The Joe Walker Podcast - Housing Bubble Week Finale: It's The Housing Cycle, Stupid! - Ed Leamer

Episode Date: May 23, 2019

This episode is about why housing busts cause recessions. Few understand their nexus better than Ed Leamer. Ed...See omnystudio.com/listener for privacy information.

Hello there, ladies and gentlemen, boys and girls, swagmen and swagettes. I'm your host, Joe Walker, and this is the Jolly Swagman podcast. Welcome to the final episode of Housing Bubble Week. It's been a fascinating journey, and in this conversation, we arrive at a logical endpoint. In its own way, I think this will be the most important episode of the series. You know that by moving a pen from one side of your desk to another, you can change the gravitational forces on Jupiter enough to shift its position from one side of the sun to the other a billion years from now. I'm deadly serious. If you're sitting at a desk right now, try it.

It's fun. I promise you, in a billion years, Jupiter could be on the other side of the sun because of what you've just done. That example comes from astrophysicist Scott Tremaine, but it illustrates a general idea, which you might have heard elsewhere referred to as the butterfly effect. The phrase butterfly effect came from a speech given by Edward Lorenz in 1972, titled, Does the flap of a butterfly's wings in Brazil set off a tornado in Texas? The weather, just like planetary orbits, is a chaotic system. Such systems have two essential properties. One, they are dynamic, meaning the behavior of the system at one point in time influences its behavior in the future. And two, they're non-linear, meaning the relationships

between their variables are not additive, but exponential. For this reason, chaotic systems are fundamentally unpredictable. The economy is precisely such a system, and to say that macroeconomic prediction is a fraught business is to understate the sense of nihilism you should feel about it. When Larry Summers was once asked for his view on the economy, he replied, I don't know what's going to happen, but anyone who says he knows what will happen doesn't know what he's talking about. Forecasting guru Phil Tetlock notes that he, Nassim Taleb and Daniel Kahneman all agree that there is no evidence that economic forecasters can predict anything 10 years out beyond the excruciatingly obvious. We may never be able to predict the macro economy over a long time horizon, but it seems as if many economists can't even see recessions

when they're staring them in the face. In November 2007, when the Federal Reserve of Philadelphia polled leading economists asking them where they thought the US economy was headed, the consensus was that GDP would be up about 2.4% in 2008. In reality, it shrank by 3.3% once the financial crisis struck. But it wasn't just the great recession economists missed. A recent IMF working paper discovered that of 153 recessions in 63 countries from 1992 to 2014, only five were predicted by a consensus of private sector economists in April of the preceding year. At the beginning of this podcast series, I said I had a secret, a party trick, if you will. I think you can predict recessions, say one to two years out, in so far as you can predict the bursting of a housing bubble.

In other words, housing bubbles almost always lead to recession. If you wanted to forecast a housing bubble recession, there are three big things you'd need to do. First, you need to concede the possibility of housing bubbles. Don't be like the father of the efficient markets hypothesis, Eugene Farmer, who denies the existence of the nasty B word. Second, you need to understand the trajectory of the bubble. Father of behavioral economics, Richard Thaleraler said in his book Misbehaving that it is much easier to detect that we may be in a bubble than it is use heuristics like credit availability and building approvals to get closer, somewhat closer, to a probability of when prices will peak. Third, you'd need a causal explanation why the bursting of a housing bubble creates a recession.

So far in this series, I've attempted to give you information that goes to the first two questions. This episode, the final episode of Housing Bubble Week, is about the third. Ed Lemer is our guest. Ed is the Chauncey J. Medbury Professor of Management, Professor of Economics and Professor of Statistics at UCLA, and he's the director of the UCLA Anderson Forecast, which provides predictions for the economies of California and the US, no less. Ed is the author of four books and over 100 articles on economics and econometrics. And as a random bit of trivia, he was the vice presidential nominee on Lawrence Kotlikoff's independent ticket

in the 2016 US presidential election. I'm bringing Ed to you for a very good reason. He has become by far one of my favorite economists because his grasp on the economy is not theoretical, but empirical. From his empirical research, Ed discovered, stumbled upon, a stunningly clear nexus between housing cycles and recessions. In so doing, Ed speaks from American experience. Let it be known that Australia doesn't quite conform

