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Depression Economics Explained, Part 1: Speculative Bubbles
People are desperate for an explanation of the economy that actually makes sense. They're not getting it from the experts. My talks with "Norm" are a composite of recent conversations I've had with friends, family and neighbors about what's going on with the economy. This first installment deals with the concept of speculation and the long "speculative bubble" that led to the current crisis.
Norm: Isn't this crash in stocks and housing prices just psychological? If people stopped selling and started buying, prices would go up—so why don't we all just start buying? It sounds too easy, but it sounds like common sense too, doesn't it?
Zack: Yeah it rings true. But it rings true in the same way as the promise of a chain letter or pyramid scheme—you know: "Let's each get ten friends to give us ten dollars...and then they'll each get ten friends...and soon we'll all be rich!" It can work for a little while, but only a little while. The financial equivalent of a chain letter is what economists call a "speculative bubble." We just had one that lasted about 20 years, it encompassed all sorts of assets. And that bubble is bursting now.
Norm: But it wasn't a chain letter—it was people investing in stocks and bonds and homes, in other words: real things with real values.
Zack: It's true that real assets are involved. But those assets become mere excuses for speculation in a bubble and are left behind in the dust of wildly increasing prices. One of the first financial bubbles was around tulip bulbs in the 1500s. It got so crazy that one rich lord traded his castle for a single bulb. He did it because he knew that the next day he'd be able to sell the bulb for enough to buy two castles. Speculative bubbles have happened over and over through the whole history of capitalism. Some say they are unavoidable.
Norm: But we're not talking about tulips, we're talking about houses. Supply and demand set prices: demand for housing was high and so housing prices went up!
Zack: It's not true that prices in this bubble were set only by "supply and demand." In the case of home prices, people were borrowing to pay way beyond what their income could "demand" in the market. They did that because they believed they'd be able to turn around and sell and retire on the surplus.
Norm: Yes, because demand was pushing prices up! My parents did exactly what you said just a few years ago when house prices were still shooting up. They got $500,000 for a house they bought in 1969 for $30,000 and paid off in 1989. Don't tell them their house wasn't really worth that much—they have the cash in the bank to prove it was.
Zack: In every bubble, there are always a lucky few who cash out at the right time and exchange their bubble assets for hard cash. As long as it's only a few people doing that at any given time, the bubble can keep inflating.
This stuff is counter-intuitive because our individual experiences in the market—like your parents' experience—are often very bad representations of the big picture. You have to take the whole market into account. To get our heads around this, let's imagine a simplified market in which there are only two people: you and me.
Now let's say I buy a $100,000 house to rent out for a little extra income. Then let's say you buy the house from me for $200,000. And then I go and buy it back from you for $300,000. We both made a profit, right? How cool! Let's keep doing that! After a few more exchanges, you're buying this house from me for a million dollars. Same house, but now it's worth 10 times what I paid in the first place. And if I borrowed that first $100,000 to buy the house, then I have literally made hundreds of thousands of dollars from nothing. How did I do that?
Norm: You did that because you wisely saw that demand for housing prices was rising and jumped into the real estate market.
Zack: But in my little example, demand for housing wasn't rising. We were just borrowing money from banks for the purpose of paying each other bigger and bigger prices. Who's renting the house? If that person was willing and able to pay a rent that increased along with our mortgage payments, then maybe what we were doing made sense. But in my example we were just agreeing to increase the price for the sake of making ourselves feel richer. It had nothing to do with the rental income, or the demand for housing. And that's exactly what happened to the actual housing market over the last couple decades.
Norm: But what's the problem? At the end of your example, I have a house worth one million dollars and you have hundreds of thousands in surplus in the bank.
Zack: Here's the problem: What if I decide that I don't want to play this game anymore? I don't buy the house from you for more. Then, suddenly, the house you bought for a million dollars is worth $100,000 again. Because there are no other buyers in our little two-person market.
Norm: Hm...
Zack: Think about what was really going on in that example. You and I were both borrowing money from our banks to buy this house from each other. Each time, one of us would take out a new loan, and the other would pay off an old one. Behind our personal experiences of feeling richer, our banks were really just swapping the same chunk of money back and forth. There was no actual wealth being created. At any moment, one bank was in the hole and the other was up—they canceled each other out.
Norm: Until you decided to stop playing. Then you got to keep your million minus the hundreds of thousands you borrowed.
Zack: That's right. But now you can't find a buyer—so you are in debt one million dollars, with a house that's worth only $100,000 as your only collateral. But it's not really you who lost all that money—it's your bank.
Norm: Ah! So that's why the banks are failing?
