Thursday, August 19, 2010

What Housing Bubble?

How does the world economy adjust when the propensity to save exceeds the propensity to invest? It has to adjust somehow, since total saving has to equal total investment. Broadly speaking, there are two mechanisms by which it can adjust. The first is that incomes can fall, held down by weak demand from firms choosing not to invest or households choosing not to spend. (This leaves less income available for saving and thus forces total saving to fall.) The second is that asset prices can rise, bid up by savers looking for a place to put their savings. (This increases the incentive to invest and decreases the incentive to save.) Over the past decade, the world has consistently faced an environment in which the propensity to save exceeded the propensity to invest, and various nations, at various times, have adjusted by one mechanism or the other. It should be obvious – and used to be obvious, at least to mainstream economists – that the latter mechanism is preferable.

During the recent US housing boom, I was of the school that believed rising house prices were an example of that preferred mechanism taking effect. At the time, I had plenty of company. Today – now that we have transitioned to the less preferred mechanism for equating saving and investment – my cohorts all appear to have deserted. Apparently it is now generally accepted that the rise in house prices was an aberrant bubble, justified only in the minds of irrational buyers who ignored the fundamentals and expected house prices to keep rising simply because they were already rising.

But what were the fundamentals? Certainly, if one had foreseen today’s circumstances, it would have been clear that housing was not a good investment. If one had been able to say, “In a few years, the unemployment rate will rise to 10%, the inflation rate will fall to nearly zero, and policymakers will be too timid to undertake the policies necessary to reverse those trends,” then it would have been clear that 2005 was not a good time to buy a house. But that’s not what most housing bears were saying at the time. And in any case, while investors must of course do their best to anticipate actual policies, it is hardly appropriate for economists to consider the anticipation of future policy timidity as part of the intrinsic fundamentals. It is hardly reasonable to declare an episode a bubble just because investors failed to anticipate the timidity of policymakers.

Less timid policies – which are indeed advocated today by a great many of the erstwhile housing bears – would have two salient features: a commitment (in some form) to higher inflation rates over the medium run and (in pursuit thereof) an aggressive attempt to reduce interest rates across the yield curve. Under those circumstances, houses – a classic inflation hedge that could be purchased with ultra-cheap financing – would seem like a very good thing to own. If such policies were undertaken, and housing prices were to rise once again to their former level, would the bears once again declare the housing market to be a bubble? Perhaps housing prices wouldn’t rise quite so much, but some asset prices would have to rise quite a lot to bring about full employment and moderate inflation. It seems to me that if one advocates such policies but is inclined to describe the result as a bubble, then one is taking a rather self-defeating attitude.

It is of course conventional (but wrong, in my opinion) to regard the current malaise as the result of the housing bubble’s collapse, so perhaps it will be argued that such asset-boom-inducing policies are needed now only because that housing boom already took place. That argument makes little sense to me. Back in 2003, as the housing boom was already taking form, the US economy was weak enough to raise deflation concerns at the Fed. The housing boom (along with its collateral effects on things like consumer spending) was precisely what drove the subsequent recovery and alleviated those concerns. And even with the tremendous stimulus of the housing boom, that recovery barely reached full employment and stopped far short of a macroeconomic boom. Surely, without the housing boom, the US economy would have remained weak, and we would have ended up in much the same situation we are in today.

I would challenge those who believe there was a housing bubble (which is, today, nearly everyone) to come up with a coherent and believable scenario in which those supposed bubble prices would have proven unjustified without either (1) bringing back the macroeconomic weakness and disequilibrium from which the housing boom originally extracted us or (2) being replaced by a “bubble” in something else. I submit that the term “bubble” is inappropriate. What we had were the makings of an equilibrium that involved very high asset prices (and low subsequent asset returns), the only equilibrium that would have allowed saving and investment to equate at a level high enough to avoid foregoing potential aggregate income. Perhaps, in 2006, housing prices were a little bit overvalued relative to that equilibrium, while some other asset prices were a little bit undervalued; but in general, very high asset prices were a critical feature.