to the statistical pattern you're about to hear. I've checked that with UNSW professor Nigel Stapleton, but that's not what I want you to focus on anyway. I want you to hear Ed's causal story about how a housing down cycle bleeds into a recession, because there's no reason why that story can't be repeated down under. Ed Lima, thanks for joining me. Great to be here. You're one of my favorite economists, but I've only heard your name recently, and yet

a few of my audience members already know of you. I guess that's my fault, but I am very excited to share some of your work with our listeners. You're my favorite economist, not just because you talk a lot of sense, but you have great style when you do it. I think you're one of the best exemplars of the use of metaphor in economics that I'm yet to come across. Yeah, I try to reach out to a broad audience. That's one thing about teaching the business school that's good because you've got to deal with the MBAs rather than just PhDs.

Yeah. Well, thank you for that. And before we kick into this discussion on housing and house prices, I want to ask you first, give us a primer. Explain the problem of causal inference in macroeconomics. Yeah, in order to describe a cause, you have to have an intervention. Any causal statement is making implicit intervention. So the problem with the macroeconomics, there are no real experiments. There's no interventions except maybe some accidents now and then. So it's very hard, for example, to tell what the impact of monetary policy is because that's occurring not in an experiment. Nobody randomizes and says Australia will raise interest rates, United States will lower.

It doesn't operate that way. So we just look at correlations in the data. What I like to say is correlations are in the data, but causality is in your mind. In other words, you interpret their correlations in a causal way. But the only way you make completely scientific, valid causal conclusions is if you actually have interventions. If you study the experiments at randomized trials. How much weight do you think we should give to very compelling causal explanations?

Well, that's all we have. So it's the only thing you can rely on in an area of macroeconomics particularly. Nobody's ever going to really do experiments. So we have to provide interpretations of the data that we have and tell stories to each other to draw causal conclusions. It's not science, but it's persuasive art. There's a quote in your textbook, Macroeconomic Stories and Patterns, that I love. I think you say, we are pattern-seeking, seeking storytelling animals i think that sums it up pretty well i when i i heard that on a national public radio oh there you go a long time ago and i said oh my god that's what economists should say

they are but you know lucas is famous for saying the opposite he, economics is mathematics and everything else is only patterns and stories. To which I replied, good economics is patterns and stories. Everything else is just mathematics. By the way, I have a math undergraduate from Princeton University, so I can speak that language pretty well. But I know that it's a limited language. It's great for talking about some things, but if that's the only language you speak, you're not going to really understand how an economy operates. That's right. And it does risk creating a veneer of precision. I think, as John Maynard Keynes put it so well, it's often better to be roughly right than precisely wrong. Yeah, that's a good way of putting it.

I think also it creates a sense of science, which isn't really there. Or scientism. Scientism, yeah. I mean, it makes you think that you're carrying out science because you wrote down a mathematical model. But science, the way I see it, requires evidence. I was talking to Dean Baker on this podcast,

and he was telling me a story about a Brookings Institute paper he did, and he put together some pretty simple algebra, but his co-author added a very complex statistical model to the paper just to make it seem a bit more credible. It was totally irrelevant, but it got published. That's the rules. Yeah, that's the rules. I just had an exchange with this friend of mine in Spain who's been working on precursors to the Spanish economy and sent me a very technical paper about it. And I sent him a version of mine, which is totally exploratory and full of stories and

patterns, but not much in the way of formal econometrics so let's move to housing Ed before we talk about your famous speech housing is the business cycle I want to discuss a lesser known paper of yours. In 2002, you published a paper titled Bubble Trouble, Your Home Has a PE Ratio Too. And in the paper, you said, and I quote, you are completely deluding yourself if you think there can be a long run disconnect between a house price and its potential rental stream, end quote. Just explain what you mean by that. Well, at that time, Americans had learned rather painfully that elevated price-earnings ratios on stocks eventually are going to punish you unless the earnings start to show up. We had that internet

period in which the firms had all P and no E, meaning they had no earnings at all, but they had extreme valuations. So I use that rhetoric to say your home has a P-E ratio, too, to make people think that there's a fundamental value that has to do with the stream of services that come off of that home and the economic value on a monthly basis, the rental that it could generate. So there has to be a connect, a long-run connect between prices and rents. Now, that connection depends on other things. It depends on the rate of growth of rents. It depends on interest rates. Those are the two critical factors.