Zack: Exactly! But it's not just houses, it's all kinds of different assets that they lent money for other people to buy. And it's not just banks—it's all kind of investors including pension funds, university endowments, etc... In other words, not just a few rich people. This effects everything.
Norm: OK, I get it—but let me push back one more time: Why can't prices just stay where they are? Why do they have to crash?
Zack: It's because, if they act logically, people will all try to sell their assets when they see that the prices are not going up anymore. It's not enough for prices to stay the same, they have to go up. When people realize that they are not going to cash out at a big profit, then what's the point of making this mortgage payment? It dawns on them that they are going to be in deep debt for the rest of their lives. For tens of millions of Americans, their homes were their retirement plans. So they try to do exactly what your parents did and sell their house for their profit, but now it's just for whatever they can get. The first few will get a nice big profit. But soon prices are collapsing as everyone puts their homes on the market. That's why now we have all these folks who can't pay off their mortgage for the sale price of their homes.
Norm: And since banks had all these homes on their books as assets, suddenly the banks are in trouble as home prices evaporate?
Zack: That's the basic principle. But in reality it's more complicated. Banks often sold their mortgages to investors in the form of "mortgage-backed stocks." It was that abstraction of risk that partly allowed us to get into this mess. Banks might have been more careful in lending if they knew they'd have to live with the consequences. The investors could pretend that the banks were being cautious. And the banks could pretend that they were being cautious. In the end, it was just like any speculative bubble: everyone simply agreed to forget about reality. It was a collective effort.
Eventually, such a huge amount of the world's money was wrapped up in these bad mortgages—mostly American, but also from around the world—that when prices starting falling, there were big consequences for all markets. When investors lost all that money on mortgage stocks, they started taking money out of other markets, like the stock market. Also, some financial companies with heavy exposure to the mortgage stocks went out of business, leaving the holders of corporate bonds (which were considered to be safe investments) with big losses. That freaked out investors so much that now companies can't raise any money by buy selling bonds. The whole mess is making everyone with cash very leery of lending it out to anyone. But the economy is set up right now to run on credit. And so the whole economy is seizing up like a stalled engine.
Norm: Now you've finally gotten to the "credit crunch" that they keep talking about on the news.
Zack: Yes. Well, let's leave that till our next session. But for now here's just a preview: Imagine a kid with a paper route. He has to buy his papers from the newspaper company, then he resells them at a profit. But imagine that he's spending all his profits on video games and McDonalds as soon as he makes them. The only way he keeps his business going is that his mom lends him the money each day to buy the new batch of papers. This works fine for a while. What if his mom suddenly refuses to lend him money? Then he can't buy the next batch of papers. His business is done. That's exactly how most business have come to be run. And that's why the withholding of credit is causing so many businesses to cancel new investment or to close down all together.
Norm: Whoa, that sounds bad.
Zack: That's what's happening. More next time!
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I like the story but you left out the chapter on the value of the paper federal reserve note that is used to sell the house back and forth.
if its fiat currency, you get what we got. if it was commodity based and the intrinsic value of that dollar was sound, the money would be real and inflation would be curtailed.
http://myslu.stlawu.edu/~shorwitz/open_letter.htm
If the dollar was backed by gold, we would have had limited economic growth over the last 35 years and a few massive recessions. Being off the gold standard is a liberal policy that helps the mass of Americans.
Gold is an arbitrary growth regulator, not based on the needs of the economy. I prefer free will: we should control the money supply for the best outcome. Scary, specially with Robber Barron BushCo running the government, but effective with good government.
I think in economics this is called "the greater fool theory". Such a theory states: "No matter how much you pay, there will always be a greater fool who will pay more."
This only works so long as there is not a huge oversupply of houses or the demand doesn't drop off because wages or the extension of credit is insufficient to meet the seller's price. In other words, when demand is met or it drops off for any number of reasons, the bubble stops for a while then begins to rapidly deflate (which it is doing now -- much more than during the Great Depression).
In this recession, those who have homes have paid too much for them and now they can't sell them (the fools). When we look back at this economy, it expanded by promoting the greater fool theory. And if you ask who is responsible for this mess, the answer should be obvious.
If, in a nutshell, you are saying that deregulation and the securitization of mortgages by the investment banks caused this, then I agree.
The economy was really buzzing along with all these bad mortgages. People were making their mortgage payments on time. Employment was good, even though incomes were level. The government was reporting "inflationary pressures," and then the fed reacted with interest rate with a year of consecutive interest rate hikes. I can't help but think that the need to control inflation caused the bubble to burst. Housing costs have doubled, so home prices had to go up. We can't control oil prices as they went up. The fed action to raise interest rates put the pressure on the middle-class, already under pressure from level earnings. My vote: The middle class has been taking all the burden for controlling inflation. Guess, what! They can't... it's the last straw!
