Are Bubbles Always Bad?

I'm not sure where I'm headed with this, so I am going to do something I don't usually do and just start writing. Hopefully, I'll find a point along the way. Vaguely, I want to connect "bubbles" to the invisible hand concept identified with Adam Smith, i.e. to the process that moves resources to their most efficient uses. [...continue...]

Okay. Let's start with some diagrams you must have seen if you've taken principles of economics at any level. The diagram on the left-hand side shows an individual firm and the right-hand side graph is the entire market. The market is competitive. The graphs show the response to an increase in demand. I assume the diagram is familiar, so I won't spend much time explaining it. (Demand increases do D', price rises, there are profits, firms enter in response to profits, supply shifts to S' and price falls back where it started. In the end, there are more firms serving more people, but the price is at its initial level, though the unchanged price in the long-run depends on the long-run cost structure of the industry which is assumed constant in the diagrams):

For illustration, suppose this is the pizza industry, but most any industry will do, and suppose it is adjusting to an increase in demand along the lines shown in the diagrams (though not all of the detail described below is shown).

Before going any further, I should also point out that I am using the term bubble according to its current popular usage rather than according to its technical definition. Technically, a bubble is an increase in price that is disconnected from underlying fundamentals, but I am allowing the term to cover any run-up in prices. In the case of, say, housing markets while some of the recent increase in prices may have been due to a bubble in the technical sense, a lot of the price movement was also driven by fundamentals such as low interest rates and robust demand. On to the example:

1. Start at equilibrium with zero economic profit. As pizza demand goes up due to, say, the opening of a new university in the area, price rises leading to profits in the short-run (this is the points labeled sr in the diagram).

2. It is widely reported on local financial pages that the industry is booming. In response to these reports, and buttressed by their own analysis, firms enter. In fact, and there's nothing in theory that says this won't happen, it's possible that too many firms enter. That is, the demand for pizza goes up and twenty firms enter, but there's only room for fourteen to survive in the long-run. Extra firms, i.e. firms that won't survive in the long-run can also enter if the increase in prices is higher than justified by the underlying economic conditions (i.e. there is a bubble in the technical sense due to over exuberance or other reasons) and false signals are delivered to the market.

3.  Makers of products such as pizza ovens, pizza boxes, and pizza trucks are getting the word out to all who will listen. They're building a new university and it's now open! There's a boom in the pizza industry! Get in now while profits are high, before it's too late. Pizza's never been better! After all, the suppliers stand to profit from every firm that enters and they have an incentive to encourage as many firms as they can to join in the boom. While not actually telling falsehoods, at least in most cases, they make the opportunities in the industry sound as rosy as possible to all who will listen, offer enticing good credit terms to entering firms, and so on.

4. City officials and others who stand to gain from the growth in the industry join in, particularly after the campaign donations begin rolling in from those profiting from the influx of new pizza firms. Zoning laws are changed, and tax laws altered to keep the firms coming.

5. For awhile, the industry booms. But, as noted above, suppose too many firms enter and after more time has passed the clean-out process begins. If twenty firms enter and only fourteen can survive long-term, six will fail. It's ugly to watch as people lose large investments in the industry, doors are closed and jobs are lost, and it's possible for the problem to spread if other firms are relying upon these six firms for their survival. In fact, it turns out that three of the failed firms weren't quite on the up and up about collateral against the loan, and the bank that made the loan to them, as well as a few others that are intertwined with it, may face some troubles and this compounds the difficulties in the industry. City leaders are worried.

6. As the industry clean-out continues, the finger pointing starts. Why did the pizza oven manufacturers encourage so many firms to enter? Aren't they guilty of fraud? Look at this ad! They must have known there wasn't room for all three firms, everybody did - it was obvious twenty firms couldn't survive- yet they encouraged people to come and set up shop anyway. They need to be regulated so that doesn't happen again, maybe fined and charged with fraud as well. The banks too. What were they thinking making these loans? Where were the regulators? People got hurt because of this.

7. People begin looking at what happened to pizza prices during this time. A newspaper publishes the following graph with the headline "The Collapse of the Pizza Bubble":

And while it could be due to fundamentals, it does look surely, obviously, like a bubble. And bubbles pop. There are calls for government to make sure that we don't let another one of these develop. It encouraged fraudulent behavior, reckless lending, over investment in pizza, wasted resources, banks in trouble, people lost jobs as the excess was cleared out, there were all sorts of problems because of the bubble. Bubbles are bad and the people who cause them need to be stopped.

I suppose that's enough. My point is that the housing bubble is an enlarged, very exaggerated version of a process we see regularly when a market opportunities open up. In the case of housing markets, for example, financial innovation allowed a segment of the market to be served that had not been well served in the past, and it also allowed existing markets to expand creating highly profitable opportunities. The result was just what you would expect when there are profits to be made, a rush of resources into the industry. Real estate agents, loan companies, builders, etc. all entered, in fact too many entered and now we are seeing the clean out that is the equivalent of the failure of the six excess pizza firms (we shouldn't forget that this is the excess that is being cleaned out, at least in the example above, the industry itself has grown and now serves more people than before).

