August 9, 2015

A Crystal Ball And Unrealistically High Expectations

A weekend topic on economists, policy and bubbles. Mortgage News Daily, “A new Economic Letter, Interest Rates and House Prices: Pill or Poison? from the Federal Reserve Bank of San Francisco, looks at the link between interest rates, mortgage lending, and house prices. So how much would interest rates have needed to increase to keep housing prices in check during the 2002-06 housing bubble? Since a 1 percentage point increase in the short rate translates into about a 4.4 percent decline in house prices, the authors calculated that keeping house prices on trend would have required about an 8 percentage point increase in the federal funds rate in 2002.”

“Instead the rate stayed between 1 and 1.25 percent from the end of 2002 until the June 2004 when it rose 4.25 percentage points, reaching 5.25 percent by June 2006. In the authors’ experiment, the rate would have been about 8 percentage points higher at the end of 2002, but would have ended at about the actual level of June 2006. Roughly speaking, such a large increase in interest rates would have depressed output more than did the Great Recession.”

“The authors conclude that slowing down a housing boom is likely to require a considerable increase in interest rates, probably one widely at odds with maintaining full employment and price stability and would also require the Fed have a crystal ball to foretell upcoming booms. ‘In restraining asset prices, while the power of interest rate policy is uncontestable, its wisdom is debatable,’ the authors say.”

PBS Newshour. “Former Treasury Secretary and Harvard economist Larry Summers has been arguing for well over a year that we should recognize that the economy has morphed into one that is no longer capable of growing in the way that it did during the second half of the 20th century and that it won’t again unless we happen to be in a financial bubble. Crucial to Summers’s argument is the observation that during the years prior to the meltdown of 2008 the economy was by no means overheating as one would expect in a boom.”

“As Summers explained, ‘Capacity utilization wasn’t under any great pressure. Unemployment wasn’t under any remarkably low level. Inflation was entirely quiescent. So somehow, even a great bubble wasn’t enough to produce any excess in aggregate demand.’ Summers’s thesis was a ‘radical manifesto,’ according to Nobel Prize winning economist and New York Times columnist Paul Krugman, noting that, ‘we may be in an economy that needs bubbles just to achieve something near full employment.’”

From “There are three classic metrics to determine when an asset has grown into a bubble: it becomes extremely over supplied, over owned and overpriced compared to historical norms. The real estate market circa 2005 was a great example of a classic bubble. However, even though home prices are currently vastly overvalued, the housing market is not in a classic bubble because the real estate market is not currently in the conditions of being over owned or over supplied.”

“But the bond bubble is a classic bubble thanks to Wall Street and the Federal Reserve. The bond market qualifies as being in a state of over supply because there has been an additional $60 trillion in total global debt that has accrued since 2007. I first explained the classic signs of a bubble at the start of the real estate crisis to help investors identify a problem before it grows too far out of control. Perhaps the Fed should now take heed and ask the question if seven years of zero percent interest rates could possibly lead to a bubble in fixed income. But even more importantly, the question everyone should be asking is: what happens when bond prices crash and who is going to buy all that debt?”

“The bottom line is that the bond market is the most dangerous bubble in history precisely because every asset class derives its value from the cost of money. Therefore, even though stocks and real estate aren’t in a classic bubble they have still become vastly overvalued due to the frantic search for yield over the course of seven years.”

From Bloomberg. “One of the strongest orthodoxies in modern economics is being challenged, and there could be big implications for the state of the profession. The new, rebellious ideas might also help us understand why financial bubbles happen. If economists insist on using an incorrect assumption as the core of their models, it will force them into ever more Byzantine theoretical contortions, as the models repeatedly fail to fit the facts. Cynics would argue that this is exactly what we see happening in macroeconomics, where the prevailing theories have led to precious few correct predictions during the past decade.”

“Now, a trio of economists from the Federal Reserve Board has gone further, exploring whether human mistakes can explain the housing bubble. The Fed threesome looked at data from the Survey of Consumer Finances, from before and after the housing crash in 2008. They found that more optimistic ZIP codes — that is, places where people had unrealistically high expectations for their own incomes — were more likely to overpay for houses in the bubble run-up before 2008. These overoptimistic people also took on more debt, and they were more likely to increase borrowing in response to rising house prices.”

“This looks an awful lot like a systematic mistake. If you were the government in 2005 and 2006, you might have been able to use expectations surveys as a warning sign that told you when to restrict mortgage lending.”

“In other words, rational expectations might really be wrong. People might make systematic errors, thinking that booms or busts will last forever. If that’s the case, then it will require the economics profession to abandon one of its strongest orthodoxies. But the payoff could be big if the profession devises models that successfully explain phenomena like bubbles and crashes.”

Bits Bucket for August 9, 2015

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