And at that period of time, in 2003 and 2004 and 2005, the markets could be said to be folding in the reality of much lower rates of interest, which support higher price-to-rent ratios. So whether there was a bubble at that time or not could be discussed, I would say. But the idea that there can be a disconnect between rents and prices, that to me cannot be discussed. It cannot be allowed. That idea is not right. So let me pick up on something you said there. Interest rates. Now, they would expect us to see more P and less E. Just explain in a mechanical sense why that's the case. Well, I like to ask the question, how much does it cost to earn a dollar? So in those equities markets, that's the price earnings ratio. Paying $10 and you earn a dollar,

that would be a 10 to 1 price earnings ratio. For the bond market, it's the inverse of the yield. So if the yield is 1%, then you have to pay $100 to earn $1. So these are two investments that are going to be related. The inverse of the interest rate and the price earnings ratio historically move together. And when one gets out of whack, like we had in the equity bubble in 98, 99, that's a symptom of the disconnect between two markets that essentially have to be linked together. There's two ways of earning a dollar. You either buy a bond or you buy an equity.

Now, a bubble, in my way of understanding them, empirically and historically, is always an overlay to strong fundamentals. So a low interest rate environment can lead to a secular shift in the P.E. ratio for homes, but it doesn't explain away the existence of a bubble or preclude the possibility. Do you want to make a comment on that statement? Well, when that interest rate falls, it's going to support higher price earnings ratios. But nobody really knows what should be in equilibrium because you don't know what the real rate of interest is going to be. Because everybody's looking around to see if that real rate of interest is going back where it was a few years ago. So there's uncertainty in the market as to what the fundamental value is. And that can create a kind of meandering path from one equilibrium to the other, a path that can involve highly elevated price-earnings ratios until it finds this new equilibrium.

And I would call that a bubble that is facilitator supported by lower interest rates that creates an uncertain path toward a new price earnings ratio. So in the US, and this is the case for Australia as well, interest rates have been low and declining since the 1980s. And some people say that that can explain the run-up in Australian house prices. They also made the same argument in the US. Do you think that that is sufficient? Well, it's a factor for rising price earnings ratio. Some of that elevate in the United States. Some of that elevation in home prices is due to the lower interest rates. There's no question about that. But at the same time, my judgment of the

housing market at that time when I write that statement about the price to rent ratio is that price to rent ratio had gotten too high. That went well beyond what the bond market would support. But there are other periods in US history where interest rates came down or were low and we didn't see a similar run-up in house prices. For example, in the 1950s or 60s, I think they came down quite a bit. Well, first of all,

you have to look at the real rate of interest, not the nominal rate. So that inflation in the 60s and 70s that brought with it higher nominal rates, it didn't do much to real rates of interest. So the real rates of interest, I believe you looked at it back in the 50s and 60s. It's like a 2% rate that elevated maybe in the 60s, it's like a 2% rate. That elevated maybe in the 60s, but then it's been on a decline ever since then. It now is about half a percent. Great. So let me ask you this, Ed.

Why do housing bubbles burst? Well, my view, another question that is similar is why do expansions end? And an old joke is that expansions don't die. They're murdered by the Federal Reserve. is that the parents of the economy, who are the Federal Open Market Committee, decide to give their children these candies in the form of low interest rates in order to help them recover from the recession that just ended.

And they keep handing out the candies and keep handing out the candies and keep handing out the candies. And eventually, they realize that price inflation is an apparent problem. And they jack up interest rates. But while that candy is being handed out, that means that the interest rates are very low and allows people to qualify

who wouldn't otherwise qualify. It supports high price to rent ratios, just like we said, just like we were talking about before. So I really think that the bubble ends because the Fed jacks up interest rates here in this country. They can end because they just get so far out of control that there's nobody else to buy a home anymore. But in the U.S., the timing is almost perfectly coincidental with an inverted yield curve caused by the Fed's decision to raise short-term rates very rapidly. Let me put a finer point on that. Last time we spoke, you mentioned that what, in your view, ended the U.S. housing bubble wasn't interest rates per se,

but the effect they had on underwriting standards. Can you explain that? Yeah. So when the yield curve is steep so that short-term interest rates are low and longer-term interest rates are high, a bank will make intermediation profits where they take deposits at short-term maturities and low interest rates. And they use that money to support longer-term loans at higher interest rates and make profit off of every loan that they provide, intermediation profits. But when the yield curve flattens out, the banking sector doesn't make the intermediation profits anymore,

and all of a sudden risk control becomes extremely important. Because when the yield curve is steep, it's okay that they get some loans that don't work out well. There's some defaults and delinquencies, because all the other loans are generating a lot of profitability. But once that yield curve flattens up, the banking sector has to really worry about default and delinquency, so you get a tightening up of lending standards. We saw that big time with the subprime lending in the United States.

