The Joe Walker Podcast - Housing Bubble Week: Can We Predict Housing Bubbles? - Dean Baker

Episode Date: May 13, 2019

I speak with Dean Baker, US economist and co-founder of the Center for Economic and Policy Research...See omnystudio.com/listener for privacy information.

Hello there, boys and girls, ladies and gentlemen, swagmen and swagettes. Welcome to the Jolly Swagman podcast. I'm your host, Joe Walker, and welcome to Housing Bubble Week. This week, we're going to be exploring housing markets throughout time and space, how they can develop into housing bubbles, and what's likely to happen for Australia's housing market. Now, I have a little secret. Actually, I think it's rather a big secret. I think you can predict economic recessions insofar as you can predict the bursting of housing bubbles. It strikes many as scandalous that the mainstream economics profession categorically failed to foresee the 2008 financial crisis and Great Recession.

Indeed, as Alan Greenspan, the former chairman of the Federal Reserve, said, nobody forecast the 2008 crisis. That includes the IMF and the Federal Reserve itself. But then again, no mainstream economists seem to have a good handle on what housing bubbles were and the fact that the US housing market was clearly in a bubble. In 2009, Dutch academic Dirk Besma trawled through academic and media reports and found a handful of economists who did see the Great Recession coming. The economists had to pass through a strict criteria. Firstly, they had to provide some account of how they arrived at their conclusions. Secondly, they had to go beyond predicting a real estate crisis and also link it to real sector recessionary implications. Thirdly, they had to make an actual prediction that was available in the public domain. And fourthly, that prediction had to have some timing attached to it.

Besma came up with 12 different analysts. Some of the names might be familiar to you. Robert Schiller, Peter Schiff, Nouriel Roubini, Steve Keen, and Dean Baker. And Dean is my guest this episode. Dean is the co-founder of the Center for Economic and Policy Research in Washington, D.C., and he's widely credited as being one of the first economists to have identified the housing bubble, which he did as early as 2002. Now, in this episode, we discuss exactly what it was that he saw, what analytical tools was he using that enabled him to see the housing bubble before virtually any other economist

in the world. We draw and distill lessons from that for the Australian context. enabled him to see the housing bubble before virtually any other economist in the world. We draw and distill lessons from that for the Australian context. And I also challenged Dean on the idea of prediction. Was he just lucky? Is he a survivor? Are we being fooled by randomness in elevating him ex post as the genius prognosticator? Or did he have some sort of compelling causal explanation for his prediction? All of that you're going to hear in this episode. I hope you enjoy. Without much further ado, here is Dean Baker.

Dean Baker, thank you for joining me. Thanks for having me on. So we're going to talk about the United States housing bubble, but before we get started, I thought I might just ask you what problem or idea you're working on at the moment that excites you the most? Well, I've been spending more time on trying to come up with alternatives for patents and copyrights for providing incentives for innovation and creative work. And this comes up most importantly with prescription drugs, because obviously there's lives at stake, but also it's a huge amount of money. And it's just remarkable to

me how little people are aware of this. I mean, prescription drugs are expensive everywhere, but particularly in the United States. And we're going to spend around $450 billion in the United States this year on prescription drugs. It's about 2.2% of GDP. It's just huge compared to almost anything. And the vast majority of that is because we have patent monopolies. If you had a free market on prescription drugs, my estimate is we'd spend less than $80 billion. So you're talking about a gap on the order of $370 billion a year between the protected price and the free market price. And again, this is people's health. So you have this issue where there's all these occasions

where people need drugs for their health, in some cases for their life, and they're going, oh, how am I going to be able to afford this? It costs tens of thousands, hundreds of thousands. The insurance company doesn't want to pay or a government program doesn't want to pay. And you go, well, wait a second. If this was sold in the free market, those drugs would sell for a couple hundred dollars. It would be a non- pay. And you go, well, wait a second. If this was sold in a free market,

those drugs would sell for a couple hundred dollars. It would be a non-issue, you know, except for the very poor. And that's something that, you know, I think it's remarkable to me. I give these numbers to people and, you know, they're all ballpark numbers, but they're not really contestable. And there's very little awareness. I don't mean if I grab someone off the bus. I mean, if I go to a group of economists and I start saying this, they're looking at me like I'm speaking gibberish. I go, no, these are all in the national income

and product accounts. They're not my inventions. I could show them the exact line. Anyhow, I think that's a hugely important area, certainly for people's health, but it's a huge amount of money. And I really would like to be able to see us make progress in getting towards alternative mechanisms for financing research. And of course, the U.S., we already spend close to $40 billion a

year on biomedical research through the government. So it's not as though that's a strange notion. We're doing it. So anyhow, so that's something that's been intriguing to me for many, many years. I've been spending more time on it in the last, I don't know, a couple of years, I would say. which some people say started in 1998, although there are different definitions around the beginning date, but clearly ended in 2006. Now, in 2002, you made a big life decision. And I just want you to tell us the story of selling the house and whether that was quite a nerve-wracking moment for you and your family. Well, it was actually 2004. And it was kind of funny because my wife and I moved in together in 1997. And we actually had not planned to buy a place. We actually had planned originally to rent. We were both renting at the time. And we planned to move in together and rent a two bedroom instead of one bedroom. She had a, I forget, one bedroom

efficiency, whatever. And we would have rented, but we found rents were very high and it was very cheap to buy and that turned out to be like the absolute low of the washington dc housing market so we ended up buying a place that we were really you know just very very happy with beautiful place perfect location we really loved it and then you know we started to follow or i started to follow my wife's also an economist by the way but she did she wasn't following the bubble the way i, we started to follow or I started to follow. My wife's also an economist, by the way, but she wasn't following the bubble the way I was. I started to follow house prices and I began being very concerned that there was a bubble in 2002, partly because we had seen the stock bubble rise in the late 90s and then, of course, collapse 2000, 2002. So I was concerned that housing was doing something similar. And D.C. was very much a bubble

