished condos for 7 months on a beach in Florida, and 5 months on a mountain in Vermont. This works great for me, as well as for the owners who are unable to sell their properties and/or are looking for a stable, mature renter to help them out on cash flow.
The furnishings are always very nice, sometimes excellent. The rent always includes cable and either local telephone or electric, and always washer/dryer. I don't have to worry about maintenance of the property and those related costs, condo fees, insurance, property taxes, water/sewer, nada. I couldn't rent an unfurnished apartment for what these are going for.
My residential bills every month consist of a lease check, cellphone bill, DSL bill, sometimes electric, sometimes not. That's IT!
The condo in VT this spring/summer will be 2 BR, 2 BA in a nice building right on a ski mountain, $800 per month includes cable. Last year the owners asked me stay at their 4 BR 2 BA condo as a favor to two other elderly tenants who couldn't stand the stairs and catwalks, so I switched out up to that unit, and they charged me $800 also. The condo I have been staying in right on the beach in FL is 2BR, 2BA and $1000/month, includes cable and electric.
So twice a year I load up my car (if it doesn't fit in my car I figure I don't need it) with golf clubs, computer, clothes, books, etc. and "commute" 1200 miles to a new place. Its a great lifestyle and my knees really like the nice climate I treat them to. I get done trading and its onto the beach for a nice 5 mile hike, or a nice 5 miler thru the beautiful green valleys and hills of VT.
The middle class is about to vanish into poverty and the taxation
we are looking at will break all but the highest earners down.
Entitlements, global military presence, large government. These
things eventually break the back of any country, go read the history books. Cost of living from food to oil is a guaranteed way to kill a
society.
Read some books about the collapse of the Roman Empire or
other advanced societies. History repeats itself with slightly
different twists. Read about the laws of diminishing returns.
If you think the Last One Was Bad; Wait Until This One Gets Going At Full Steam.
We Will All Pay For It In Sweat And Tears.
On Apr 06 11:00 AM johnbee wrote:
> So whats the next bubble. The spend without any collateral bubble?
>
> or was this what we have pretty much gone through?
The answer is actually quite simple: leverage. Leverage creates losses that are multiples of the original amount of capital that put at risk. Low margin requirements amplified the losses associated with the 1929 crash, making the fallout much more severe. Obviously, leverage associated with mortgage lending is exacerbating this situation, as is the fallout from the naked swaps that AIG sold. In the latter case, the likes of Goldman Sachs put up pennies on the dollar for the swaps they bought, thus leaving AIG with losses of 30x-50x of what Goldman paid. Because our brainiacs in Washington decided to bail AIG out, the public will now be paying for those losses for decades, thus putting a stranglehold on the economy for years.
The dot-com crisis, for example, was different. Trillions were lost, but any money that had been lost had in fact been put into circulation in the economy at some point, and there was no residual overhang of debt to be paid off after the meltdown. In other words, although the dot-com stocks took a beating, the economy as a whole was net neutral. Hence, the recovery was fairly swift, given the magnitude of thd disaster. Today, however, losses have been created without the lost monies ever having been put into circulation, as the losses were created with leverage. Hence, the economy as a whole is in a net loss position, whereas it wasn't following dot-com mania. Such losses a much more difficult to recover from.
I think the CPI calculations aren't right. I couldn't prove it quickly, but I think "shelter" is 23% of CPI, not "owner equivalent of rent." The BLS uses rent and owner equivalent of rent --- plus a wee bit for college dorms, etc --- to determine shelter. Even if you want to include house prices changes in CPI --- which the BLS argues should not be done --- you only want to apply it to home owners, not to renters and owners, as he seems to have done.
[Don't blame the BLS for this part.] I would further argue that the fact that only a fraction of the homes being sold each year would mean that the difference in prices of stuff sold last year and prices of stuff sold this year ought to be derated for the fact that so little of the total stock turns over in a year. Of course, the faster the turnover, the weaker my argument gets.
Here's how BLS defends what they do. Shame on them for comparing 1983 --- a year of painfully high interest rates --- to 2007 to overstate their case; IMHO, they didn't have to.
The CPI used to include the value of a house in calculating inflation and now they use an estimate of what each house would rent for -- doesn't this switch simply lower the official inflation rate?
No. Until 1983, the CPI measure of homeowner cost was based largely on house prices. The long-recognized flaw of that approach was that owner-occupied housing combines both consumption and investment elements, and the CPI is designed to exclude investment items. The approach now used in the CPI, called rental equivalence, measures the value of shelter to owner-occupants as the amount they forgo by not renting out their homes.
The rental equivalence approach is grounded in economic theory, receives broad support from academic economists and each of the prominent panels, and agencies that have reviewed the CPI, and is the most commonly used method by countries in the Organization for Economic Cooperation and Development (OECD). Critics often assume that the BLS adopted rental equivalence in order to lower the measured rate of inflation. It is certainly true that an index based on home prices would be more volatile, and might move differently from other CPI indexes over any given time period. However, when it was first introduced, rental equivalence actually increased the rate of change of the CPI shelter index, and in the long run there is no evidence that the CPI method yields lower inflation rates than some other alternatives. For example, according to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period.
On Apr 06 11:00 AM johnbee wrote:
> So whats the next bubble. The spend without any collateral bubble?
>
> or was this what we have pretty much gone through?
Or we can watch our economy grind itself down to nothing.
Your choice. It's about time you realized you had a choice though, as few people seem to realize it.