I don't mean that nothing went wrong in housing markets, things did go wrong and there are regulatory and other responses that need to occur both in the private sector and the public sector to help avoid problems in the future. But having winners and losers is part of the "bubble" process, part of the way the economy finds its efficient allocation of resources as described by Adam Smith long ago. It would be better if we knew the exact quantity of resources needed in each industry, which firms can survive, and so forth so we could avoid having a rush of resources to an industry in response to price bubbles, too many resources in many cases followed by the market cleaning out the weaker performers. But we don't know how to make sure nobody gets hurt as markets adjust, how to make sure prices remain connected to fundamentals. If we want to have a dynamic economy, while the process is sometimes smoother than described above, there will be winners and losers as resources are reallocated. We should, of course, help those who are victims of the market process as best we can while doing our best not to create poor incentives for the future (helping can actually encourage risk taking and innovation), but a dynamic economy is not always pretty to watch.

What we see in housing markets has happened before and it will happen again with the next gold rush, whatever it might be, it's part of the process of moving resources where they are needed most. We saw the same thing as the tech sector developed and expected profit opportunities were present. There are winners and losers when the resources move from one sector of the economy to another (less cars, more accountants), and there can also be subsequent problems - as described above - when the adjustment is less than perfect and too many resources enter in response to a false price signal. So let's fix the problems we've discovered in the industry, at least the ones the private sector can't fix by itself -- these are relatively new assets and the private sector will also respond to protect itself from this happening again, e.g. it will reprice risk, demand more transparency, etc., so the government may not have to mandate all change -- and let's help people as we can. And we should do what we can to make sure prices don't disconnect from fundamentals, e.g. through transparency requirements. But let's not overreact to the point where we interfere with the economy's ability to quickly move resources where they are valued the most to take advantage of profitable opportunities.

I am biased. When I was younger, loans were much harder to get. There was, for the most part, one kind of loan. It had a high required down payment with restrictive rules on how the down payment could be obtained, and there were also strict debt-to income and other ratios that you had to meet to qualify. You either met them or you didn't, yes or no, and that was that. The first time I tried to get a house, the answer was no. Today, I have no doubt that a loan under the same circumstances would be easily approved, solicited even, but it wasn't then and it still irks me to this day. I could have paid the monthly amount on the loan I wanted, would have paid it, I had a pretty secure job as those things go, but there was no way to convey that information to the market.

But I got lucky soon after. The house I was renting was repossessed. It was the 1980s and it had been purchased on speculation during a boom, but the owner defaulted and turned over a bunch of houses to the bank. The bank wanted to dump the house, badly, and I wanted to buy it. All of a sudden the ratios didn't matter so much and somehow they got it through the underwriters. I suppose I was subprime in that market, but my house payment was less than the rent I had been paying (even before tax breaks), and making the loan payment was no problem. House prices went up substantially in the next few years, and that allowed me to move up the ladder. So not everyone loses when there are crashes. Houses are cheap(er), sellers are motivated, and there are people like me who can benefit if loans are available. But I don't mean to minimize the losses of others.

There was, in my opinion, a large unserved segment of people in mortgage markets at that time. There were lots of people who were pretty good bets, but they could not get loans, even at higher interest rates. The recent financial innovation changed that and I would hate to see us stop serving people as part of our efforts to clean up the industry. Not every subprime borrower failed, many are living happily ever after and I hope we'll remember that, while there are problems to avoid, fraud to clean up, and so on, there are also lots of good things that have happened as a result of financial innovation. As we try to make these markets work better, we should be careful to preserve or even improve the changes in the mortgage market that have allowed so many people who could not get loans in the past to purchase a home.

Comments

[Mayo]

Now how about a chart explaining why buying more of anything than you can afford isn't a problem and why we should always bail out poor economic choices.

[nat clarke]

Depends on what the problem was:

Was it over supply, e.g. too many firms copying great finanacial innovation?

Was it an information problem? The credit risk of the collaterialized assets were tranched (sliced) and sold to investors with varying demand for risk/return. If the default rates were properly recognized, high risk investors should have absorbed the higher risk of loss. But a AAA rating should signal there is no question about value.

Did the problem stem from moral hazzard, e.g.the supplier thought they passed the risk to the buyers?

[real person from the real world]

When I was a kid, I heard a cousin refer to a couple's house as a "starter" house. With my own family, the only time we changed houses was when my father's job required us to move. This new concept was a surprise to me, that you would buy one house, a very expensive thing to buy, but presumably not one you liked too well, with plans to eventually move into something "better." In hind sight, both marketing, and increasing salaries played into this trend.

Maybe 10 years ago, I took my elderly father to see some condos in what used to be a church in an old urban neighborhood where he grew up. Down the street, people were moving out of an old apartment building, and we talked to them. The place was a hovel, but had sold for what was then a tremendous sum, in the process of gentrification. The building was sold to be renovated and sold to "upscale" new urbanites.