Significant increases in interest rates has derailed the economy many times over the past decades: See 1970, 1974, 1980-82, 1990, 2000, etc. This time around, however, the economy remained strong long after the interest rate hikes ended in the summer of 2006. The economy was actually strong from the spring thru the fall of 2007, then took a turn for the worse while the fed had already been lowering rates.
Okay, I know that this is a lot like trying to look into a crystal ball, but just how bad is this thing going to get? I'm the "low gal on the totem pole, but already I've seen early evidence out there that inventory is at a standstill and retail prices are being cut across the board for non-essentials (everything but food).
I went to Walmart the other day, and women's shirts were marked down to $2.00, and still ,there weren't any takers - and that same stack of shirts had been there for over two weeks! In more flush times, shoppers would have snatched 'em up and they'd be GONE! Has anyone else noticed this kind of thing happening as well?
Yes it is a loan slavery system and humans are not machines which can carry such burdens indefinitely.
The burden of debt with credit cards, morgages and car loans will eventually wear the borrower down to depression. At the present it is recess, the depression comes just a bit later when the loses become insurmountable.
It's convenient for the GOP to blame the poor, because this is the one group that is least able to fight back, and the group least likely to vote for them anyway. But the numbers don't lie, folks.
While the poor did in fact get caught in this web, and did default on a number of loans, the total percentage of those loans is nowhere near big enough to cause a world market collapse. Look around. This mortgage crisis is not restricted to urban low income neighborhoods here at home. (If this was just a problem in the projects, I guarantee it would never have made the front page.)
No, we are talking about world market collapse. We are talking about the foreclosure of McMansions, ocean front estates, and banking failures on a global scale. (As if the poor could pull that off.)
This crisis did not occur because the poor abused the free market principle of deregulation to rip off Wall Street, this crisis occurred because the greedy ghost of Gordon Gecko is the acting grand wizard behind the curtain of deregulation policies.
http://www.huffingtonpost.com/kelley-bellwenzlaff/the-welfare-queens-of-wal_b_134478.html
Squeezing currency out of the economy is never a pretty sight. The problem is that no one wants to do it. Liberals jump to increase the deficit by pumping more dollars into domestic spending. Conservatives want to keep high levels of profits in the private sector.
Housing prices do not rise continuously as part of any economic trend. Prices have been kept artificially high and when interest rates increased availability of currency and new questionable forms of financing were devised they continued to create the seeds of their own destruction. "The bigger they are the harder they fall" . So expect it to be big. It has been going on for some time.
I think it's a little bit over-simplifying to say that "banks are melting-down on mortgages and it's the end of the world as we know it." Bubbles come, and bubbles go. What's happening this time is that the banks want to divert all of their speculative losses onto the ultimate borrower ... Uncle Sugar.
But if that happens, all of the "fluff" in the money-supply will stay-put. The money used to pay everybody off was ALSO borrowed. So, we haven't really accomplished anything at all.
The root cause of the problem, I think, is that too many "lawyers and accountants" have been running this show, and not enough manufacturers and businessmen. What businessmen there are have been making their fortunes from ... things that are paid-for with insurance and with (guess what!) more borrowed-from thin-air Federal Money! It's exactly what Dwight D. Eisenhower was trying to warn us about.
"Okay, they're really just tulip-bulbs. Stick 'em in the ground and they grow. Period."
Vast(!) Losses(!) .. oh really? Where did all this "money" that you "lost" actually come from, anyway? What did you make, and sell, to earn it? Oh. You just waved your magic credit-card and it just appeared? Well, "you can't 'lose' leprechaun money."
We've had housing bubbles before.
This crash was caused by the GOP religion of deregulation.
Bring back glass stegall.
Ban derivatives, leverage and shorts.
Exactly!
The sad thing is our first MBA president probably wouldn't grasp the ideas laid out in this article.
Dugan, when you say "US population growing rapidly", do you mean birthrates or immigrants/illegals? This growth is not going to fuel a housing frenzy like we saw over the 10 years ending in 2006. The housing boom was fueled by middle class Americans (with STAGNANT WAGES in that time frame), they were speculators, buy as big as the bank will allow(max debt) and hope to sell for a profit. The banks, government, builders and real estate agents also fueled the fire. Here in the rustbelt, we never had the huge run-up in prices(in average homes) but prices are still dropping and there are plenty of apartments available.
For all you Republican single issue voters out there, just think if we really fall into a full scale depression which is still very possible of all the women forced for economic and sheer survival reasons to abort babies they other wise might have had..?
Republicans are really bad for a civilized progressive society and it's overall real security and prosperity..!
darth, populations are declining in eastern Europe and Russia for this very reason, it's no joke.