In any case we are far away from that equilibrium today. Asset prices are far too low to bring us anywhere near full employment. Relative to that “classical” equilibrium, asset prices are far below where they should be, and prospective asset returns are far above where they should be. That’s not to say that prospective returns are necessarily high in historical terms: in the classical equilibrium, when a lot of people (and nations and institutions) are trying to save, they bid down the returns that can be earned on those savings. And that’s just the thing: we need to get to the point where houses (and stocks and bonds and everything else that people hold for the future) are very expensive, not because prices are expected to keep rising forever but because people realize that low returns are the best deal they’re going to get. Along the way to that equilibrium, though, asset prices will have to rise. Unfortunately, current policies do not appear to be moving us in that direction – at least not very quickly.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.


David Pearson said...


"Bubble" is a vague, barely useful, term. What we had was an adverse positive feedback loop between Fed-generated expectations of macro stability, higher optimal leverage, rapid credit growth, and rising collateral prices. This feedback loop resulted in the extreme fragility of the shadow banking system, which, in response to a minor shock (flat house prices), in turn led to a series of banking panics beginning in August of 2007 and culminating with the failure of Lehman.

You ask whether we would have been worse off without the housing bubble. My answer is that, in the absence of the credit feedback loop described above, "macroeconomic weakness" in 2002 would have led to the necessary adjustments without bringing down the financial system. In other words, a deep recession in 2002 would not have endangered either shadow banks or banks.

You say that asset prices are too low to bring about full employment. The other way to look at it is that debt levels are too high to do the same. They weren't in 2003, which is the last time the Fed tried to guarantee asset prices.

MW said...

"It seems to me that if one advocates such policies but is inclined to describe the result as a bubble, then one is taking a rather self-defeating attitude."

Surely doing so is simply an acknowledgment of the bubble problem highlighted by Adam P?

JKH said...

Are your two mechanisms really alternative ones?

Aren’t rising asset prices part of the range of outcomes that follows from the mechanism that inevitably causes incomes to fall?

E.g. given an unbalanced high propensity to save, isn’t the initial downward pressure on incomes the same whether the choice is to leave money in the bank or buy stock?

So won’t incomes fall at first in any case?

And isn’t it then a question of how the wealth effect from asset prices if any contributes to spending and income readjustment from there?

Nick Rowe said...

Andy: this is a very brave, and a very good post.

I have one minor suggestion to make your argument even clearer (it's clear to me, but just in case some miss it). When you say: "The second is that asset prices can rise, bid up by savers looking for a place to put their savings." you should say that high asset prices are just the flip-side of low rates of interest/rates of return.

Nick Rowe said...

Yes, you are not the first to have made essentially the same point. But the clarity with which you state the underlying logic of the dichotomy (recession or high asset prices) is beautiful.

Forget my suggestion above.

AndyFromTucson said...

Great analysis of the fundamental dynamics involved in this issue. The one weakness I see is that you skip over the story of how the rise In housing prices reversed.

One factor was that in order to get the excess savings invested in housing the finance system had to borrow savings from savers and then lend to people who would never have qualified for a mortgage loan in the past. When the high risk borrowers started defaulting it terminated this pathway for savings to flow into housing which helped terminate the housing price rise.

The other factor is that the housing price rise led to construction of a lot more houses than we had the population to inhabit. When supply exceeded demand prices started to fall.

I think these intertwined dynamics will tend to undermine any dynamic where rising assets prices compensate for weak demand.

Andy Harless said...


2003 was still below full employment, whether or not debt levels were too high. I don't see what "necessary adjustments" would have happened without rising asset prices. It's true that high asset prices are inherently fragile, since they depend on having small numbers in the denominator of discounting formula, but if the world is trying to save too much, the alternative to a fragile recovery is a robust depression.


But surely it is, at least theoretically, possible to have an equilibrium, which would have to involve high asset prices. It seems pessimistic to me to look at rising asset prices and say, "This is a bubble" rather than, "This is markets trying to find an equilibrium."


