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WEDNESDAY, MARCH 19, 2014
American Delusionalism, or Why History Matters
If you start from the assumption that the event you’re trying to predict is unlike anything that’s ever happened before, though, you’ve thrown out your chance of perceiving the common pattern. What happens instead, with motononous regularity, is that pop-culture narratives such as the sudden overnight collapse beloved of Hollywood screenplay writers smuggle themselves into the picture, and cement themselves in place with the help of confirmation bias. The result is the endless recycling of repeatedly failed predictions that plays so central a role in the collective imagination of our time, and has helped so many people blind themselves to the unwelcome future closing in on us.
An economist recently recommended that I read a paper by three Fed researchers titled: “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis.” It was presented at a major conference last year and made the rounds again in the economics blogosphere this year with generally positive reviews. It seems to have been influential.
The authors – Christopher Foote, Kristopher Gerardi and Paul Willen – argue that the financial crisis was caused by over-optimistic expectations for house prices, while other factors such as distorted incentives for bankers played only minor roles or no roles at all. In other words, it was a bubble just like the Dutch tulip mania of the 1630s or South Sea bubble of the early 1700s, and had nothing to do with modern financial practices.
Then the authors make absolutely sure of their work being well-received by those who matter. The financial crisis is surely a touchy subject at the Fed, where the biggest PR challenge is “bubble blowing” criticism from those of us who aren’t on the payroll (directly or indirectly). But Foote, Gerardi and Willen are, of course, on the payroll. They tell us there’s little else that can be said about the origins of the crisis, because any “honest economist” will admit to not understanding bubbles.
Here’s their story:
[I]t is deeply unsatisfying to explain the bad decisions of both borrowers and lenders with a bubble without explaining how the bubble arose. …Unfortunately, the study of bubbles is too young to provide much guidance on this point. For now, we have no choice but to plead ignorance, and we believe that all honest economists should do the same. But acknowledging what we don’t know should not blind us to what we do know: the bursting of a massive and unsustainable housing bubble in the U.S. housing market caused the financial crisis.
We don’t often critique papers like this (who cares about Fed research outside of academic economists?) But what the heck, the bolded sentences above – in particular, the hypocritical reference to “honest economists” – deserve at least a few words of rebuttal.
We’ll limit our comments to two areas. First, we’ll offer a redline edited version of a key section in the authors’ conclusion, mostly to share a different perspective on the financial crisis. Second, we’ll point out an example of dishonesty from these economists who brazenly claim that their own perspective is the only one that can be called honest.
Where did the bubble come from?
In practice, the authors don’t completely “plead ignorance” about the causes of bubbles as they claim to do. They offer a few “speculative” ideas about the housing bubble, writing:
One speculative story begins with the idea that some fundamental determinants of housing prices caused them to move higher early in the boom. Perhaps the accommodative monetary policy used to fight the 2001 recession, or higher savings rates among developing countries, pushed U.S. interest rates lower and thereby pushed U.S. housing prices higher. Additionally, after the steep stock market decline of the early 2000s, U.S. investors may have been attracted to real estate because it appeared to offer less risk. The decisions of Fannie Mae and Freddie Mac may have also played a role in supporting higher prices…
This smells to us like a strategy of gently acknowledging criticism (of the Fed’s interest rate policies), while at the same time attempting to neutralize it. The authors imply that low interest rates were an unavoidable byproduct of the Fed’s recession fighting, and then shift some of the blame to foreigners in developing countries before moving on to other possible explanations.
But even if you believe the Fed’s anti-recession measures were worthwhile, the authors’ story is nonsense. It needs corrections for the facts that the Fed continued to slash rates nearly two years after the 2001 recession and then maintained an ultra-easy stance for a few years after that. It also begs the question of why the Fed responded to high foreign savings rates – which were the flip side to U.S. current account deficits and primary source of disinflation – with even greater stimulus. Moreover, there’s much more to the Fed’s role in the housing boom than these factors.