There was a fad? for townhomes. A newly married niece moved into a townhome, because they were selling cheap, less than what they went when they were built. Eventually, they moved into a house, in one of those new far out residential communities.

Today, we suddenly have the era of the McMansions and gated communities where the new rich live. It used to be you moved far out, to get more home value bang for the buck, but now far flung communities have the newest most modern homes selling for amounts similar to older more established communities.

I am not sure I see a bubble as much as marketing games and fads being played out, as the tide of incomes rises and falls. The innovation in financing was not to benefit buyers, but a way for capitalistists with money to invest, to tap into whatever stream of interest income was out there, and adapting and trying new tricks. As a byproduct, maybe we have some "financial innovations" that may stand the test of time, but we also now need to pass regulations to handle the accompanying rapciousness and vulture-like behavior that got it started and took its toll.

[spencer]

The problem is that this is the way the economy really works-- overshooting in one direction and over correcting in the other.

The problem is economic theory that never builds this into the main stream models.

We teach the cob-web function in one lecture in intro-economics and then forget it. But the cob-web
does a better job of explaining the system than the main stream theory that academics teach.

It also implies that free markets are inherently much more wasteful than most economist like to believe.

[reason]

Mark,
I suppose that's enough. My point is that the housing bubble is an enlarged, very exaggerated version of a process we see regularly when a market opportunities open up.
yes and no. I agree that technological innovation, stimulates emulation and not all the new entrants will be viable. The problem is with the "enlarged" bit, and the tendency of humans to linearly extrapolate past experience and ignore hysterisis (saturation) effects. This is exactly what experienced bankers should be looking to dampen (i.e. they should identify the risk). Something stinks in our financial system, it is exaggerating problems not smoothing them.

[ken melvin]

In your model, as in real life, all might go broke trying to survive. Seldom so clean. One sees it in contracting alot where some one comes in bids a lot of work to cheap and by the time he goes under many another contractor goes broke for lack of work.

[Ryberg]

The supply and demand model from the economics sphere does not work the same in the financial sphere. First of all, both buyers and sellers like rising prices and dislike falling prices. Rather than producing an equilibrium, the financial market exaggerates volatility.

Second, not all loans have the same economic significance. In the good old days, when you couldn't get a mortgage, a loan would enable a consumer to purchase a long term asset - that is one that would produce value over an extended period of time - and to pay for this value over time. It is especially helpful productive assets to better match the receipts with the expenditures, which is not quite the same as matching the value received with the costs incurred. There is a confounding of the time value of money with accrual accounting.

Then along come the financial engineers. They find they can use debt to leverage cash flows to produce higher financial profits. Most economists dismiss this as a natural part of supply and demand and equate financial profits with economic profits. But this kind of debt and the financial profits are not a natural part of the economic model.

A bubble is not an economic phenomenon. It is a financial phenomenon. As the bubble grows, it distorts the natural economic fabric until some limit is reached. When the fabric bursts, fundamental notions of value and cost become unstable and have to be re-established. That process is often accompanied by a Depression.

[baileyman]

Is this a good analogy? How well does a pizza market model map onto housing market reality?

Pizza is a short-life consumed product. Were any investors buying pizza output for subsequent sale, betting on price appreciation? There may be a disconnect here in pizza having no investment characteristics. To my knowledge, there's no no bubble I'm aware of that doesn't involve speculation on capital gain.

Maybe you could say the investment in pizza stores was like the investment in home builders. Where in the analogy are the pizza store roll-ups, levering and speculating on flipping the bunch in an IPO? How would you draw charts for pizza store resale prices? Replacement value?

[reason]

Ryberg,
I like your comment, because it corresponds to some thoughts of my own, but I'm not sure I fully understand it. Do you have link that formalises this view?

I see danger in something else, the proliferation of limited liability, leveraged investment agencies, where going broke is a deliberate strategy of shifting risk. (That is the rich can get the rewards of taking risk without actually taking the full risk).

There used to be of course a banking oligarchy which had strict reserve requirements to limit leverage. I don't see any such controls presently (I wonder how many hedge funds for instance fully disclose leverage when borrowing).

[Bernardo Aito]

Dear editor,

I'm still not entirely convinced that the subprime mess and the consequent August 2007 crisis have been "tolerable" events as you suggest with your argument. Your model is, I'm afraid, probably too simplistic to depict the current situation. Your model describes a "tolerable" mechanism in which genuine bad expectations produce an excessive supply and hence a bubble.

In your model, a bubble occurs because too many pizza-producers think they can take advantage of the situation, while the market could actually only recieve a part of them. That's a genuine (though ill-driven) expectation about the future that produces an excessive supply of pizza. But it's different from what occurred with the subprime market. In subprime mortgage market something rather mean-minded occurred that is not accounted for in you model. The excessive participation of lenders into the subprime market occurred because rating agencies made it possible. The latter "helped" lenders making bad loans. Lenders ran into the market by taking advantage of actually "unfair" financial operations practices by the rating agencies. I'm not implying here the mean-mindedness of the latter, just that the lack of transparency that characterizes the financial system made it possible. The failure of the subprime mortgage market has nothing to do with genuine expectations, but rather with the breaking of rules and the exploitation of a non-existent market.