market. Prices had really gone through the roof. So our decision to sell in 2004 was very much kind of a defensive decision. I would have felt like an idiot that I'm writing about the housing bubble and sitting there, you know, like most middle income people, most of our wealth was in our house and sitting there and just watching the price plummet. So it was really kind of a defensive move that I thought we should do. And my wife totally concurred with me again. She's an economist and she understood the points. And, you know, so she concurred with me and we're very happy. We just moved a few blocks away and rented a very similar place to the one we had sold. And we, I had no expectation of

getting the top of the market, but we did end up getting pretty close to the top of the market because prices, of course, did continue to rise for another couple of years, but not in that neighborhood. And we know this pretty well because the person who bought our place tried to resell it about six months later. And he asked about 10% more, as I recall, and he didn't get it. And this was even after putting in some money for renovations, repairs. So, you know, again, I didn't have any expectation we'd hit the high of the market. I just didn't want to be sitting there as it crashed. So we ended up very well with that. So in 2004, when you were listing it on the market, what was your Bayesian probability for whether or not the United States housing bubble would burst?

Oh, I thought it was close to absolute certainty. I mean, the only question was the timing. And I learned from the stock bubble because I was writing about the stock bubble in the 90s that, you know, I couldn't guess the timing. You know, so, you know, someone grabbed me in 1998. When's the bubble going to burst? I could say, look, there's a bubble and prices don't make sense and I'd say I don't probably six months just because that seemed like a reasonable thing but it went on much longer and prices went much higher than I would have

anticipated and it was the same thing with housing that I had no doubt prices would correct the only question was the timing and one of the things that I certainly did not anticipate was the total abandonment of, you know, any sort of lending standards, because people after the fact said, oh, my God, we had no idea that their banks were making all these bad, even fraudulent loans. You just go, no, this is widely talked about at the time. And I was just sort of amazed just because I'm thinking, well, someone is going to lose money here. You know, I was well aware I knew about mortgage securitization and banks weren't issuing to hold, they were issuing to sell. I understood all that. But at

the end of the day, you still have to have someone who's sitting there holding the mortgage. And we found out, of course, who that was later. But in any case, it didn't occur to me that you could have such massive abandonment of standards. And again, it was all widely known at the time and even boasted about. The National Realtors Association did a survey of its members, and they found that almost half of first-time homebuyers in 2005 purchased homes putting down zero or less and that or less is serious because many people actually borrowed more than the full value of their home to cover moving costs closing costs whatever it might be so it was not any sort of secret that traditional standards had

basically been thrown by the wayside it was just you know economists people in policy positions chose to ignore it or alternatively, as I said, in many cases actually to celebrate it. This is great. People can buy homes who couldn't previously. In August 2002, you published a research briefing titled The Run-Up in Home Prices, Is It Real or Is It in Another Bubble? In which you argued that the housing market was in a bubble. How long before that did you form the view that it was clearly a bubble? It wasn't long before. I'd say I'd been following house prices. I'd been noticing that they'd been substantially outpacing inflation. In the United States, house prices, this is again nationally,

because you could find huge regional variation. But nationally, house prices had just kept pace with inflation. At that time, I was looking at government data sets that I could construct back to roughly 1950. So from 1950 to 1996, they just more or less kept in step with inflation. Again, ups and downs for the cycle, but that was the general pattern. Robert Shiller, of course, later went back, constructed a series that goes back all the way to 1896. And he finds that same pattern from 1896 to 1996. So you have quite a long period where house prices had just kept pace with inflation. Suddenly, they were outpacing them substantially. And there was a story that fit with the stock

bubble. And there was some research that supported this, that in the late 90s, of course, when we had the stock bubble, there's a stock wealth effect. People were spending more. We could this that in the late 90s of course when we had the stock bubble there's a stock wealth effect people were spending more we could we could see that in the data consumption rose relative to disposable income savings fell in other words so we can see that and you could buy more most things you could buy more cars or more clothes and manufacturers will produce more cars or clothes but with housing of, it's in fixed supply, at least in the short term. So what you saw, and this was research I found very interesting, that in areas like Silicon Valley, that there was a direct relationship

between the NASDAQ, run-up in the NASDAQ, and house prices. It wasn't airtight, but given you have very limited data here, but it did seem pretty convincing. And, you know, that led me to be concerned that, okay, we've kicked off a housing bubble here. So I was sort of following that. And then what really kind of prodded me was Greenspan, Alan Greenspan, of course, who was at that time Fed chair, was giving testimony before Congress. And I forget whether he brought this up on his own or whether it was in response to a question, but he dismissed the idea that housing was in a bubble. And he gave four reasons to justify the run-up in house prices. And none of them made any sense whatsoever.

So he was saying things like, well, we've had rapid income growth. And we did, of course, have good income growth in the late 90s, but we'd had good income growth in the 50s and 60s and no run up in prices. And furthermore, at that point, we were already in the recession. Income had stopped growing. So that really didn't fit. He was talking about population growth. And you go, well, you know, the big population story in the U.S., of course, is the baby boomers. And that might have explained a run up in house prices in the 80s, even the 90s, when baby boomers were first forming their own households were in a position to buy a house that doesn't explain that in the 2000s so basically

none of the things he said made sense so that caused me to really go back and look at it very very closely so I looked not only at the divergence between house prices and rents but I was looking at other factors, such as the rising vacancy rate. That was one of the things that was striking to me. Vacancy rates, if you're seeing a run up in house prices, that should be because housing is scarce. Well, it turns out vacancy rates were actually rising and they continued to rise through the bubble years. So looking at a number of factors, I became convinced that this was a bubble, it was like the stock bubble.