As we see it, the financial crisis validated certain principles that aren’t reflected in mainstream models but feature in fringe areas such as Austrian business cycle theory orbehavioral economics. Economists in these areas offer far more detailed explanations for the housing bubble than the “speculative story” above. For example, recent Nobel Prize winner Robert Shiller filled a whole book with bubble theories. While Foote, Gerardi and Willen would presumably call these economists dishonest, we beg to differ. Borrowing from non-mainstream ideas, here’s our edited version of the excerpt:
If this version is accurate, the Fed’s failures include three whoppers:
- Monetary policy was too stimulative throughout the boom.
- Two decades of Greenspan/Bernanke “puts” created a mentality that risky bets couldn’t lose (moral hazard).
- The Fed applauded rather than stopping the deterioration in lending standards, blithely disregarding its status as only institution that was mandated to set nation-wide lending requirements.
As you might expect, Foote, Girardi and Willen weave a story that either denies or diverts attention from all three failures. One part of the story is their claim that bubbles can’t be explained and anyone who thinks otherwise is dishonest. If the defining feature of the crisis can’t be explained, then it can’t be blamed on the Fed, right?
Other parts of the story are embedded in 12 “facts” that are said to describe the crisis. As written, many of the “facts” are strictly true. Some may have even added to the public debate because they weren’t widely known in policy circles, even as they were understood in the fixed income business. Others, though, can only distort that debate. The worst of the so-called facts are somewhere in between flat wrong and technically accurate but interpreted in ways that don’t stand up to scrutiny.
Lending standards didn’t really change during the boom?!?
We’ll point out a single example, from pages 9-11 of the paper and sub-titled, “Fact 4: Government policy toward the mortgage market did not change much from 1990 to 2005.” In this section, the authors deny that policymakers dropped the ball on lending standards. They don’t mention central bankers explicitly (that would be too obvious?), choosing instead to absolve the Clinton administration of blame for its ill-fated National Home Ownership strategy. Of course, their argument also exonerates the Fed if you happen to believe it.
The argument depends partly on a history lesson that begins like this:
It is true that large downpayments were once required to purchase homes in the United States. It is also true that the federal government was instrumental in reducing required downpayments in an effort to expand homeownership. The problem for the bad government theory is that the timing of government involvement is almost exactly 50 years off. The key event was the Servicemen’s Readjustment Act of 1944, better known as the GI Bill, in which the federal government promised to take a first-loss position equal to 50 percent of the mortgage balance, up to $2,000, on mortgages originated to returning veterans.
The authors then tell a nostalgic tale about loan-to-value (LTV) ratios in the 1950s and 1960s, before skipping ahead to the 1990s and 2000s. For the latter period, we’re told to believe that lending standards didn’t decline in a meaningful way:
Figure 6 shows LTV ratios for purchase mortgages in Massachusetts from 1990 to 2010, the period when government intervention is supposed to have caused so much trouble … But inspection of Figure 6 does not support the assertion that underwriting behavior was significantly changed by that program [Clinton’s National Homeownership Strategy].
Here’s the key chart that goes with this claim:
Here are a few reasons why the thesis doesn’t fit the reality:
- The authors share data for only one state (Massachusetts), while failing to mention that it didn’t have much of a housing bust. Consider that Boston is one of only four cities (out of 20) in the S&P/Case-Shiller Home Price Index for which prices didn’t fall by more than 20%. During the bear market period for the full index, the Boston component fell only 16%, less than half the 34% drop in the national index.
- The authors’ sweeping argument relies on not only a single state, but also a single indicator (LTV ratios). You might wonder: What were the credit scores of borrowers at each LTV level? How did their incomes compare to monthly mortgage payments? Were their incomes verified? These types of questions need answers before you can draw general conclusions about underwriting behavior.
- Even the cherry-picked data – Massachusetts LTV ratios! – doesn’t support the authors’ conclusions. It shows that the incidence of ratios greater than 100% tripled during the housing boom, from about 8% of all Massachusetts mortgages to about 25%. The claim that this change isn’t significant is incredulous.