They let people with low incomes create their own they when they filed for a loan as they they called it a ninja loan no income no job and that went out for a long time people were qualifying which should never have qualify for a loan and Fed jacks up interest rates and that was the end of the subprime market you know it's interesting in Australia, although interest rates haven't increased, we have seen a clear and impactful tightening of lending standards. There was a banking royal commission announced, which is like, you know, the highest, most resourced sort of inquiry you can have into a certain issue. And what they found was the banks were using a household expenditure measure

to assess people's ability to assess their loan service ability. But it was like just a population level statistic that didn't actually take into account the circumstances of the individual. And it was incredibly generous. Now, since the Banking Royal Commission ended, the banks, because of the cultural, political and legal environment, have been making it a lot more difficult for borrowers to get loans and that's clearly been driving the falls in Australian house prices. But this is interesting because a lot of people say that we can't see a prices crash in Australia

without an increase in interest rates but what you're saying at least from the US experience is that interest rates aren't the story it's the effect that interest rates have on underwriting standards so presumably if underwriting standards are tightened by another means, they can still have the same impact on prices, because it's really the availability of credit that drives the housing bubble, both upwards and downwards. Yeah, I completely agree with that. I would say another thing that affects lending standards is the rate of appreciation. Because if you have rapid appreciation, the loans are self-collateralizing. You don't have to put anything down because a year from now, you'll have something down because the appreciation will allow that to occur.

So your loans evaluation ratio will become less risky in times of great appreciation. Yeah. And so banks are not going to be so worried about default and delinquencies when they're feeling that there's going to be continued depreciation. So that's another way, another thing that amplifies the cycle. So the lender says, I'm about ready to give 100% loan to value mortgage to a homeowner. I'm worried because that homeowner doesn't have any stake in the property. How do I know that's ever going to get paid back? But if you know the property is going to be worth 20% more a year from now, you can rely on that appreciation to create the collateral that's important.

Another point, which is many people in the United States took out home equity lines of credit when you had that appreciation. So they allowed the lending standards to deteriorate without necessarily the approval of the original lender. And they used that money to buy automobiles, for example. That was a big driver in the US economy in 2003, 2004, and 2005. Yeah, we'll come to that. Have you heard of Bill Gross's plankton theory? I seem to recall that the last time we talked, perhaps. Ah, yeah. Tell me again what that is.

So in plankton theory, the least creditworthy borrowers, which are the ones who can now enter the market thanks to the lower underwriting standards, are like the plankton of the ecosystem. The rest of the food chain ultimately depends on them. And as soon as the plankton get eliminated from the equation, in other words, as soon as underwriting standards are eventually tightened, it has flow on impacts for even the higher price terms because people can't trade up as easily and you also have less credit being shoveled into the bubble because these plankton have been disappeared. Well, that's a perfect description of the

bubble that we had in 2003, 4 and 5 because it was focused on the lower income people, the people who would never have qualified traditionally were given loans and it just drove the whole market crazy. On the other hand, in the last few years, we've had these foreign buyers, Chinese, buying higher end homes that have contributed to the escalation of home prices here in Southern California. So it's not always a plankton story that Bill Gross suggests. The money can come from other places. Yeah. Same story has occurred in Australia, although it's become more difficult for foreign buyers, especially the Chinese, to get their money into Australian homes.

That's true in the US as well. Right. Yeah. So, Ed, we've spoken about the problem of causal inference. We've spoken about housing bubbles. I want to now turn to the macroeconomic consequences of the housing cycle, which I think is just an incredibly important topic and almost a secret in the economics profession. But you've been drawing attention to it in a very common sense and absolutely compelling manner in your metaphorical style, as you like to do. And this is really a logical endpoint for a podcast series I've been running on housing bubbles. So far, we've spoken with Dean Baker about his foresight in the US housing bubble.