And at that time, it wasn't as large, but it continued to grow for the next four years. And when it collapsed, of course, the impact was considerably bigger than the collapse of the stock bubble. So in the 2002 research paper I mentioned, you identified the dramatic increase in the cost of owning versus renting a home as a key indicator suggesting a bubble. Can you explain this metric to us and why it was so telling? Well, the cost of owning is basically looking at what you should expect in terms of annual costs. So on the one hand, you have a mortgage payment that's composed of, of course, the principal,

you know, normal principal and interest payments, And that's based on mortgage interest rates at the time. And then, you know, typical maintenance costs, you know, we general rule of thumb, it's roughly one percent of the house price. And then say property taxes, which, again, are roughly one percent in, you know, again, varying by jurisdictions. But, you know, roughly one percent is the national average. So that that those figures were rising rapidly. So you sort of sit back and go, why is it that given you have a big run up in the cost of ownership relative to the cost of rent? Why are people why are people interested in doing that? And, you know, again, that didn't make any sense to me. I mean, the obvious answer was, well, because they expect house prices to continue to rise, which they did for the next four years.

But that's, of course, a bubble where people are buying something because they expect the price will continue to go up as opposed to this is what they think its underlying value is. It sounds quite a bit like another formulation for a price to rent ratio. It's basically the same story. It's a little more complicated because if you want to say, well, some other factor has changed, well, interest rates, of course, is a big factor that does change. It had not changed hugely at that point. Interest rates fell later in response to the collapse of the bubble. But it is basically

looking at price to rent. So I don't want to make it overly complex. If you look at price to rent, that's the bulk of the story. So my approach to the price to rent ratio is just to say that the common sort of man on the street definition for a bubble is when the market price comes sufficiently unstuck from the intrinsic value. And because houses are both a consumption and an investment good, you can sort of gauge the intrinsic value using the rental yield. And that means that the price to rent ratio is a really handy indicator for a bubble because it builds in both of those components, the rent being the intrinsic value and the price being the market value. And there's a great chart that John Cochran at Stanford University produced, which shows the price to rent ratio in the United States,

which for most of the 20th century tracked sort of a 20x price to rent ratio. And he has a dotted line showing where prices would be if they continued along that trajectory. And then over the top, there's the Case-Shiller Index and the Government Index. And you see them coming off the 20x price to rent ratio from about 1998 to crashing back down beginning in 2006, obviously. So I always thought that was quite a neat way to define a bubble. And I've used something similar for Australia. Does that sound fair? Yeah. Again, I think that's a perfectly reasonable. I was trying to sort of look in every corner to see if I was missing something. And the qualification I'd make there is if there were a long, a sharp and sustained fall or for that matter, rise in interest rates, that would explain changes in the price to rent ratio. But again, that wasn't a story you could have told during the bubble years. Sure. Yeah. I also remember seeing a graph from Shiller, which you might remember. It was comparing house prices to interest rates, population growth, construction costs on the same chart. And it proved that point rather neatly that prices had moved

disproportionately above any of those fundamentals. Yeah, yeah. No, that was a very nice, I recall the chart, I don't know if he's updated it, but it is a very useful way to show the basic, the fundamentals of the market. So fast forwarding four years, in November 2006, as things were sort of coming to a head, you wrote another research paper, which argued that the recovery that began, quoting here, in November 2001 is likely to come to an end in 2007. The main factor pushing the economy into recession will be weakness in the housing market. So you were right on both scores that

not only the housing bubble would burst, but that the macroeconomic implications for the United States would be a large recession. And then prices began to fall in earnest in 2007. And the Great Recession, we now know, began in December 2007, lasting until June 2009. So even then, people were still reluctant to say that the bubble would end in a crash and that it would cause a recession. What were you seeing that other economists missed? Well, a couple of things. First off, people were very reluctant to accept the idea that house prices really would fall a lot. And I just found it bizarre.

I remember once being on a panel and saying, you know, look, we could expect 20%, maybe even a 30% decline in national nationwide house prices. And the other people on the panel were just completely dismissive saying, well, we've never seen anything like that. And I was trying to point out, well, we had never seen anything like the run up in house prices we just had. And it was just remarkable to me that there was just so little appreciation that we really had, whether you want to call it a bubble or not, I don't care. The divergence in house prices from the long-term trends was undeniable. But there was almost no recognition of that.

The other part of the story, and even to this day, it astounds me how little recognized this is. Housing construction peaked at about 6.8% GDP in 2005. That was the peak building of the bubble. Prices peaked a little bit later. But it was about 6.8% of GDP. It's typically around 4%. And you go, okay, well, that's going to disappear when this bubble bursts. We're going to see a fall off, and it stands to reason that we're going to overcorrect, which is what you expect to see in a downturn, any downturn, much less one from a bubble. And of course, we did overcorrect. Construction fell to less than 2 percent of GDP because there was so much overbuilding. But in any case, you just go, OK, what's going to replace this, you know, 2.8 percent of GDP or thereabout? And again, it ended up being much more than that, but just being very

conservative, just saying it falls back to long-term trends. What's going to replace that in demand? And then on top of that, we had a consumption boom following from the wealth effect, which again, is very clear in the data. We had savings rate. We since revised the savings rates. But at that time, the reported savings rates were just about zero. You know, it's against the long-term average of 6% or 7% of disposable income. And you go, what's going to replace that consumption? And people were just acting, economists people were acting just like, oh, this isn't a problem.