- LTV ratios in the 1950s and 1960s, while interesting, are irrelevant to the early 21stcentury housing boom. Different era, different circumstances, different implications.
Needless to say, the authors’ attempt at defending fellow public officials falls well short. Lending standards declined sharply during the boom, and this was encouraged by both the federal government and the Fed. No amount of data mining can change these facts.
Overall, the Fed staffers’ paper fits a common pattern. It’s stuffed with enough data to be taken seriously, but inferences are based more on spin than objective analysis. The approach aligns conclusions with an establishment narrative, while protecting the authors’ establishment status. The last thing you would call this paper is an honest piece of research.
As long as we’re at it, here’s an extra edit, this one offering another perspective on Foote, Gerardi and Willen’s conclusions about our knowledge of bubbles (from the first excerpt above):
Heinz shuts down its plant in Leamington, Ont., laying off more than 700 and ending a 104-year-long presence in the town. Three weeks later, Kellogg’s shuts down its plant in London, Ont., erasing 500 jobs. Days after that, drugmaker Novartis announces its pharmaceutical plant in Mississauga will shut down, taking 300 jobs with it.
Add it all up, and what you have is the largest medium-term threat to Canada’s economy, BMO chief economist Doug Porter said in a client note this week.
Porter noted that Ontario has lost 4 per cent of all its manufacturing jobs in the past year — something he understatedly describes as “not good.” Canada overall lost 2.5 per cent of all its manufacturing jobs this year, the Wall Street Journal notes — and that’s despite a recent rise in manufacturing output.
There are now more jobs in health care in Ontario than there are in manufacturing; as recently as 2000, there were twice as many factory jobs as health care jobs.
The decline of factory jobs is taking place even as manufacturing around the world, particularly auto manufacturing, is experiencing a boom — one that appears to bepassing Canada over.
“It would seem to us that this is a much bigger issue for the medium-term Canadian outlook than the more hyped housing bubble/household debt concern,” Porter wrote.
The Bank of Canada appears to disagree, once again reiterating this week that it sees high house prices and record high consumer debt levels as the dominant domestic risk to the economy.
But maybe those two risks aren’t entirely unconnected. As manufacturing employment wanes (even with manufacturing output growing), the real estate boom has picked up much of the slack, and construction employment is at or near record highs in Canada today.
But few market observers, even those optimistic about the future of the housing market, expect this juggernaut to continue. That’s why economists are constantly looking to external demand (i.e. exports) to pick up the economic slack from a housing boom that’s expected to level off.
On that front, there is some hope for good news, BMO economist Robert Kavcic says.
“With the high-profile job cuts in Ontario’s manufacturing sector piling up, there might be some reprieve coming from the weaker loonie and stronger expected U.S. growth,” he writes.
“But keep in mind that a weaker currency won’t help overnight — the impact tends to filter through over the course of at least two years.”
So here’s hoping the housing construction boom keeps up for a few more years, or Canada could get a nasty surprise in future unemployment reports.
Today’s AM fix was USD 1,271.50, EUR 939.69 and GBP 787.11 per ounce.
Yesterday’s AM fix was USD 1,272.25, EUR 942.13 and GBP 790.12 per ounce.
Gold fell $0.30 or 0.02% yesterday, closing at $1,273.40/oz. Silver slipped $0.09 or 0.44% closing at $20.32/oz. Platinum climbed $3.40 or 0.2% to $1,411.40/oz, while palladium rose $3.75 or 0.5% to $718.47/oz.
Gold in sterling terms is testing strong support at the £775/oz level. A breach of this level could lead to gold testing the next level of support at £740/oz and below that at £700/oz which was resistance in 2009 (see 5 year chart below).
Gold was trading in a tight range until it suffered another very sharp concentrated sell off at 1126 GMT which led to prices falling from $1,272/oz to $1,259/50 in seconds. The selling was so furious and concentrated that it led the CME to stop trading for a significant twenty seconds. Some entity appeared determined to get the gold price lower and they succeeded – for now.