Here is a suggestion of how to adapt your model to the actual situation. Imagine that the actual land, available for building pizza-restaurant in the area of the University, is limited. That is, the land that is suitable for building can contain only up to 14 buildings. The rest of the land is instead deemed as unsuitable for building -- at least this is what the current standards suggest. What happens is that, during the University bonanza, 6 firms decide to build their restaurant excactly on that land, the one where the standards suggested it wasn't suitable to build on. After a while, these 6 restaurant collapse becasue of a landslide. As a consequence, peole die, others lose their job and so on and so on.

This, very dramatic, scenario may be useful to identify the actual villains of the situation. Possibly villains were the regulators, becuase they didn's notice that the land was unsuitable to build on, or because even if they noticed it, they didn't stop the builders. Morale: Regulation hasn't worked, and the crisis (the bubble, and the burst) were all the regulator's fault. All in all, there wasn't enough room to build restaurant, and if some restaurant at the end collapsed it was just becuase they built where they couldn't.

Now even in this scenario the prices adjust: this is because even with 14 firms, prices will eventually go down (i.e. you don't need excessive supply to make a bubble burst. Prices go up when there are 4 firms, they stay up while firms enter the market, and they go down as soon as there are the efficient amount of firms, say 14. The presence of the excessive six doesn't make the bubble burst in my view).

I like to think of the subprime mess in this way rather than in the way you modeled it. I don't think that the bubble burst has been driven by a supply of mortgages that exceeded the demand. All in all, the demand for mortgages can be unlimited (you can buy as many houses as you want. Conversely, the demand for pizza isn't: you can't have more than 2 o 3 pizzas per day). And I am not sure the subprime market is actually saturate yet. Ideally, there is room for mortage prices to go down further. No, the bubble collapse has not been driven by an excessive spread between the supply and the demand for mortgages.

What made the bubble collapse is, I think, an excessive supply > (that is, given the actual land suitable to build on). What made this possible (i.e. what made the lenders lend more than it was possible to lend) has been, among other things: a) a long period of low interest rates; b) rating agencies that hindered the risk of those debts. According to this model, then, the subprime bubble has been an "intolerable" one, based on ill-drive expectation (based on the idea that you can make profits by lending money to an extent that the economy will never be able to sustain). Securitization made this expectations possible (and rating agencies mis-behaviour as well).

Now, who are the villains for this? Rating agencies? Greenspan? Mortgage firms (Schumer accused Countrywide of "abusive lending practices" source: FT, Wall St rallies after Bernanke pledge, 30th aug)? Or, who knows, even borrowers, for being too prone to easy borrowing? The answer, nobody knows.

Regarding the dynamic economy point you make: I agree that the US are a formidable economy, one that prizes risk takers and entrepreneurship. What I fail to understand is: is someone aware of how much this economy is based on borrowing? Borrowing is successfull if future earnings are good enough. But how will they be good enough if you spend borrowed money to buy foreign goods? This suggests that others' earning will be high, but it does not imply yours' will be high as well.

Regards.

[Bernardo Aito]

Paragraph 7 should read:

"What made the bubble collapse is, I think, an excessive supply given the actual capability of the economy (that is, given the actual land suitable to build on). What made this possible (i.e. what made the..."

[Alex Tolley]

There is a big difference between houses and pizzas.

1. If pizza prices rise too far, the students can substitute other foods - wraps, chinese, etc. If house prices rise too far you go where?

2. Houses are considered investments. Thus high West Coast prices (relative to medium income) have been "justified" since WWII because prices rose faster than the rest of the country. Pizzas are consumables.

3. because of 1 & 2, the psychology "forces" people to "buy now before it is too late" - that is secure a dwelling now before prices (and rents) grow beyond affordability.

4. The pizza boom and bust happen within a few years. The housing boom has arguably gone on since the 1950s. Affordability (price as a % income) just continues to drop, especially in major cities. The time horizons are just too long to gamble on a bust.

Every "cycle" there is a prediction that house prices will collapse, but with each minor price correction (burst bubble), the real price of houses just continues to leap ahead - a long term secular trend. The last bubble burst on the West Coast in 1990/91, yet houses never recovered reasonable affordability, reinforcing the meme that houses are great investments , so "buy now before they are too expensive"...

[johnchx]

I think Mark presents a very useful framework here, because it suggests a handy empirical way to distinguish between two possible stories about what's happened in the residential real estate market.

The first story, the "benevolent bubble," goes exactly the way Mark describes: (1) demand curve shifts up, so price rises and quantity rises; (2) supply curve shifts down, so price falls back to the original and quantity rises still further.

The second story, the "bursting bubble," starts the same way but has a different ending: (1) demand curve shifts up, so price rises and quantity rises; (2) demand curve shifts back down, so price falls and quantity falls. This is the classic bubble pattern in which buyers temporarily increase their willingness to pay for the commodity in question, then suddenly reverse course.