We have some mechanism, God knows what, that's just going to come in there and fill that demand gap. So they just, they literally, you know, my experience was economists literally couldn't conceive of the problem. And I'll carry that a step further because we just had all this round of, you know, 10th anniversary, the 10th anniversary of the collapse of Lehman, which is generally thought was the height of the financial crisis. To this day, there's still very little recognition that we would have had enormous

demand gaps. So most of the discussion of the financial crisis or the Great Recession, however you want to put it, I prefer the Great Recession, has focused on the financial crisis. This is sort of this mysterious thing that we couldn't have predicted, as opposed to this very visible bubble. All you had to do was looking at the quarterly gdp data you know was not hard to find this very visible bubble and effect on gdp that with or without the financial crisis would have meant a very severe recession just to be clear i don't doubt the financial crisis made it worse and certainly brought it on more quickly but there was no plausible story you could tell where we could have the bubble deflate and not have a very, very sharp hit to the economy.

So I want to move on to prediction now and prediction in relation to bubbles. What would you say to an economist like Nobel Prize winner Eugene Farmer who sort of throws his hands up in the air and says, well, you know, economists have never been good at understanding recessions. We've only had 11 of them since World War II in the United States. So there's simply not enough data, not enough outputs for our statistical models, given that there are millions of possible inputs in terms of economic variables. And the real thing that exacerbated falls in house prices was the fact that we had a big recession. And so maybe causation flows the other way, or maybe there's a feedback loop, or maybe it was something else altogether causing both the rapid falls in house prices and the Great Recession. What would you say to that? Well, first off, on the uncertainty point, sure. Economics isn't like a natural science. It's not like biology where we could do an experiment 20,000 times and see whether we

get the same result each time. So we're always dealing with a world where we can't know all the possible factors. So one of the things, for whatever reason, people maybe just fell in love with the idea of home ownership. I mean, people are telling me that. Okay, why would we think that happened? But sure, that's a possibility, you know, so they so they don't care that you know prices are out of line with rents i mean it's that's that's a possibility um so in that sense sure but that's true of everything

we do in economics and i'll just point to the federal reserve board the federal reserve board's constantly making a decision you are a central bank whether they're going to raise interest rates because they're worried about inflation or they're going to keep them where they are or lower them. And that's based on an idea of what the economy's capacity is. You know, what's how low can the unemployment rate go before we start to see inflation? And we know our predictions there have been terrible. So both in the 90s and in the recent recovery. So, yeah, you know, it's there is uncertainty there. But we do have a basis for looking at the data and saying it looks out of line. And that's what I was saying in 2002 to 2007 when finally burst. And, you know, I'd say that makes it look like I was right now.

He's saying, oh, well, we had a great recession. That's what caused it. Well, the biggest chunk in the recession was the fall off in housing construction. So treating that as something foreign is a little strange. And of course, consumption fell off as house prices fell. Again, to treat that as something that was outside of the housing bubble, again, that seems very strange. These were the factors driving the recession. So to treat it as something else that happened, I don't really understand that. That, you know, Pharma's a very smart guy and all that, but I just don't see how that makes any sense. So I guess your answer would be that you have a pretty compelling and intuitive causal explanation. That's right. And again,

to just say that, oh, we had a great recession, go, well, great recessions don't just happen. Tell me, you know, give me an alternative story. I mean, I guess that's what I would say that, oh, we had a great recession, go, well, great recessions don't just happen. Tell me, you know, give me an alternative story. I mean, I guess that's what I would say to, if we had Fama sitting here, give me an alternative story as to what caused that recession. Something caused it. And even if you could say,

oh, we couldn't predict it beforehand, should be able to recognize what it was after the fact. Otherwise, you know, what's our economics worth? Fama's other critique of bubble predictions is that in the total set of economics prognosticators, you'll find a range of predictions before the fact, including some for a bubble, including some for other scenarios. And if after the fact, you simply identify the people who happen to be successful and elevate those as the genius predictors, you're simply being fooled by

randomness, so to speak. So I wanted to ask you, have you made any other predictions that were successful? You mentioned the stock market run up, but are there any others? Yeah, well, I was happy about it. I was right. I should also point out back in the 1990s, because my reason for looking at it originally was I was involved in the social security debate. And at that time, there was a lot of support for investing Social Security money in the stock market, either in individual accounts, as the Republicans had wanted to do, or collectively, as President Clinton had proposed. And the big motivation for that was that we would get very high returns in the stock market.

And I was just sort of struck by that because the underlying story was that Social Security was very high returns in the stock market. And I was just sort of struck by that because the underlying story of security was a much slower growing economy. So I did my own calculations as to what would be plausible in terms of future returns in the stock market, given price to earnings ratios at the time. And I came up with numbers that were way better than what they had. And we now have 20 years to look back on. My numbers are pretty much right on the mark. So and that that that I feel comfortable about. But a couple of other ones where, you know, again, I'll take a little bit of credit. I certainly wasn't alone in either of these cases. In the mid and late 90s,

the conventional wisdom in the United States was that if the unemployment rate got much below six percent, inflation would begin to spiral upward. And that was, you know, again, pretty much across the political spectrum. I remember talking to Clinton administration economist, I'm saying this because these are people who are left of center, you know, certainly on the right side of the spectrum. And they were just dismissive of the idea that the unemployment rate might be able to get to even 5%, much less four and a half or 4%. Well, of course, we did see that the unemployment rate got down to 4% as a year-round average in 2000. And, you know, it was enormously beneficial for the U.S.

That was the first time that workers up and down the wage ladder had gotten real wage gains on a sustained basis since the early 70s. So that was a really big deal. Also, I'll point out that, you know, again, obviously, U.S. has enormous racial disparities. When you get low unemployment rates, disproportionately, it's African-Americans and Hispanics that are getting those jobs. So that was a really big deal. And, you know, again, I'm happy to say I was right on that. Again, hardly me alone, but that was an important one. And same story more recently. If you go back to 2014,

the median estimate among members of the Federal Reserve Board, the open market committee that determines our interest rates, was that the unemployment rate couldn't get below 5.4 percent. That was their estimate of the non-accelerating inflation rate of unemployment, the point at which inflation would start to rise rapidly if unemployment fell below that. And we've seen now the unemployment rates falling actually below 4 percent, 3.7 in the latest numbers. And, you know, we just got our latest data on inflation today. Not really any evidence of any acceleration. So, again, that's, to my view, a great, great story. And thankfully, you know, we had Yellen at the Fed who was prepared to sit back and wait before raising interest rates, going against a lot of people, a lot of economists and certainly economists at the Fed. And we've, to my view, gotten enormous benefit, enormous dividend from that.