Gold failed to make any headway despite dollar weakness after more dovish comments from exiting Fed Chairman Ben Bernanke about the bank’s bond purchases.
Bernanke said yesterday that the Fed will maintain an ultra loose U.S. monetary policy for as long as needed and will only begin to taper bond buying once it is assured that labour market improvements would continue.
The assumption that QE will be trimmed is like a lot of assumptions – wrong. There are strong grounds for believing that the weak state of the U.S. economy may lead to Bernanke’s even more dovish successor, Yellen, increasing the QE programme.
Physical demand continues at these levels but is not at the very high levels seen in recent months.
Many bullion coin and bar buyers have accumulated their allocation of gold and silver and are waiting for higher prices. There is a real sense of the calm before the storm in the gold market. How that will manifest and the catalysts for a resumption of the bull market is yet to be seen.
The Bank of England’s Systemic Risk Survey semi annual report to quantify and track market participants’ views of risks to, and their confidence in, the UK financial system shows increasing concerns of a house price crash.
The report presents the results of the 2013 H2 survey, which was conducted between 23 September and 24 October 2013 with 76 financial services companies.
Fears that a house price crash could damage the financial system have risen sharply in the last year, the key Bank of England survey shows. Increased concerns were expressed by the participants over ultra loose monetary policies and the extended low interest rate period.
Concerns about a property price bubble rose and were mentioned by 36% of respondents, up 21% from 14% since the previous survey in the second half of 2012. Concerns were concentrated almost exclusively on the residential market, where responses focused on the risk of a house price correction.
As we know house price corrections tend to feed on themselves and often lead to house price crashes.
Other Key Risks To The UK Financial System:
• Perceptions of the two main risks to the UK financial system remain sovereign risk and the risk of an economic downturn, although citations of both have fallen: 74% of respondents mentioned the former (-3 percentage points since May 2013) and 67% (-12 percentage points) the latter. Concerns over sovereign risk continue to focus on Europe, but unsurprisingly given the uncertainty surrounding the U.S. debt ceiling negotiations that prevailed during the survey period, there was a sharp increase in concerns around U.S. sovereign risk.
• For the second survey in succession, risk surrounding the low interest rate environment was the fastest growing, with 43% of respondents citing it, up 17 percentage points since May 2013. Over half of the responses emphasised risks around low rates, with the remainder referring to risks associated with a snapback in those low rates to more normal levels. Perceived risk around property prices also rose, being mentioned by 36% of respondents, up 11 percentage points since the previous survey. Concerns were concentrated almost exclusively on the residential market, where responses focused on the risk of a house price correction.
• Other top risks include regulation/taxes (cited by 41% of respondents, up 1 percentage point since May 2013), financial institution failure/distress (+4 percentage points to 30%) and operational risk (+1 percentage point to 25%).
Outside of the top seven, geopolitical risk has grown in prominence, with concern focusing on instability in the Middle East.
The report may have led to GBP weakness upon its release as the pound fell against the dollar, euro and gold.
Interestingly, also on Monday came news of a sharp 5% drop in London property prices in what could portend a bust of the London property bubble.
Values in the U.K. capital dropped 5%, or 26,956 pounds ($43,500), from the previous month to an average 517,276 pounds, Rightmove PLC said Monday. Across England and Wales, average prices declined by 2.4%.
Estate agents and property industry blamed the falls on a seasonal pre-Christmas decline, however valuations are extremely stretched with very low yields and the hot money that has fueled the huge increase in London property prices may be pulling back.
“This is different” and “this location is different” is the mantra of every property bubble. We will soon see if the London property bubble is truly different or will suffer the fate of bubbles throughout history.
Of the four charts in our market update today, which ones do you think show characteristics of a bubble?
Those diversifying and buying gold in the UK today will be rewarded in the coming years. The smart money is reducing exposure to overvalued London property and increasing exposure to undervalued gold.