I've spoken with Pete Eichholz about the Herringgracht Index and how housing performs over the very long term. The Herringgracht Index begins in 1628. I've spoken with Tamor Karan about modelling or conceptualising housing bubbles as availability cascades. I've spoken with Chris Joy, who manages $3 billion in Australia, about the likely extent of falls in Australian house prices and the significance of investor expectations and animal spirits. I've spoken with Timo Henkel, a behavioral macroeconomist at the ANU, about a philosophy of bubbles. And I've spoken with John Hempton, who manages Bronte Capital,

a very famous short seller. He actually investigated the decline or the deterioration in underwriting standards in Sydney by going undercover and visiting banks with Jonathan Tepper of Variant Perception. So with that long preface, this really brings us to what are the consequences for the broader economy of a housing cycle because at the end of the day, that's really what matters, the impact on people's lives. Now, in 2007, you gave a presentation at the Housing, Housing Finance and Monetary Policy Symposium held by the Kansas City Fed. And your talk, you titled it, Housing is the Business Cycle. Explain to us why you chose that title and how the talk was received.

Well, I was asked to write a paper that was titled Housing and the Business Cycle. And I changed the word to is in order to make the point that this plays a critical role in the U.S. economy. And there's no sector that you can point of that both is a reliable precursor to recessions and also contributes to the downturns as well. So that was my way of saying the Fed ought to spend a lot more energy on the housing market than they have historically. I would like to back up and say something about my own experience with this. Why did I get to where I was? So I was teaching in the UCLA Economics Department, teaching PhD courses in econometrics and international trade through 1990. 1990, I moved to the business school at UCLA.

And I thought, what can I teach these MBAs? It's not going to be the things I was teaching at PhDs in economics. And I decided I would create a course that I would describe it as turning numbers into knowledge. The premises that we have on our desktops via the computer and the internet virtually unlimited access to textual and numerical data and that we need to figure out a way to filter that and create knowledge, insight, and wisdom from that incredible resource. And I would illustrate that with macroeconomics. And instead of taking the theory of macroeconomics, we would just dig

into the data set. We look at what was happening in recessions and what was GDP doing and what were the components. It was heavily data oriented. We're downloading data, creating visual displays, talking about it, maybe some numerical analysis or regression here and there. But the whole idea is to give the students an experience with the creation of knowledge using the textual and numerical information that was on the internet. In that process, I learned a heck of a lot about how the US economy operated. Stuff that is not taught in macroeconomics. Macroeconomics continues to be highly theoretical.

The worst version of this is that real business cycle stuff. And, you know, you talked a minute ago about how do you get papers accepted in academic journals. Well, they have particular rules that involve what I would call a simplistic model, but it's mathematically difficult to work with and not too easy to program on a computer. That's the rule about how you get something published in academia. It's almost like the profession needs to justify its existence in the same way that lawyers can mask quite simple concepts with a lot of Latin jargon. Yeah, so you notice what I do is I try to make it absolutely clear and simple. I think most of the ideas that economists have are really simple. And what we need to do is find ways to communicate with each other and with a broader audience. When I try to publish academic articles,

people say I have an unscientific style because it's sort of casual and transparent rather than opaque and un-understandable, which is often the way mathematics can be. So I think it's important for your audience to understand that we need to have an exploratory attitude when it comes to data analysis and economics. And it's that exploratory attitude that allowed me to come up with this conclusion about housing. Once you start actually looking at the data, the housing just pops out at you. There's no question that it plays a huge role and the Fed ought to be

worrying about it. Got it. So you stumbled on this by doing empirical research, not theoretical research. It reminds me of how the early surgeons who had a very theoretical understanding of anatomy could create some quite disastrous results in their patients whereas when they transitioned to the you know the the empirical skeptics who operated on the body and in a more mechanical sense it it really improved results well it improved it but you know that that time the word empiric meant a quack okay You had the theorists who understand how medicine actually operated. They were in control. And there were these empirical types who were trying to figure out what works or not.

They were regarded as a quack. You look it up in a dictionary, you see that the word empiric means a quack. Didn't know that. You gave me an idea, though. You mentioned the business cycle. Maybe we should actually start by talking about that. Just explain what that is so people have some context. Well, what it really means is we have a recession.