What, if anything, was systematically wrong in the vast majority of neoclassical economist models that made them blind to the housing bubble? And if there are any lessons, has the economics profession learned them? Well, at that point, the idea that the economy could have a sustained downturn, that the Fed just couldn't correct, couldn't offset with lower interest rates, it simply wasn't viewed as plausible. And that was really across the political spectrum. So it wasn't just, you know, sort of, you know, the Chicago School, the Minnesota, the real business cycle people said that most mainstream economists had a view like that, that, you know, OK, so we'll get a downturn. Maybe Baker's right about his bubble. Not that they were looking at that, which was just amazing to me. But let's say that I somehow could have gotten one of these people to humor me and suggest that, OK, maybe

there will be a big fall off in house prices and big contraction in construction. Fed will just offset that. They'll just lower interest rates. So it was not even thought to be a possibility that you could have a sustained downturn that the Fed could not offset with its traditional monetary policy. So basically, it was ruled out by assumption. Now, since then, of course, we do have this idea of secular stagnation that has made an enormous headway within the profession, so that a lot of very mainstream, very centrist economists accept as a plausible risk. So we do have that. So that's a big step forward. But on the other hand, I made a reference to this before, there continues to be this

focus on the downturn as being a financial crisis. And I find that very frustrating because I think it's, well, both it excuses the past mistakes and opens the door for future ones. I'm saying excuse the past mistakes. Well, finance, of course, is complicated. You know, who was holding all the credit default swaps? I used to joke about it back in 04, 05, 06, 07. You know, someone's holding these mortgages. I mean, they don't disappear. So who's holding them? And, you know, well, we found out. But how would you have known that, you know, AIG, the huge insurance company, had issued something like $600 billion in credit default swaps against these mortgages or mortgage-backed

securities? That's hard to know. So when you move it to the realm of finance, you make it much, much more complicated. And to my view, this story was actually very simple. And again, it's, you know, partly, yeah, people should own up to it, they should have been able to see it. But the other point is, well, let's focus on the right thing. So I have all these people now saying, Oh, do you think we have a bubble in this particular asset? You know, there's been a lot of writing, including in outlets like the New York Times, Washington Post said, Oh, my God, the corporate bond market, you know, that looks very shaky. And I don't dispute, you know, where there has been a deterioration in the quality of corporate bonds. And that could mean some losses.

But the talk that that's going to lead to some sort of financial crisis, great recession. So it's literally nonsense because you just go, OK, carry it through. What happens? Suppose a very large share of corporate debt goes bad. Well, people are holding corporate debt. Take a hit. How's that different than if the NASDAQ, if the stock market fell by 20 percent? I mean, that would be that would be a big hit to people, money and stock, which is obviously a lot of rich people, but also a lot of middle income people now have their 401ks.

There'll be some hit to the economy. But can you tell a story how that gives us a great recession? I don't see that. So I think it's unfortunate that people continue to focus on the financial side rather than the real side, both because, as I say, the real side is easier to follow, but also it misleads them about what the potential problems in the economy are. There was a large demographic pressure in the US, which would have led one to expect suppression on house prices at a time when they were running up. And that was that the first cohorts of baby boomers were reaching retirement. Why do retirees put downward

pressure on house prices? Well, the conventional view, and I haven't looked at it closely enough to say that it's borne out, is that you expect as people hit retirement age that they're downsizing so that their maximum demand for housing is when they're raising their kids, they need a big house or want a big house, I should say, a yard, whatever. And then when they're approaching retirement age or actually retiring, they're looking to move into a smaller house. So again, this is one of the perversities that, you know, we had in the bubble years that the demographics would have suggested that, you know, downward pressure on house prices instead of we're seeing upward. That was actually one of the factors that Greenspan cited back in his 2002 testimony as saying that demographics are driving the housing bubble. And as I said, that just kind of had me scratching my head

because I'm going, wait a second, that really doesn't make a lot of sense. He also talked about immigrants and he can go, OK, so we are getting immigrants, but, you know, you don't expect immigrants to be buying four hundred thousand dollar homes. And the joke was, well, actually, some of them were. That literally is true. I mean, because, you know, you the banks were pushing mortgages so much that in many cases they were giving mortgages so much that in many cases, they were giving mortgages to people who obviously could not afford them. And some of those people were recent immigrants who didn't have incomes that could come close to supporting their mortgage payments. And of course, those people end up losing their house. It wasn't a pretty story.

On that point, a lot of people talk about how price falls lead to defaults and that a falling market exposes the risks in subprime. Price falls and equity aren't synonymous with mortgage repayments. So what's the causal mechanism that allows that to happen? Well, in most states in the United States, you can't recover. Mortgages are non-recourse loans, meaning that if I borrow $300,000 against my house and for whatever reason, the bank ends up foreclosing on my house. I stop making the payments, in other words. They're foreclosing the house. They're entitled to the house, but they can't get anything beyond that.