Now we can ask which story better fits the facts. Specifically, now that real estate prices are falling, is the quantity transacted going up or going down? My understanding is that volume is slumping. This would seem to be strong evidence that the applicable story is the second one, "bursting bubble." The alternative, "benevolent bubble," is consistent with the price movements we observe, but yields an incorrect prediction of the quantity bought and sold.

[groucho]

Mark does an excellent job in explaining the current policy makers' theories on "mopping up" rather than "tightening up".

The problem is the theory is failing, in regards to living standard increases for the general population(US). Why is this?

At the end of the day, the blame HAS to rest with the structure of gov't finance. The majority of REAL WEALTH in society is derived from the private civilian sector. Some public sectors also increase real wealth(education, transportation infrastructure,etc)

In the US, the FED was set up to provide liquidity to the private sector through Real Bills. So far so good, but when US gov't through the Treasury co-opted this mechanism for the STATE's use, the table was set for the eventual decline in the civilian standard of living.

For national security reasons, the argument that the STATE should be allowed first dibs on the national output is sound under times of real or potential war.

With the end of the cold war, a fantastic opportunity to return the FED to its proper role as a business mechanism was wasted.

We read about "bubbles" all the time. But are there any "bubbles" that aren't pyramid schemes in one form or another? I think of "bubbles" in terms of "organic" pyramids and "ponzi" pyramids.

Ponzi pyramids are by design fraudelent. The current global monetary system makes ponzi schemes all but inevitable. And this is where Central Banking destroys living standards. Central Banking is a mechanism for STATE use. STATES care about their own survival, not "the little people".
Somewhere in the world a CB is always trying to destroy it's domestic exchange unit to generate more worker output.
The private financial system feeds off of these new "counterfeit claims"(no work was accompanied with their issue)

This system is morally and soon to be financially bankrupt. Greenspan did the world "a world of good" by making sure the day of reckoning was moved up a decade or so.

I wonder what Alan will have to say in his new book next month..................hmmmmmmm

[esb]

Mark ...

By your own admission, it was "the crash" that allowed you (the deserving economic actor) to be served by removing a set of properties from a gambler.

It was probably some form of novel financing (through a private capital banking division of an institution ... very common in the early '80s) that allowed the gambler to acquire the set of properties.

By all means allow the gamblers to gamble, but also allow the crashes so as to move the assets to more deserving economic actors who are waiting for them at lower prices ... as you were.

Best regards.

[Alex Tolley]

jonchx: I like the way you distinguish between 'benevolent' vs 'bursting' bubbles.

Krugman has characterized the US economy as selling each other houses with borrowed money. Once the money supply to continue this game stops, the bubble bursts.

[Bruce Wilder]

When I look at the list of leading foreclosure cities and states, I see San Diego and Las Vegas, and I see "bubble" or, more or less, what you model. Las Vegas, in particular, would seem very much like your new university creating a pizza boom.

When I see Michigan and Georgia, I scratch my head.

The value of real property is driven, ultimately, by household income, but can be affected by changing interest rates.

I think of Michigan, and I don't recall a bubble. I imagine, perhaps, declining real incomes, and people extracting wealth from homes the theoretical value of which was being driven upward by falling interest rates, even as the actual market for real property stagnated. So, "innovative" home equity loans are made, based on values derived from models perhaps since the actual market isn't going anywhere, by shysters practicing the new usury, until the inexorable implications of falling household income, finally, makes itself felt.

It might be that financial innovation helps people. It might be that it is just a form of coercive and exploitive gambling, in which "the house" always wins, not where anyone wins a house.

[robertdfeinman]

First I think we need to differentiate a "bubble" from a fad. If you can remember the CB radio craze that was a fad. It mirrored the Pizza example above, except that the market became permanently saturated and collapsed. The pizza market remains after the excess production capacity gets shaken out. I think people engaged in marketing into fads know the window is short and just hope they will be among the winners.

The housing market boom may represent pent up demand. Just like Mark Thoma had a problem getting a conventional loan 20 years ago the same thing has been true more recently. The population is growing more rapidly than in some prior periods. There is a large-scale internal migration from the rust belt to the sun belt. There is a migration from the inner cities further out and there is the movement to the exurbs. Once a lot of this pent up demand gets worked out the market suffers a reversal. Perhaps its not as bad as the CB radios, but the broad aspects are similar.

In addition to the real demand there was the speculation. Since both groups (the sharpies and the real homeowners) were involved in the same sector they get lumped together when explanations are offered. I think a more fine-grained analysis would reveal some interesting information. Right now the only detail looked into is either home price or credit rating, this is probably inadequate for a real understanding.

Even in the best of times 80% of new small businesses fail within five years. I'm not sure what this says about the ability of entrepreneurs and their backers to understand the market they are entering. Inadequate economic training, wishful thinking, or bad business plan? Something seems wrong with how people are educated whatever the cause is.

