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September 16, 2013

The Stability Bubble

Robert Samuelson offers an interesting perspective on Obama's "Blame Unregulated Markets and Evil/Greedy Bankers" explanation for the 2008 financial crisis. Unexpectedly (!), it turns out that these greedy bankers lost more of their own money when the housing bubble burst than other professionals did:

Take the popular notion that banks and investment banks (“Wall Street”) knowingly packaged bad home mortgages in securities that were then sold to unsuspecting investors. The bankers, the story goes, understood that there was a housing bubble — that prices would crash and defaults explode — but peddled bad loans because it made them rich.

Although this happened, it was the exception, not the rule. That’s the conclusion of a study by economists at the University of Michigan and Princeton. They reasoned that if the investment bankers packaging mortgages expected a housing collapse, they would have been careful in their own home purchases. So the economists compared the bankers’ home-buying with that of lawyers and stock analysts who lacked specialized housing knowledge. The study, published by the National Bureau of Economic Research, found that the bankers showed little “awareness of a housing bubble and impending crash.” During the boom, they bought larger homes and second homes. Compared to the lawyers and stock analysts, their housing purchases fared “significantly worse.”

What explains their lapse? Probably this: Before the real estate collapse, there was a widespread belief that housing prices would rise indefinitely, preventing (by definition) a bubble. We now know this belief was mistaken, stupid and suicidal. But for many, it was genuine. An earlier study by economists at the Boston Federal Reserve reached a similar conclusion.

We've written about skewed expectations many times but it's an important point, so allow us to flog that decease equine flesh a few more times. Before the crisis, American households were saving far too little and borrowing far too much.

The financial crisis was a much needed correction to a distorted market made possible by overleveraged overconsumption. "The way things used to be" was not just unhealthy - it was unsustainable. Instead of looking at bubble-based affluence as the solution, we should be looking at it as the problem.

People once thought the future was more stable and more predictable; now they fear it’s less stable and less predictable. Their behavior becomes more precautionary. For consumers and companies, there’s a greater bias against spending, lending, hiring and taking economic risks of any kind. The economy, though not crippled, isn’t invigorated either. With changed behavior, economic models based on past patterns frequently over-predict growth.

The second reason to reexamine the crisis involves policy. The “scoundrel” theory of causation suggests that, once defects in the economic system are identified, they can be rectified with “reforms.” The Dodd-Frank financial legislation reflects this philosophy. The true history of the crisis raises a larger problem. Success in stabilizing the economy in the short run fostered greater long-run instability. What are the limits to stabilization policy? Might more short-term upsets minimize long-term calamities? Economists should be wrestling with these and other hard questions. They aren’t.

More and more, I'm becoming convinced that even the smartest people aren't terribly rational. As a homeowner, I can remember thinking back in 1983 when we bought our first home that we were in a housing bubble. It's not as though there was any shortage of predictions that the era of continually rising housing prices could not last forever.

Prices are signals. So are market fluctuations. Economic policies whose explicit goal is to distort or entirely block those signals produce a false sense of security that perversely magnifies the damage from the inevitable reckoning with reality:

Prices operate as signals in a free marketplace, efficiently allocating goods to those who want them and are able to pay for them. Few Americans would accept the proposition that we don't need information to make intelligent decisions and yet too many Americans buy off on the notion that markets will operate efficiently if the federal government restricts the free flow of information between consumers and producers.

It's almost as though we were living in an alternative universe where reality is kept strictly at arm's length.

We never learn.

Posted by Cassandra at September 16, 2013 06:34 AM

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Now, now--let's not let all those pesky facts keep getting in the way of the message that must be delivered over and over...

Posted by: CAPT Mongo at September 16, 2013 09:05 AM

Amen, tovarich!

Posted by: Joseph Stalin at September 16, 2013 09:12 AM

"I'm becoming convinced that even the smartest people aren't terribly rational."

The great levelers are the human genes – that three percent of the code that separates us from the chimps and chihuahuas. It's that three percent that allows us to recede from rational to rationalizers. The next head of the Fed should be one of the brighter of Pongidae troglodyte.

"It's almost as though we were living in an alternative universe where reality is kept strictly at arm's length"

It's not almost. It's the very definition of a Gnostic and it's pandemic.

Posted by: George Pal at September 16, 2013 09:45 AM

The next head of the Fed should be one of the brighter of Pongidae troglodyte

Hey buddy - you got a problem with my candidacy?

/gets dragged offstage by Mlle. Yellen

Posted by: Larry Summers at September 16, 2013 10:21 AM

Mon cherie Laree,

Mon petit chou, cherchez les femmes. Aujourd'hui, l'économie, demain, le 'grand bâton'.


Posted by: Christine Lagarde at September 16, 2013 02:55 PM

Aujourd'hui, l'économie, demain, le 'grand bâton'.

*snort* :)

Posted by: Cassandra at September 16, 2013 05:43 PM