Maybe this time, it really is different. Maybe life expectancies have grown, and with them, people’s willingness to take on more debt. That would mean house prices could stay up higher than history would suggest.
Maybe interest rates aren’t going back up. If there is no inflationary pressure, either in Canada or in the U.S., there isn’t much reason for central banks to push interest rates back up.
Maybe we’re in for an endless housing boom. Maybe. But if history is still any guide to go by, then folks, it looks like we have one whopper of a housing bubble on our hands. Because just about every single indicator that warns economists of trouble in the housing market is now flashing red.
Investment bank Goldman Sachs and British business paper the Financial Times are the latest to throw in with the “Canada has a housing bubble” crowd. Goldman put out a report last month saying that some parts of Canada are suffering from overbuilding, and given the excess construction, a “price decline can be quite significant.”
Meanwhile, FT declared Monday that Canada’s “property sector is perched precariously at its peak.”
U.K. house prices rose to a record last month as easier access to credit drove first-time buyers back to the market. As Bloomberg reports, the second phase of the government’s Help to Buy program was introduced this week, providing government-guaranteed mortgages to buyers with smaller deposits. The acceleration has fueled further concerns that the initiative may stoke a bubble. But have no fear…
- *BOE’S CUNLIFFE SAYS U.K. HOUSING NEEDS TO BE WATCHED CAREFULLY
- *CUNLIFFE SAYS DOESN’T AGREE U.K. IS ENTERING A HOUSING BUBBLE
What could go wrong? – “Demand has increased significantly in a short space of time, and raced ahead of the supply of homes.” Now where have we heard that before?
U.K. house prices rose to a record last month as easier access to credit drove first-time buyers back to the market, Acadametrics said….
- U.K. September Inflation Rate Unexpectedly Stays at 2.7% (bloomberg.com)
- U.K. September Home Prices Rise as Aid Programs Boost Demand – Bloomberg (bloomberg.com)
- Cameron’s Housing-Market Loan Fix Seen as Bad Policy for Britain (bloomberg.com)
- House prices hit record high during summer (theguardian.com)
- Re: Which Housing Bubble Is Going To Pop first: Australia, U.S., U.K. or Singapore? (forum.prisonplanet.com)
- Housing and Property Bubble – The Double Trouble! (shrikantgshete.wordpress.com)
- FSN: Bullard Sees No Asset Bubble… Because All Previous Bubbles Were “No Secret” (silveristhenew.com)
- This Day in Crisis History: Sept. 4, 2008 (blogs.wsj.com)
- The Financial Crisis: ‘What Has This Got to Do With Monetary Policy?’ (minyanville.com)
- Asset Bubbles Found by Finnish Economist Inspired by Grandfather (bloomberg.com)
- Three Cheers for the Next Economic Bubble (foreignaffairs.com)
- The Smell Of Collapse Is In The Air (etfdailynews.com)
- Study: Financial Booms May Be Created by Instinctive Behaviors (usnews.com)
- New Research in Economics: Rational Bubbles (economistsview.typepad.com)
- Housing: Another Bubble? When Was the First One? (wallstreetpit.com)
- Paul Krugman: This Age of Bubbles (economistsview.typepad.com)
Is There A Bubble In The Canadian Condo Market? We Drill Down Into The Facts To Find Out | Zero Hedge
- ‘Jury out’ on whether Canada will avoid nasty housing downturn: report (globalnews.ca)
- A Better Look at Household Balance Sheets (canadaecon.wordpress.com)
- Flaherty Says Not Considering Further Housing Tightening – Bloomberg (bloomberg.com)
- Canada housing market has calmed down – finance minister (xe.com)
- Osborne Says Help-to-Buy Won’t Create UK Housing Bubble – Bloomberg (bloomberg.com)
- Top economist warns of ‘disastrous’ house price crash due to new Government lending scheme (express.co.uk)
- Chancellor in push for Help to Buy (bbc.co.uk)
- Pouring money down the drain – Osborne’s Help to Buy scheme (taxresearch.org.uk)