[wimpie]

"If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered"
- Thomas Jefferson

It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."
- Henry Ford

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.
- Alan Greenspan

[donna]

When Greenspan first started playing games with the official inflation rates, I used to tell people the inflation was in the stock market. When the market crashed, they switched the game to asset inflation in the housing market. Now there's nowhere left for the real inflation to hide, so people are realizing how much they've really been taken. Funny, gas prices have dropped lower than they've been in ages. I guess they talked the oil companies into making a couple fewer billion to keep the game going a bit longer.

Game's almost over. Better cash in your chips...

There's no assets left to inflate, and nowhere for the inflation to hide anymore. But Bernanke still thinks the Fed can inflate its way out of this mess.

I don't think so.

says...

If by this analogy,

Pizzas = houses
Pizza firms = home builders

it is far off the mark. Pizzas are not assets, they are a consumption good.

Instead if you use

Pizza = shelter
Pizza firms = owners of homes (which provides shelter)

then it starts to make sense. Maybe there were people who were not able to eat pizza before, and they could now. But then you will have to agree that bailing out pizza firms after the bubble bursts will be ridiculous.

So "now we are seeing the clean out that is the equivalent of the failure of the six excess pizza firms" and there is nothing the Fed has to do. The market will work it out.

[Winslow R.]

Mark wrote: "I am biased. When I was younger, loans were much harder to get. There was, for the most part, one kind of loan. It had a high required down payment with restrictive rules on how the down payment could be obtained, and there were also strict debt-to income and other ratios that you had to meet to qualify. You either met them or you didn't, yes or no, and that was that. The first time I tried to get a house, the answer was no. Today, I have no doubt that a loan under the same circumstances would be easily approved, solicited even, but it wasn't then and it still irks me to this day."

I sympathize as I've been in similar situations. This is why I think the general direction that finance is headed is in the correct direction. I just don't think a leveraged system is the best way to get there. No U.S. citizen should be denied a loan just because a bank says no.

Banks don't need to be involved. Anyone claiming banks 'need' to be involved in order to avoid corruption of the lending process or make it more efficient needs to rethink their framework.

New proposal to remove all leverage from citizen borrowing-

Allow 'average' citizens to open a new class of small Fed banks that accept deposits of $100,000 all internet based.

These banks would not be allowed to invest and instead would be required to offer interest bearing accounts at 1/4 point less than the fed funds rate. These deposits would be deposited at the fed which would pay the current fed funds rate.

As I've proposed before, these banks would offer loans to U.S. citizens with SS# based on credit score up to a $100,000 limit which the Fed would provide at a 1/4 point higher than the current fed funds rate. If these citizens default it is the Fed that loses not the bank. The Fed's job is then to regulate its citizens not amorphous corporations.

If these citizens choose to take those loans and deposit them at a non Fed bank, let them but provide no insurance.

[Meh]

This doesn't address your model, but the argument for "Schumpeterian Creative Destruction" isn't a new one. The difficulty is, no-one, but no-one wants to do any work measuring the waste or wealth destruction involved.

As a result, we keep track of the wealth created and write hosannas for the dynamism of the economy, but we have no genuine idea how much we actually advance in a "beneficial bubble." And the problem this causes is that we have no means to actually distinguish between "good bubbles" and "bad bubbles."

Further, if we are to construe "interest rates" as a "fundamental" we're never going to see "bubbles" in the housing market, as it's manipulations of interest rates that cause the bubbles in the first place.

[anon]

The standard way of distinguishing a bubble from economic behavior based on fundamentals is to look for the speculators. When it is abundantly clear (i) that there is a population of buyers who could care less about fundamental value/owning the property, but are betting on making money through a price increase and (2) that lenders are encouraging the growth of this population through loose credit, you have a bubble. (This is basically the definition in Galbraith's Great Crash.) In fact, I would say that your pizza analogy fails to meet the bubble standard, precisely there are no lenders in your model marketing a quick buck.

The reason we care about bubbles is that when they get big their consequences involve a lot of average Joes and the issue inevitably becomes a political one. Ponzi schemes are illegal and it's always the case that the bubble draws the entry of lenders who are marketing the equivalent of a Ponzi scheme. (i.e. the problem is that the crooks follow the money.)

[calmo]

"Maximizing the efficiency of the allocation of resources..." (--could one possibly sound more academic?)"...ought to preclude the occurrence of those deviations from the fundamental values of those goods and services." (see, one can.)

We no B ants, man.
We B evolvers of the strong and terminators of the weak.
We ain't puffin on this bubble just to listen to you whine about the fallen soufle later.
Harvest or B harvested.
Says so right in the Bible (draws attention to passage using the usual Invisible Hand...and slams book shut on yet another harvestable nose).

Most of us fall between these elevations...ok, depths.

But not all, I'm sure...maybe.

[richard]

I'd like to suggest that there were actually two financial engineering "revolutions". Most of the attention is on the more recent one: the one that permitted refinancing of portfolios of mortgages, corporate loans and credit card debt (as well as a distressing increase in acronyms: CMO, CDO, ABS . . .). But the first financial engineering largely made the second one possible: automated credit models, especially for mortgage loans and credit card applications.

