By Karl Smith
By Adam Ozimek
The post-housing-bubble narrative has been that the unsustainability of prices was obvious ex ante, and so we should be able to call them in the future. This to me seems to be a bit of hindsight bias, but it is always difficult to make a case that claims which turn out to be ex post false were nevertheless ex ante reasonable. Kristopher Gerardi, Christopher Foote, and Paul Willen have a new paper out that I’ve been waiting for someone to write. They go through pre-collapse claims of the housing pessimists, optimists, and agnostics, and evaluate not just who was write and wrong but which beliefs where obviously right and which were debatable. This is a fun and accessible paper starring a well-known cast of characters, with prominent roles for Paul Krugman, Dean Baker, and Robert Shiller, and a quick cameo by The Economist, Calculated Risk, and John Cassidy. I strongly recommend it.
Rereading the cases of the optimists and the agnostics should be a reminder to those who claim to have identified the bubble, and also argue for the identifiability of future bubbles, with a high degree of confidence. The burden of proof on those making those claims is to argue convincingly against, for instance, Himmelberg, Mayer, and Sinai who argue that you can’t just look at price to rent ratios, but must consider changes in the user-cost of housing.
Even more prominent than the housing optimists are the housing agnostics. Rosen and Haines argued that the academic consensus on the issue was that the relationship between prices and fundamentals was sound, and that overpriced markets, if they existed at all, were limited. The authors find that the beliefs of agnostics can be summarized in this quotation from Davis, Lenhart, and Martin:
If the rent-price ratio were to rise from its level at the end of 2006 up to about its historical average value of 5 percent by mid-2012, house prices might fall by 3 percent per year, depending on rent growth over the period.
There is a tendency to call anyone who bought a home during the late stages of the bubble “irrational”, because prices were obviously unsustainable. But as the authors point out, the consensus of economists gave no indication that this was the case, and so behaving as if it wasn’t was quite reasonable for non-experts. Of course, pointing out that current prices were justified by fundamentals does not rationalize a 120% LTV negative amortization mortgage.
To those who simply point to lower lending standards as sufficient proof for a bubble, the authors offer this:
Did lax lending standards shift out the demand curve for new homes and raise house prices, or did higher house prices reduce the chance of future loan losses, thereby encouraging lenders to relax their standards? Economists will debate this issue for some time. For our part, we simply point out that an in-depth study of lending standards would have been of little help to an economist trying to learn whether the early-to-mid 2000s increase in house prices was sustainable. If one economist argued that lax standards were fueling an unsustainable surge in house prices, another could have responded that reducing credit constraints generally brings asset prices closer to fundamental values, not farther away.
I believe the case for humility about the obviousness and knowability of bubbles is underappreciated. Many, I’m sure, will simply point to the pre-bubble agnostic consensus of economists as more evidence that economists are rational expectations obsessed, over-mathematized fools who don’t know what they’re doing. I think they would benefit from a close reading of this paper.