What was different about this bubble was that much of it in the later stages was financed by people selling their houses to the banks and buying them back argain at a higher price.
http://machiavelli.blog.co.uk/2008/10/13/2f3a4fccca6406e35bcf33e92dd93135moneythe-great-freemarketillusion-4864992
Speculation is when buyers base price more on the future sales price of an asset than on the predicted income from that asset. A house is fundamentally worth some multiple of the expected revenue stream of that house (rent); built into that calculation of future revenue should be factors like changes in neighborhood desirability, etc.
The same is true for stocks. But people were treating both classes of assets as lottery tickets, not investment instruments attached to anything real. So much for "real" estate.
***
The bubble was further fueled by parallel behaviors on the part of consumers and Wall St. Both were leveraging frail or non-existent assets far beyond their safe weight-bearing capacity. Consumers did it by withdrawing value from their homes and buying lots of stuff. Wall St was doing it by inventing exotic derivatives that laundered risk out of assets until a shaky mortgage began to look "safe," then using the money to buy lots of stuff.
Most of the growth over the past decade has therefore been an illusion, because the money moving at high velocity from pocketbook to pocketbook turned out to have very little backing it up. Now that consumers can no longer withdraw money from their houses, no more money is going into that big-screen TV, and a cascade of people are losing their jobs. That will further deepen the mortgage crisis and spread it to other areas of consumer debt (credit cards, student loans).
The back and forth house selling story sounds like Baby Boomers were trading up in the market until the children left home and then there was a sudden surplus of high end houses. This may be the first Baby Boomer retirement related effect that exhibits itself in the real economy. The bank is out the value of the last sale of the property (make a +/- list of transactions to follow this).
Being on the tail end of the boomer cycle I am not looking at a great appreciation in my house. But that's okay. It is equivalent to long term rent, without a landlord to deal with.
Not all this was people selling homes to each other. Home construction was near all time highs for a long period so many of the homes being purchased were new. One speaker in the article seems to overlook that people still need homes to live in and the population of the United States is growing fairly rapidly. Right now we have a housing glut where supply far exceeds demand. However, since homebuilders have cut back dramatically on contruction and since we have a second baby boom generation reaching the age of household formation soon, the inventories could quickly come into balance with demand, which will result in the stabilization of prices. The speaker in the article also doesn't mention that the massive price increases were mainly in only a half-dozen metro areas in the US, so it's not like the entire US is affected. The speaker should also have pointed out that the metro areas with the biggest price increases are also the areas with the fastest growing populations, thus stabilization could arrive more quickly than many imagine. This is not the first housing boom-bust cycle in the US. Homebuilders have overbuild many times before since WW2.
Home pricing isn't just limited to particular metro areas only. One can easily test the postulation by going on realtor.com for example and look at the price of a house say in Virginia (in a rural area), then compare it to a rural area in Texas, South Dakota, etc., and you will see a wide variation in price for that 3 bedroom, 2.5 bath house with two car garage.
But, don't take my word for it. Try it yourself and you will see that home prices and the wide variation in price just doesn't center around metro areas such as, Washington DC, or Reno Nevada, Chicago, Boston, Tucson, etc., etc.
The driver of the housing bubble was not supply. There were always plenty of homes on the market. Prices kept rising because people thought that buying a home was a good investment because they had seen it having been a good investment for other people. That is exactly what happens in every Ponzi scheme. The first few generations of chain letters etc. make good money, the late comers get greedy, thus fueling the early players which then makes the late comers even more willing to go out on a limb to get a piece of the pie.
Population growth is not a major driver for the bubble, either. There are plenty of people moving to my area, but most of them will never be able to afford a home at the current price level anywhere close to where they rent now. Population growth only feeds suburbia. And that, at this point, is also quickly fading as a viable option due to transportation fuel cost.
"The back and forth house selling story sounds like Baby Boomers were trading up in the market until the children left home and then there was a sudden surplus of high end houses."
Not exactly. The houses themselves have not changed. Don't let anybody fool you into believing that the value of your cinder box goes up significantly just because you put some insanely expensive and incredibly ugly marble slabs into the kitchen and the bathroom. It doesn't. In real estate the real value is the location. What you do to a house makes almost no difference. In most locations and for most homes you could replace an existing structure with a brand new one and you would never make the construction cost back.
What has changed are not the homes but the ratio between income and mortgage. A sane ratio would be 25 percent. If you spend more than thirty percent of your income on your home, you are in trouble. If you spend fifty percent of it on your mortgage, financially you are "dead man walking". And that is exactly what many late buyers had to do to "get a piece of the market". They went in with insane income/mortgage ratios, let go of any safety nets and played Russian Roulette with their lives.
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