Before the mid-eighties, applications for credit were essentially local. You applied for credit cards through your local bank, and applied for mortgages similarly. This isn't a model that scales well, so the fixed costs and the knowledge of a locale put an upper bound on credit availablility. But when large banks could develop statistical models of lending that out-performed the local branches, and started to develop operations that could process application levels in the several 100,000s per month, the race was on to compete. And in the twenty years since then, the price for both credit card loans and mortgages, controlled for FICO, has declined.

[Tom Bozzo]

Alex@7 AM: If house prices move too far out of line with rents, then you can rent -- IIRC Mark Kleiman put his money where his mouth was on this front a while back.

I'd also second Spencer's comment. It isn't that you can't get interesting dynamics from models with well-specified microfoundations (in fact, the more realistic the microfoundations, probably the more interesting the dynamics), but I have thought that economics pays an unhealthy amount of attention to "equilibrium."

One thing that might be productively brought into this analysis is a consideration of adjustment costs, which would seem to help address whether it's worth interfering in the market to try to avoid (or reduce the amplitude of) boom/bust cycles.

Last, Mark makes an excellent point that a return to old-fashioned lender paternalism isn't necessarily that wonderful. I saw this from the perspective of growing up in a female-headed household in the '70s, which put me off a generation of bankers, car salesmen, and the like. The risk, a propos of this post's topic, is a swing too far in the other direction from the late excesses of lending without regard to repayment ability.

[gordon]

Well, that solves the problem nicely. Housing bubble? What housing bubble?

[Robert]

The pizza parlor bubble is not an analogy for the housing bubble.
1. Housing is not an efficient market.
2. Housing has more information asymmetry.
3. The housing bubble was supported by all sorts of illegal fraud in the bubble markets.
4. The housing bubble was supported by buyer beware fraud on the part of Wall Street and the ratings agencies.

[calmo]

But tis an analogy Robert.
That B different from a representative example.
That B an educational device (heuristics, no?) about which you may argue whether its distortions outweigh the personal interest.
So, do you suddenly have a dog in your apartment that sheds hair to the point where the vacuum cleaner starts smoking?

[jan perlwitz]

The starting point of this thought experiment puzzles me and I wonder why a professor of economics himself doesn't get a headache from it:

"1. Start at equilibrium with zero economic profit."

A capitalist economy in a state of equilibrium with zero profit is simply non-existent, since nothing is being produced in such an economy. No capitalist is going to invest anything, if there isn't any expectation for profit. Making a profit is the only motivation for capitalist economic activity. In such an economy, capital and capitalists just wouldn't exist. Market economy wouldn't exist in such an equilibrium state. How can you start from something that is non-existent?

There is a solution to this absurdity, but you have to dismiss the thinking of mainstream economy which is founded on a circular price theory that can't explain why there is a positive profit integrated over the whole economy and which leads to a static equilibrium model of economy. Choosing the alternate approach, there is a positive profit even in an equilibrium state of the market economy (which, from my understanding, would be a highly unstable one at maximum) in which demand equals supply for each good produced. The solution is that human labor is the source of the value of goods and for the surplus value, as part of the total value, that appears as profit for the capitalist producers in a market economy. Since surplus value is also produced in an equilibrium state, there will be a positive profit even in this equilibrium state of economy. There isn't any problem to start the whole "bubble"-argument from here.

[Mark Thoma]

Zero economic profit does not mean zero accounting profit. They are different concepts. Production will take place at zero economic profit since it is define as everyone making a
"normal" rate of return.

[jan perlwitz]

@Mark:

Thanks for the reply.

Thus, the "economic profit" is rather an extra profit in addition to the average positive profit you implicitly assume for the equilibrium economy.

A simple model from mainstream price theory for the equilibrium economy would look like this written as matrix equation:

(V=)P=C,

P the price vector for all goods and C the cost matrix (and V the value).

Reference e.g.:
http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_3/PThy_Chapter_3.html

Where is the "accounting profit" in this model? The total profit integrated over the whole economy is Zero in this model, since P-C=0.

[Mark Thoma]

The accounting profit is in C.

See, e.g.

http://books.google.com/books?id=XzCE3CjiANwC&pg=PA393&lpg=PA393&dq=economic+accounting+profit&source=web&ots=aQQLB-2LgN&sig=IQHQyvGclt5X7u7CuRZNGFTSLSE#PPA393,M1

[reason]

Spenser
It also implies that free markets are inherently much more wasteful than most economist like to believe.
This is a good comment, but it ignores the fact that in fact this inefficiency is one of the market economies strengths. Because it is part of the process of finding the most the efficient techniques. There is a not easily analysed conflict between static and dynamic efficiency. We don't understand this discovery very well, I don't think.