And what that means is if the house falls in value to $200,000, I have a very big incentive to just walk away from the house. So they get my house that's worth two hundred thousand that's better for my vantage point than paying off a three hundred thousand dollar mortgage and there are doubly many people that made that choice and I should be clear again the arguments I'm not making a value judgment where people bad to do that I'm not saying they're bad people but just as a practical matter if you're struggling to make a mortgage payment you you're working two jobs, you know, it's a couple and they're working

four jobs between them and they have kids and they're exhausting themselves and they go, okay, we're trying to make a mortgage payment on a $300,000 mortgage for a home that's worth $200,000. Are we going to do that? Well, it strikes me, it's pretty hard to blame the person and say, okay, we'll just give it back to the bank and we'll become renters for a time. And a lot of people end up doing that. So there's a very, very strong incentive for people to default on a mortgage when they're in a situation where the mortgage, the value of the mortgage is substantially greater than the price of the home. So those are what we'd call strategic defaults. Interestingly, however, Florida and Nevada, two of the states with among the highest foreclosure rates in the U.S., were actually recourse states. very much bubble markets. In case of Nevada, it's basically Las Vegas. And again, very much

a bubble market. Prices in Las Vegas fell by like 60 percent, the bottom end of the market, like 70 percent. So you had more incentive that way. The other point is even where it's a non recourse loan, I mean, it is a recourse loan. So you actually can, in principle, go after the person. The general practice had been that banks didn't do that. That was changing somewhat as you got into 2010, 2011, and you were getting more defaults. But generally, banks didn't bother for the simple reason that most of the people, they don't have liquid assets. So it's not as though someone's got $100,000 sitting in the bank so they can go, okay, we foreclosed on your home. We got $200,000 from that, but you owe us another $100,000 we're going to get from your bank account. They don't have that money. So it's a question of could they try to go and have their wages attached and in effect take $100 out of their wages every month for the

next two decades or whatever it might be. They could possibly do that, but it's for the most part a pain for them. So generally, even where they had a legal recourse, it usually wasn't worth their while to do it. Earlier in the conversation, you mentioned the wealth effect. This cuts both ways. And when prices fall and people fall into negative equity, that can generate a negative wealth effect. This sounds like a mostly psychological phenomenon. Can you briefly describe what exactly the wealth effect is to us and how economists calculate its impact? Yeah, well, the idea is that as you get more wealth, then you'll increase your consumption independent of your income. So say my income is $60,000 a year, and I went from a situation where I had a home that had $20,000 of equity in my home to $120,000, which is a story many people could have told in those years,

the housing bubble years. Well, the idea then is that people will spend more based on the fact that they have this additional 100,000 in equity. So there's two reasons, two stories you could tell them that one is simply a psychological. Well, I know I have this 120,000 in equity in my home, so I don't have to put money aside my 401k so I don't have to put money aside my 401k, or I don't have to put money aside for my kid's college education because I have my home. I have my $120,000 equity in the home. The other thing, and we saw this in a really big way in the housing bubble years, was that people directly drew on their equity. So we had a lot of people that either took out home equity loans, so in addition to their mortgage, they might say, okay, I now have

$120,000 in equity. I'm going to take out a home equity loan against that of 50,000, whatever it might be to, you know, take a nice vacation or buy a car or maybe, you know, pay for your kid's education. So I don't mean to make it sound frivolous. There are all sorts of good reasons people might do that. So you saw that. And the other thing was simply refinancing. And banks are really pushing this. I remember I actually, on the condo that my wife and I owned, we actually refinanced in that period simply because rates had fallen. So we wanted to get a lower interest rate. And the mortgage broker who was selling us the mortgage was really pushing us to take out a larger loan. I was kind of playing

along because I want to hear what they said. I mean, I know what we're going to do. We had no interest in taking out a larger loan, but they really were pushing that very aggressively. So you had a lot of people during those years, 2002 to 2006, who basically borrowed very heavily against the equity that was created by the run-up in house prices. And of course, those people are more likely to be in a bad situation when prices fell. In most housing price bubble collapses in history, we've seen rising interest rates prick the bubble and act as a catalyst for price falls, both because it's less attractive for prospective buyers with higher rates and also higher rates lead to unbearable mortgage repayments for homeowners, which leads to fire sales. Do you think rising interest rates are essential to pricking housing bubbles? And are

you aware of any price crashes in history that have happened without that? They certainly make it more likely. But when you hand in our bubble, interest rates, of course, the Fed did raise interest rates, but long term rates barely budged. Greenspan made a big point. He was talking about this was a conundrum that he's raising short term rates, long term rates didn't fall. I actually didn't find it that much of a conundrum because basically you had foreign central banks, most importantly, China, buying up large amounts of U.S. debt. So I joke about that, that we didn't have quantitative easing. We didn't have that term. But in fact, China's central bank was doing quantitative easing. You know, the market doesn't care whether it's the Fed that buys long term bonds or whether it's China's central bank that buys long term bonds has the same impact.

So in any case, we didn't see a big run up in long term interest rates. We did see some rise or or shouldn't say some rise. We saw a substantial rise in short term interest rates that probably did have an effect on the market more so than typically because so many such a large share of the mortgages at that time were variable rate. Not all your listeners may know, but in the U.S., the standard mortgage is overwhelmingly a 30-year fixed rate. In the bubble years, 2002 to 2006, there was a huge movement towards adjustable rate mortgages, which tend to follow the short-term rates. So those were going up in price during that period. So we did definitely see an interest rate effect, even though it didn't show up very much in the long-term mortgage. So I guess what I'd say is that obviously interest rates are a factor.

Could it, if we envision somehow that rates had stayed low, both long-term and short-term, would the bubble have burst? My guess is it does at some point, but, you know, it would have been further out. And just to take an analogy that's obviously imperfect, the stock bubble burst in 2000, 2002. Interest 2002 interest rates i mean the fed was raising rates somewhat not a huge amount i think you'd be pretty hard pressed to tie that to the rise in interest rates so i think interest rates certainly could bring it on quickly but more quickly but when you have a market where prices are clearly out of line with fundamentals and of course at the end of the day you can at the end of the day, you can build more housing.