In a logical sequence, falling incomes have to happen first, if, for example, there is an unanticipated increase in saving, because the immediate result would be less demand. But in a temporal sequence, the saving might be anticipated, and asset markets could, in theory, react immediately to the anticipation of a savings glut and then feed investment demand as the saving takes place, thus avoiding the need for falling incomes. So in that sense they are alternatives. Obviously, markets won't always anticipate correctly, but they could overanticipate as well as underanticipate.


Thank you.


There certainly was some kind of "credit bubble" or whatever you want to call it, where markets started to underestimate the amount of risk involved in mortgages. In fact, the same argument that says housing prices were fairly valued in 2005, also implies that prices could fall, since there was no guarantee that the savings glut would continue. If people had actually thought about this, they would have realized that subordinate CDO tranches were much riskier than their ratings implied, but people passed the buck to the agencies, and the agencies passed the buck to their models. And in this case those mistakes did ultimately lead to a crash in housing prices (and everything else).

But it's not clear that the credit bubble was a necessary condition for house prices being high. It speeded up their rise, and it propped them up for a while once the fundamentals seemed to shift a little bit against them, but house prices might have risen that high anyhow. If credit had been better controlled, the boom wouldn't have taken off as quickly, and the Fed would have kept interest rates lower for a longer time, and eventually this would have produced the same incentive for more creditworthy borrowers. And in that case, prices would not subsequently have collapsed.

As for overbuilding, I'm not sure that would have been such a big problem if the collapse hadn't happened for other reasons. In places where there was a lot of space to build, prices didn't rise all that much, so there wasn't as much room for them to fall. That suggests that markets were anticipating building, as they should have. And the building itself was part of what kept the economy up. Were there really too many houses built? I'm not so sure. Today, a lot of people live with relatives or have more roommates than they would ideally want. If they had more income, they would be living in those vacant houses.

mig said...

or (2) being replaced by a “bubble” in something else.

You mean like Gold and Tbills, today?

We're in the midst of a fear bubble.

And the fear is pulling in opposite directions.

mig said...

... and in that same vein, one can argue that the bubble in Housing was due to the deflation of the bubble in Tech Stocks (that led, in addition to the terrorist attack) to the downturn you're referencing in the "(1) bringing back the macroeconomic weakness and disequilibrium from which the housing boom originally extracted us" challenge.

Originally housing was the "safe" alternative vehicle for people to park the assets that were fleeing from the stock market, precisely because people were drinking the "house prices never go down" Kool-Aid.

I'll give you my own conclusion: The "AM Radio Bubble Indicator" -- once an asset class has grown in relative proportion to underlying economic growth to the point that you start having Newsradio (especially conservative talk radio) advertisements for getting into that asset class, it should be considered in the middle stages of a classic economic bubble and avoided like plaguedust.

Anonymous said...

There's a single point not addressed in that discussion.
bubble or not other countries had experiencied a housing boom. But only the us had the power to inflict the pain after the bust in others countries
while the us was a surplus country there was a alignment them and the rest of the world.
now the target is to be the number one not to spread productive capital outside its borders.
us is not doing the amount of sacrifice it needed: it just involved everyone because it has the world's printing machine.
the question is: if it had not?
the answer: pain or inflation and a weak currency.
as it has we, from the outside, must be preparade: mrs. Inflation is back.

mig said...

See, now, "Anonymous" exemplifies one of the two different viewpoints on the economy currently being promulgated out in the Great Marketplace of Ideas, today.

The "economist"-oriented talking heads all say that deflation is the most dangerous problem we currently face.

The "political"-oriented talking heads all say that inflation is the most dangerous problem we currently face.

Which is why we currently see two very disparate -- and, arguably, opposite -- bubbles occurring in both Gold (inflation hedge) and Tbills (deflation hedge), depending on whether or not you pay attention to the political or economic side of the current level of noise being presented by the media in general.