[Guilherme Oliveira]

In which concerns this crisis, I agree in some extent with the author: most of the bubble was not originated with bad intentions of some economic agents. If we think about the dynamic exposed in this text, it explains a lot of the phenomena. There was that usual expectations overshooting and that normal rush to the ultimate source of wealth. And, as always in the economic world, there were loosers and winners in that race.
Nevertheless, I would like to say that probably there were some cases of moral hazard, especially in the constitution and in the management of the so-called Hedge Funds. I think that I am right when I say that there was a lot of people trying to get some easy cash by fooling other investors.

Therefore, the governments and the regulators should be more careful about the legal framework of the new financial assets available in the capital markets. But, pay attention politicians of the world, do not prevent the formation of new solutions for the finance world and for risk management: just create a panel of laws and mechanisms that find and punish the ones who fool the other investors, by selling ashes as gold. Not only this intervention is essential to make the markets working properly but it also is vital to create an environment of mutual trust among the economic agents participating, which will enable more growth and more resources to the overall economic activity.

[Mike]

PLEASE! NO BAILOUT FOR SPECULATIVE REAL ESTATE INVESTORS:
—————————————————————————————————
I hope that the Feds don’t intervene in the housing market. The house prices have nearly doubled in the past 5-years in many cities due to speculative buying. This has priced-out many first time home buyers because most salaries didn’t double in past 5 years and aren’t anywhere near the house price inflation. For example, imagine living next to your neighbor whose mortgage is $1000 per month for a similar house that you as a fresh college graduate would have to pay $2000 for. And just because you got in the game 5 years late. And you will be paying double of what this family would be paying for next 25 years!! If Feds intervene, they would be doing a disservice to all first time home buyers by keeping the inflated prices high. Let the market decide. Please don’t take the tax money of prospective first-time home buyers to keep the inflated home prices high!!

[calmo]

Following 'reason', statically and dynamically, I believe, but woefully inefficiently:There is a not easily analysed conflict between static and dynamic efficiency. We don't understand this discovery very well, I don't think. You? Well, are you understanding and following or still sputtering on the discovery? Still discovering, maybe and not yet conflicted?
reason, do you have a background in engineering by any chance?...which is better here than, say, Tibetan Buddhism...barely.
Maybe not.

[John M 307]

> (V=)P=C,
>
> P the price vector for all goods and C the cost matrix
> (and V the value).

[and later]

> P-C=0

Excuse me, a vector can never equal a matrix (except an Nx1 or 1xN matrix). And subtracting a matrix from a vector is meaningless.

says...

jan perlwitz:

"Accounting profit" is basically the economic return on resources owned by the firm, including capital investments, land rent and entrepreneurial wages of superintendence. It does not appear in your model because economics accounts for it as a cost.

[TDDG]

Dr. Thoma:

I liked this piece a lot and despite most of the comments above, I think its an apt analogy. I think there were good economic fundamentals in housing coming out of the 2001 recession, so speculators and builders rushed to provide housing. Now we have an inventory overhang.

I'd love to hear your thoughts on how this view of housing reconciles with your recent post on the Austrian view of recessions. This post sounds an awful like the overinvestment theory.

I continue to enjoy your blog very much. Keep up the good work.

[jan perlwitz]

@John Morrison:

You said:

"Excuse me, a vector can never equal a matrix (except an Nx1 or 1xN matrix). And subtracting a matrix from a vector is meaningless."

Well, I didn't say anything about the dimension of the cost matrix, did I? The general dimension of a matrix is MxN with M and N any natural > 0. M or N could be 1. Actually, you acknowledge that yourself in your comment. The price vector is a matrix, too. And the matrix C is a vector in this equation, respectively. I should have called C more precisely "cost vector" about which, how it is composed, I haven't said anything. Thus, I apologize for not having said this more clearly.

[jan perlwitz]

@Mark Thoma:

Mark,

thanks for the link. It just doesn't really solve the problem which I have with the model of equilibrium economy. It rather helps me with supporting my case.

You wrote:

"The accounting profit is in C."

If the accounting profit is included in the cost vector C then C is composed of two components,

C=AP+B with

AP - the vector of the real costs for the input factors in which a(i,j) the quantity of good j which is used for producing one unit of the i-th good and p(j) is the price of an unit of the j-th good,

and

B - the vector of the accounting profits, b(i).

For equilibrium we could assume that the accounting profit for each branch of the economy is the same, thus b(i)=bI(i) with I is the unit matrix.

We would get following system of equations for the N prices in our equilibrium economy:

p(i)=SUM(a(i,j)p(j)) + bI(i), i=1,...,N

How is this equation supposed to be solved, then? With b and the prices, we have N+1 unknown variables in this model, but only N equations.

I don't see how it is possible to even explain a simple equilibrium economy with the model V=P=C to be found in economic textbooks like the one by Friedman. Maybe, the accounting profit is assumed to be already given as input parameter. But that won't make sense, if you really want to have a model which explains how economy functions, since the profit whether you rename the part which you would get in equilibrium as cost or not is a result of the economic process, not an externally given parameter.

Is this the model on which your argument is founded also? Or what model do you use when you talk in your blog about an equilibrium economy?