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Sunday, May 18, 2008

Bubbles, Not in the Abstract

Tim Duy uses an analysis of local conditions as a lead-in to a more general discussion of "The Scars of Losing a Home," bubbles, and Fed policy:

Bubbles, Not in the Abstract, by Tim Duy: I am working on a presentation for an audience in the Bend, OR area next week, and thought I would share some charts that I thought interesting. They touched a nerve as well. Using Census data from the American Community Surveys, I looked at relative income profiles in Bend and Eugene in 2000:


Roughly comparable communities – the median family income in Bend in 2000 was $49,387, compared to $48,527 in Eugene. Housing values were also roughly comparable:


In both cases, median home values were about three times median family incomes. Flash forward to 2006. For income:


Income distributions are not as evenly spread, but median incomes are once again similar, $58,225 for Bend and $57,361 for Eugene. But look at housing values:


In both cases, the distribution of home values shifted to the right, but the magnitude of the shift in Bend is quite stunning. The median home value in Eugene in 2006 was $224,900, about four times median family income. The median home value in Bend was $345,400 – just under six times the median family income.

The local story is that the Bend area will always attract a steady stream of wealthy California retirees with plenty of wealth. If this were true, I cannot understand why so many of these recent migrants are desperate to leave. Consider the 55 price changes on just one day, Friday May 16:


[Update: Apparently I misunderstood the price change data. From the Bend Economy Bulletin Board

They write "Consider the 55 price changes on just one day, Friday May 16", which is incorrect. The price changes posted on this bulletin board don't happen "on just one day", they typically happen over a period of two days to a week before they're posted here.

I stand corrected.  Still bad, but not quite as bad.]

While there is truth to the underlying story that Bend is attractive to retirees, and is a very pleasant place to live, work, and play, that story clearly does not justify median home prices at six times median incomes. Bubble, plain and simple, and now there is a rush for the exit.

What strikes me most in these charts is the massive misallocation of capital during the last six years. The housing stock in Bend was twisted in a direction that is fundamentally misaligned with the community income profile. True, this happened in many places – I would argue that home prices in Eugene are also misaligned, although to a lesser degree. But the magnitude of the misalignment in Bend is quite remarkable, and in my mind represents a complete failure of social policy. This is especially the case when policy has turned homeownership into a moral imperative, creating a culture that equates renting with failure and granite countertops with success.

In these charts I see the immense damage done to everyday Americans by allowing an asset bubble to propagate unchecked. And while there is some chatter that the Fed is moving toward a more serious look at the wisdom of ignoring bubbles, I remain underwhelmed. I believe the Fed views asset bubbles as primarily an academic puzzle, a problem in the abstract that conveniently allows them to ignore the very real impact on average citizens, whose paths they rarely cross. I see little in the current discussion that is new (see also Naked Capitalism); New York Fed President Timothy Geithner offered the dominate view back in early March:

I don’t believe that asset price and credit booms are preventable. They cannot be effectively diffused preemptively. There is no reliable early warning system for financial shocks. And yet policy plays an important role in determining the dimensions of financial booms, and policy helps determine the ability of the financial system and the economy to adjust to its aftermath. We need to undertake a broad set of changes to address the vulnerabilities in our financial system revealed by this crisis. Just as a long list of factors contributed to the trauma, there is no single reform that offers the promise of sufficient change.

This implies we need to accept that capital formation will be a random event. This doesn’t sound like a good way to run an economy to me. Almost reckless. From Keynes:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism….

And finally, I find the Fed’s appeal to regulation to be almost laughable if it were not so sad. Fox. Henhouse. The Fed abdicated their regulatory responsibilities long ago. One example from the WSJ blog:

Although it has been gotten little attention, this was made possible in part thanks to an explicit decision by federal bank regulators in 2003, then finalized in 2004 to exempt banks from holding full capital against such vehicles, which post-Enron accounting changes could potentially have required. (To be sure, regulators did require additional capital to be held against some entities to which banks had short-term funding commitments. And banks eventually found ways around the accounting standard anyway.) The ruling reflected the prevailing belief that as long as the entities were legally separate, the sponsoring banks had limited exposure. “There’s always been this mentality that if it’s somehow legally separate they’re not liable for it anymore and that ignores the reputational risk and the de facto obligation,” says Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta and now chief monetary economist at Cumberland Advisors. Sure enough, when some of the vehicles were locked out of the commercial paper market last year, some banks, fearing the damage to their own reputations had the entities failed, took them back onto their balance sheets, straining their capital

I will be surprised to see real, effective regulation emerge until the Fed is divorced from the very unfortunate marriage to the fetish of liquidity that allows policymakers to turn a blind eye to the unquestionably damaging bubbles spawned by that marriage.

    Posted by on Sunday, May 18, 2008 at 12:24 AM in Economics, Housing, Monetary Policy | Permalink  TrackBack (0)  Comments (30)


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