Unfortunately, of course, this analysis is entirely based on psychological principles rather than macroeconomic ones.

This may be why they don't properly synch with the original poster's concept of How the World Works.

Oh well.

James said...

Permanently high plateau! Permanently high plateau!

Andy Harless said...

Housing prices obviously aren't at a permanently high plateau, since they are way down from where they were 5 years ago. But that doesn't mean they weren't fairly valued at the time. I think there's a strong case to be made that stocks were fairly valued in 1929. Better public policies would have avoided the Great Depression (which would only have been a minor recession) and justified 1929 stock prices. And Irving Fisher was one of the greatest economists on the 20th century, so I guess I should take the comparison as a compliment :)

Anonymous said...

It's good to know the quality of Harvard side-products. :)

The "logic" is somehow similar to blaming bears for the housing burst instead of the hundreds of billionaires who benefited from the housing BUBBLE. :)

Millions of people were trying to catch maybe the last train to richness, while house-gambling with money from thin air made by banks, in fact signing slavery contracts for life and giving without constraints the value of their life-time work to... those hundreds of billionaires... at that "very present moment".

"Chief economist"? :)) ... chef... this pie is insulting.

Anonymous said...

House prices will return to pre-1998 levels, like none of the price appreciation ever happened. What better definition of a bubble do you want? It was based on nothing but mass hysteria and imprudent lending practices.

John L said...

I believe you may have it backwards.

As I understand it, well-intentioned government policy allowed poor lending practices, which led to artificially high RE values, which spiked the market, which then crashed under its own unsustainability.

The only way this wasn't a bubble is to redefine "credit worthiness" to something far less restrictive than sound historical practice (as happened from 1998-2007). When we lower credit standards, we increase risk. Historically, I believe it can be shown that such lowering of standards leads to economic suicide.

This isn't rocket science. Bad lending standards = bad economics.

MW said...

But surely it is, at least theoretically, possible to have an equilibrium, which would have to involve high asset prices."

Sure, but wouldn't it be a rather unstable (and unsustainable) equilbrium? To return to your "Prose Hack" post, it seems that a 'better' equilibrium would result from a much lower dollar and higher net exports (via both lower imports and higher exports).

JO said...

I gather the main point to be that rising house prices indicated an effort by the economy to equilibrate savings (presumably by Chinese consumers) with investment (i.e., construction of American housing stock), and not necessarily any kind of mania. (Although the high leverage used by speculators and the illiquid nature of real estate seem to be ingredients for a bubble to occur.)

However, I don't follow it all the way to a conclusion that the choice is between high house prices and recession.

Doesn't this assume that the equilibrium can be *achieved*? E.g., the necessary housing investment might very well exceed what Americans can actually occupy. Why isn't there some other route?

Игры рынка said...

I am confused. The macro definition of savings is a nominal amount. When on a micro level somebody saves in a real asset, on the macro level it is not saving. So when micro level bids up prices of houses how can it be related to savings?

On the other hand, when current period savings exceed previous period planned investments then some stock of produced goods is not sold and ends up as forced investments in inventories. That is how S is balanced with I in national accounts in accounting sense. This macro process means that house purchases can not be savings because house purchases ARE transactions and therefore get those incomes which ARE spent and not saved.

Ruth Harris said...

So the problem occurred because the employment that soaked up the excess savings was in US housing, which we can have too much of. If only it had been a second Mount Rushmore, handmade, using only sharpened teaspoons, we could have stayed in the Great Moderation for longer!

Fred said...

Household debt was $8T in 2001 and $14.4T in mid-2007.

That was the bubble. We handed out $6T+ in new debt and it all was cycled through home mortgages.

The upper decile got their 2001-2003 tax cuts, the rest got the opportunity to borrow as much money as they wanted. And they did.

It was all unsustainable, but the economic recovery of 2003-2007 was entirely driven by this debt take-on. On average, over this period each household got the equivalent of $1000/mo in stimulus -- that's how much new debt was created.