The economy has a healthy period and followed by these intermediate periods of time in which there's an of what's called an official recession I I don't I again I have my own view as to what we should define as recession to me it's a disease that is symptomized by unwanted idleness so we have elevated unemployment rate you had declining capital utilization and manufacturing we have idle idle offices, idle apartments, idle homes. Maybe it's idleness. Something's gone wrong with our markets that allows an unwanted level of idleness of all kinds of productive assets. So the U.S. economy cycles in and out of these periods of healthy, in which the idleness is optimal and small, into these periods in which the

idleness is elevated and highly undesirable. And they call it a cycle. A cycle sounds like it's repeats in some kind of cyclical behavior. It's not that, it's not, it's more like catching a cold than it is like a seasonal cycle. It doesn't have that kind of repetitive nature to it. It's not predetermined. Yeah. You don't know.

It's not like the winter comes around every year. Sometimes it's going to be longer and sometimes shorter. That's true with human illnesses as well. It might be the longer you've been healthy, you might have an elevated hazard rate, but that doesn't turn it into a cycle. It's something that occurs infrequently. Well, I don't know whether the word would be infrequent. It occurs every five to 10 years in the US economy or something like that. Yeah. That's such a good way to put it, an unwanted period of idleness.

Now, so you told us your story of how you were trawling through this data and the connection between housing and this cycle jumped out at you, as you say. Tell us what that connection is in numbers. Well, I'm like the empirics, the quacks of the Middle Ages. I want to know what it is that was happening before the economy went into the downturn. So I looked at all kinds of different data sets. But housing is one of the things that is measured with a pretty high degree of accuracy. And you could see that housing was proceeding these downturns by about three quarters pretty consistently. And you couldn't find another indicator that

was so good. Now, all U.S. recessions are not housing-led. We've had two that are not. But the other ones have all had a contribution from housing, an early decline in housing, followed by an early decline in durables, automobiles and other consumer durables. And then it's not until the recession was officially there you had the businesses saying, this is not looking good, and they cut back their spending on equipment. And it's that timing that has led me to say rhetorically,

we call it the business cycle, but it's really a consumer cycle. This is the passenger, not the driver. So it starts with housing, then it moves to consumer durables, and then finally business equipment. Yes. Wow. Now, we're talking about post-war recessions in the US? That's correct. And so we've had 11. You mentioned there were two that weren't led by housing. One is obviously the dot-com bust and the recession in 2001, was it? That's correct. 2001. What was the other one? That was the Korean War, the Department of Defense downturn. So if you look at the expansion that preceded that 1953 downturn, you'll see it had a huge component of contribution from the Department of Defense,

federal spending on defense. And then when that armistice was signed in 1953, I think it was June or July, at that anniversary on a dime, there you had a huge decline in spending by the Department of Defense. That's our test of fiscal policy. That's the only test that we have in that data set of the efficacy of fiscal policy. A huge run-up in Department of Defense spending. We have another one in the 60s, by the way, where we had a run-up of spending for the Vietnam War. And a third one, which is not as pronounced, was the Reagan build-up in the early 80s. So those things are playing a role in affecting the U.S. cycle,

but they don't eliminate the role, except in the one Korean case, they don't eliminate the role of housing that's contributing as well. So there was no housing contribution to 2001, and there was no housing contribution to 1953 recessions. Now, do we have a false positive? Yeah, there's a couple of them. One is in 1965, where the housing market was deteriorating, but it didn't lead into a recession. There was another one in 1995. It wasn't as extreme, but the housing market was weakening. Other things were symptomatic of recession, that too was offset by some big ramp up in spending.

In that case it wasn't DOD, it wasn't defense spending, it was spending on the internet, the internet bubble. So what I would say is that those are not false positives. Just like if your fire alarm in your house rings off and you stop the fire immediately, that doesn't mean it was a false alarm. It was a valid alarm that was intentionally or not intentionally was offset by something else. Yeah, gotcha. Now, let's talk about the sequence of housing to then consumer durables to business equipment. Firstly, you say that the housing cycle is a volume cycle, not a price cycle.

What do you mean by that? Yeah, that turns out not to be entirely accurate, but that's what I have said, which is when the cycle ends, you get to the cycle peak, at that point you have high prices and you have high volumes, large amounts of sales, large amounts of housing starts, new building. And then in the year after that cycle peak, you get hardly any decline in prices, but you get a cut in volumes by about a factor of two. And then slowly you get a price discovery process where the owners are slowly absorbing the fact that the market isn't as good as what it used to be, slowly pointing their homes on market for lower prices. And it's a slow price discovery process.