It takes time, but you can build more housing. And, you know, vacancy rates grow. And as it has happened in 2004, 2005, and 2006, the quality of mortgages deteriorated ever more. And at some point, you have someone sort of scratching their head on the supply side in terms of the banks issuing the mortgages and just go, wait a second, we're giving a $400,000 mortgage to a family with $50,000 in income. Maybe that isn't a good idea. So that is kind of what happened in the U.S. housing market is that the subprime market ran out of buyers, that enough of the mortgage-backed securities became sufficiently dicey that

at the end of the day, they just couldn't find anyone to buy them. And basically, the subprime market closed down in the second half of 2006. And then that began to sort of fizzle up or go up to the opposite, trickle down, trickle up to the rest of the housing market. And that was what stopped the bubble. Okay. So interest rates can help to prick a bubble, but price falls can also occur endogenously, almost like a pendulum when expectations flip. Exactly. Exactly. I heard you're doing some work on comparing asset bubbles at the moment. And I wanted to ask you, what do you think the most dangerous type of asset bubble is and why? Well, I would definitely say housing is the most dangerous because it has the

largest real impact. So if we compare the housing bubble to the stock bubble, the stock bubble did have a large impact. I think people do underestimate the severity. Obviously, I'm talking about the US here, the severity of our recession in 2001 2001 because they look at the growth numbers and those actually were reasonably good in other words if we if we just focused on growth in the US economy the 2001 recession it looks looks very mild I mean we had a quarter of negative growth and second quarter of 2001 very small positive in the third quarter and this quarter of negative. So, you know, our technical definition of a recession is two quarters of negative, consecutive quarters of

negative growth. We didn't even have that. And then the economy is growing again at a good pace in 2002, 2003. So by that measure, it's not a terribly bad recession, but I tend to focus more on the labor market. And if you look at what was going on in the labor market, we lost jobs not just in 2001, but all through 2002 and most of the way through 2003. And we didn't get back the jobs lost until January of 2005, which at that time was our longest period without positive job growth until the Great Recession. But in any case, even with that, even saying that the stock bubble recession was more severe than generally recognized, stock wasn't driving the economy in the same way that housing was. It was driving the economy, but not nearly to the same extent. So you have a wealth effect on consumption in both cases, but the housing wealth effect tends to be larger on a dollar basis,

basically because housing is held more by middle-income people. The vast majority of stock is held by very high-income people, and I doubt Bill Gates's consumption matters very much. If Microsoft goes up 10% or down 10%, it probably has almost no impact on its consumption. On the other hand, the story I was talking about earlier with housing, if I get another $100,000, a middle-income person gets another $100,000 equity in their home, that is likely to have an effect on their consumption. So with housing, you have both this wealth effect, which tends to be larger on a dollar basis, certainly, than the stock wealth effect, but also, probably more importantly,

the impact on construction. And as I said, in the bubble years, construction really went through the roof. And that both has the problem that you're going to lose the bubble-driven construction, but on top of that, you get overbuilding and that that's going to cause you to fall below what would be the trend level. So I think housing is definitely a much more problematic bubble than stock. And in terms of other assets, you know, again, I was talking about with corporate bonds, you know, you could point to any number of other assets where you could say, OK, there's Bitcoin, you know, clearly there was a bubble there. It's the well, to my view, as long as it's positive, there's a bubble. But in any case, I think it's like something like

80% of its value from its peak. You know, those will be problems for people invest in them, but those don't drive the economy. So you want to look at where's the bubble actually driving the economy in a really big way. And housing is going to have the biggest impact, is what I'd say. I have only two more questions, Dan. One is philosophical and the other is very real. The philosophical question is, in economics, why do the historians seem to do better at predicting than the mathematicians? Well, I think historians tend to view things more deeply, more holistically. And I think if you really want to understand the economy, you have to sit back and try to look at it. And the reality is we don't have our samples here, particularly in macro are very small.

I mean, if we're looking at an individual country, I mean, we tend to I'm in the United States. Of course, we tend to look at the U.S. as the whole world. We don't have that long a period we could look to. We don't have that many samples. But even if you bring in other countries as comparison, they're going to be imperfect just because they aren't, you know, they aren't as closed. They aren't as large closed economies as the U.S. I mean, we're obviously an open economy, but we're still overwhelmingly, you know, most of our sales go to the U.S. So we're different from Germany or Australia or any other economy in that respect. But our samples are just not that large. So I think you tend to get, you know, sort of false sense of security when you try to look at it as a statistical issue going.

How many you know, how many countries do we have and how many data points? Because it's very, very limited. And there's only so much you can tell from that. I don't discourage anyone from doing that. I mean, we want good data, good statistical evidence, but that's not going to be the whole story. So I think that it really does help to be able to sit back and try to understand how is this situation different than other situations, how it might be the same. And that requires more than just the statistical analysis. It would seem that which reference class you choose is a crucial matter as well. You mentioned earlier in the conversation being on panels with economists before the US housing bubble collapsed and people saying, well, we've never had a collapse of that magnitude before.

But as you said, there's never a run-up in prices that dramatic either yeah and you know this is a sort of thing was just kind of striking to me because i wasn't relying on secret data sets i mean this was government data we now have the case schiller index that was the early years that case schiller index but we had government data on house prices that went back uh well you had a totally consistent set that goes back to the mid-70s, but I was able to construct another, extend that back to, I think it was 1950, with another, again, official government data set. So it didn't require any, at least on my part, any, you know, innovations, any, you know, questionable work that could really call into question the credibility of the data. But there

was very, very little awareness of that. So, you know, people were trying to look at the housing market in 2005, 2006, and just say, oh, well, we can look back to what happened in the 90s, what happened in the 80s, what happened in the 70s, and assume there'll be nothing different. Well, you had to look at what was going on and go, well, there is something different there. And it was just, you know, very strange to me at the time and very strange to me even today that economists were not willing to recognize that, yes, there are things about the economy in 2004, 5, 6 that are very, very different than in prior decades. So we can't just apply the analysis from prior decades.