And that's why the economy is tanking now, everyone is tapped out. Happened in 1929, and 1989 in Japan.

Matt Waters said...

First of all, it's correct to say that "bubble" is a term used far too often. In fact, the financial crisis put all sorts of unwarranted apocalyptic language in vogue. The vast majority of people still think the current recession is some form of necessary adjustment vs. a general decline in unemployment across all industries and sectors. Every honest analysis says that the problem is demand, that we will not have high inflation and that most assets in 2006 and now were not overvalued.

However, the case for large housing mispricings and large misallocations of capital seems pretty clear-cut to me. From 2006 to early-2008, the economic situation did not change too much but housing prices and construction decreased dramatically. The case is even more clear-cut with CDO's, since many subprime bonds not only couldn't stand a housing decline, the loans could not stand even a flat or slowly rising market due to negative amortization.

Now, these misallocations of capital should not be and were not catastrophic for the economy as a whole. The possible underlying issues of bad regulation did have material costs, but the material costs have been borne by investors and taxpayers. The high unemployment is purely a ZLB issue that has costs far beyond the misallocation and generally paid by people with nothing to do with those misallocations. But, having said all that, the market failures were big and were real, even if the rosiest scenario turned out.

Andy Harless said...


I won't deny that there was an obvious (after the fact) problem with mortgage credit in the years before the crash and that ceteris paribus this problem would result in a severe excess allocation of resources to housing. But I question the ceteris paribus assumption.

Risk-free interest rates were much higher in 2006 than they are now, and they are probably higher than optimal even now, given the impact of the ZLB. Now if you imagine a shadow mortgage spread, by which I mean a spread between consumer mortgage rates adjusted for availability of mortgages and Treasury yields, that spread was obviously much too narrow in 2006, and it is much wider now (perhaps a bit too wide, but almost certainly closer to the optimum). However, I would suggest that the absolute level of shadow mortgage rates is still too high. That is, if we could do away with the ZLB, we should bring Treasury yields low enough that, even with appropriate caution on the part of lenders, it would be considerably easier to get an affordable mortgage than it is now. And home prices would go back to where they were in 2006 (or higher).

Now I'm going to quibble with your assertion that "from 2006 to early-2008, the economic situation did not change too much but housing prices and construction decreased dramatically." First of all, how dramatically is dramatically? I see the FHFA house price index (PDF) down about 5% from its peak (in seasonally adjusted terms) during early 2008, compared to about 20% at the 2011 trough and about 17% today. 5% is a noticeable correction, but it doesn't seem all that dramatic. Second of all, while it's true that the trajectory of NGDP didn't change that much, it's also the case that the US was experiencing a mini export boom which was able to replace the demand lost due to the decline in housing. The US was benefiting from the boom phase of the world economy's business cycle, but this was a temporary benefit. But for this temporary boom, the level of asset prices consistent with full employment would have been very high, possibly high enough to imply housing prices that should still have been rising rather than falling in 2007.

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maynardGkeynes said...

This theory fails to explain why virtually all of the inflation was in asset prices, rather than in goods/services as measured by CPI. That is why it was (and is) a bubble, much like the stock market. Oddly, the one market that is not a bubble today is bonds, which until the recent scare, have clearly been indicating that dominant economic force outside of inflated financial markets continues to be deflation.

Andy Harless said...


"This theory fails to explain why virtually all of the inflation was in asset prices, rather than in goods/services as measured by CPI."

This is exactly what you would expect when the demand to save is high. Saving means not buying consumer goods. So when the demand to save is high, the prices of consumer goods go, if anything, down, rather than up. Saving means taking income that you might have spent on consumer goods and instead spending it on assets. So by trying to save, you bid up asset prices, and you bid down consumer prices.

The real anomaly is the opposite of what you suggest: not why was no there no inflation in consumer prices, but why was there no deflation in consumer prices. And the answer is that consumer prices (and wages) are sticky. Without such price rigidity, the increase in real asset prices might have partly taken the form of a decrease in nominal goods prices.

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