Do you think there might also be a bias against quite simple and intuitive explanations? Earlier, I mentioned how useful the price to rent ratio could be. That's an idea that you could really describe to a high school student, but maybe that doesn't really justify a professorship in an economics department. Oh, absolutely. I mean, there's a real premium on complexity. A number of people asked me during those years, have I published this? And of course, I wrote papers and had some small publications. But in terms of an academic journal, my comment was always, no, it's too simple. And I could tell you an exact story. I mean, I swear to God, this is 100 percent

true. In 2005, this was during our Social Security debate. President Bush had wanted to privatize Social Security. And his big Trump card, the big Trump card of all the privatizers, was that, oh, if we put the money in the stock market, you'll get everyone's going to get rich. So everyone's going to have their little individual accounts. They're all going to end up as millionaires. And the point that I've been writing about that was, no, that doesn't make any sense. You can't do that. And I actually came up with something. Well, it was originally a joke, but it make any sense. You can't do that. And I actually came up with something. Well, it was originally a joke, but it was very useful. I call it the no economist left behind test.

That was a play on Bush because he talked about no child left behind with his education reform. And what it was was they said you could get 7% real returns of stock market. So I said, fine, write two numbers down decade by decade, you know, for the zeros, the 2010s, the 2020s, the 30s, our time horizon for Social Security, 75 years, write down two numbers that add to seven, you know, one for capital gains, one for dividends. You know, PhD economists should be able to write two numbers that add to seven. Well, no one could do that because you either had to have a story, you carried it out, you either had to have a story where you had price to earnings ratios going into the two or 300 to

one, or alternatively, you had companies paying out more than all their profits as dividends. Clearly, neither of those make any sense. Anyhow, you know, in terms of, you know, the economics profession, Brad DeLong, who you've probably heard of, a professor in economics at Berkeley, very good guy. He called me up. I said, do you want to do this as a Brookings paper? They have a Brookings paper on economic activities, very prestigious, you know, publication comes out three times a year. And he suggested that we do that. And he said, I'd get Krugman on board, which he did. And I said, but is this really a Brookings paper? I mean, this is really simple. And he goes, oh, yeah, you know, we could do this as a Brookings paper. So I said, OK,

you know, and I want to do my share. So I wrote it up, you know, here are the numbers. You know, it's basically simple algebra. There's not much here. So Brad goes, OK. And then he basically throws it out and he puts in an intertemporal optimizing model that basically had nothing to do with the issue. But that's what he had to have in there to justify it as a Brookings paper. So he had that in there. And then he had a second half that had my point about the numbers don't add up. So in order to have it sold as a Brookings paper, we had to have this intertemporal optimizing model. I mean, it wasn't hugely complex, but it was considerably more complex than simple algebra. And that was what made it a Brookings paper. But the only thing anyone cared about when we actually presented it and had the discussion, the only thing anyone cared

about was the simple algebra. That's classic. Yeah. And I guess the other explanation is that people are engaging in motivated reasoning. So taking Greenspan, for example, it's possible that privately he was persuaded by the more intuitive explanations for the housing bubble, but publicly he wouldn't have wanted to create a self-fulfilling prophecy. But because there were no good simple reasons available to him for explaining the run-up in prices, he had to resort to more complicated mental gymnastics to justify them. I think there is a lot of that. So I think there's motivated reasoning. But the complexity, you know, there is really this idea that, oh, you know, economists do this very

sophisticated stuff. And, you know, it's really complex. Don't bother your little heads. You know, this is over your head. Just take the experts on that. And, you know, my attitude really in economics is there are certainly things that require some on that. And, you know, my attitude really in economics is there are certainly things that require some degree of expertise that, you know, your typical person, even an educated person, someone who reads the papers carefully and everything, they're not going to have. But our job as economists is to be able to talk about this so that those people could understand it. And, you know, unfortunately, I think a lot of economists have sort of the opposite attitude that, no, we want to make it really complex so that those people have no idea what we're talking

about. My final question, Dean, is have you heard what's happening in the Australian housing market? A little bit. I have a friend who's been in contact with me periodically, and he sent me some of the data, and it certainly looked like you had a very, very serious bubble. I was always hesitant to say that too much because, you know, I don't study their market the way I studied the U.S. market, but the basic numbers, your house prices were way above house prices in the U.S. And, you know, I know Australia is a wealthy country, but it's a hair less wealthy than the U.S. It's not a country that has a shortage of land in any obvious way. So that had me scratching my head and certainly concerned. And I know that seems to have flipped

and prices are now falling there as I understand it. I don't know fully the extent of the declines and whether that's further implications for the economy. But, you know, just the numbers he was showing me led me to believe that there could be a serious problem there. Watch this space. Well, Dean, this has been so enjoyable. Thank you very much for joining me. Thanks a lot for having me on. I really enjoyed the questions.

Thanks so much for listening. I hope you enjoyed that as much as I did. Before you go, I have a quick favor to ask. If you liked this episode, please rate and review the podcast on iTunes. I know everyone asks, but it really makes a difference. I make these podcasts for free. They are bloody time consuming, but they're important and I couldn't do it without you. Finally, for show notes and links to everything discussed in that conversation, you can find them on my website, josephnoelwalker.com. That's my full name, J-O-S-E-P-H-N-O-E-L-W-A-L-K-E-R.com. You can also get in touch with me there or on Twitter.

My Twitter handle is at Joseph N Walker. Thanks again for listening. Talk to you soon. Ciao.