In California in the 1990s, it took about five or six years before we reached the new price bottom and started getting appreciation again. Yeah. And tell us why the sales volume starts to dry up in a down market. The owners of the homes are not motivated to sell. They feel they can wait it out. They think that their home is worth what it would have been earlier, the way I described it before, my idiot neighbor sold his for a million dollars, and I'm not taking a penny less. So I've waited out, waited out, waited out, and only slowly will I come to the realization

it's not worth a million, and if I want to get out from under this, I'm going to have to accept a lower price. So these home owners are not typically motivated sellers. They don't feel a desperate need to sell their home. They can stick it out. Now, you described that as hormones in housing. I use the term loss aversion.

I know you don't like the phrase loss aversion. Tell me why that is. Well, I don't know what it means, I guess. It's some nonlinear utility function? I'd rather have a metaphorical description of the mind of the individual. Like you said, a hormone. Another way of saying hormone is I love my house. I want to get a fair price for my house.

And when somebody, and I think it's a brutal million dollar somebody comes in and say well I KB 800,000 that's my child I'm not going to sell that off I love my house that would be another hormone kinda story but but lost version that's the word doesn't motivate me doesn't excite me in terms of what it reveals it's just a description that people are reluctant to sell. So we use different words, but essentially we're describing the same thing.

Living in a home is a radically different experience to being a property investor or even a stock market investor. You can live in a home, but you can't live in a stock certificate. Nor for that matter can you renovate a stock certificate or graffiti one or paint one or have a home birth in one yeah but you can also sell a stock or sell a rental property without having to move the home that you move away from the home that you're in so there's a lot of inconvenience that's to me the big cost of selling the home you live in is you all of a sudden have to move somewhere else.

And you put a lot of time and effort in finding your home, and you make a big investment in the neighborhood, meeting people and understanding what the schools are like. To give that all up involves a huge cost. So that isn't loss aversion. That isn't some kind of psychological loss aversion it's it's a meaningful investment that you've made in that house you don't want to give it up yep now when the volume cycle dries up for the reasons we've just discussed in a housing down market it has an impact on jobs in real estate, in finance, and in construction. Tell us

a bit about that in terms of the U.S. experience. Yeah, you have a huge decline in construction of homes. So there's job loss immediately. That's in the recession, you're getting a lot of job loss in construction. Typically, it's been construction and manufacturing have been the big centers of job loss. More recently, we had other sectors like retail where the job loss has been more severe than it had been historically. But three or four recessions ago, retail didn't play much of a role at all. It does now because of the internet. You know, firms are realizing that this bricks and mortar business isn't so unprofitable anymore. So when the recession comes, they use that as an opportunity to change their business model. And you get loss in retail

jobs as well. But historically, it's been manufacturing and construction is where most of the job loss occurred. Yeah. Now tell us your causal explanation for why this all now flows through to an impact on consumer durables. Oh, because the home prices, high home prices have historically been used to support a feeling of optimism about your wealth and allows you to either take out a loan to buy consumer durables. If you're building a new home, you've got to fill it with consumer durables. And those two things lead to very strong consumer durable markets while the housing market is hot.

Sorry, there's just a bit of background noise. Is that like a wind? That's a little dog walking around there. Good boy or girl, whoever it is. My wife is here tiptoeing around. Hi, Mrs. Lema. Behave yourself, man. All right.

Gina, dog, quiet over there now oh thanks uh and then finally we have the business equipment so by the way finally we have business structures yes so there are four things that decline first it's homes then it's consumer durables, automobiles. The recession is officially there, then it's equipment. And the last thing, and the most delayed, is business structures, factories and office buildings. And in coming out, in the recovery, exactly the same ordering occurs. The first thing to recover historically has been homes, then it's vehicles and other consumer durables, and then it's business equipment, where the businesses feel things are good again, and we've got to invest to create the capacity

to take care of the new demand. And last of all, it's business structures. The reason, by the way, for that is that the structures take a long time between their conception and the actual actual building so it's a very slow process where these other things are much quicker in response gotcha and this macroeconomic story or pattern that you're telling us describes nine out of the 11 last post-war u.s recessions. That's correct. Wow. So, Ed, let me put two more questions to you. The first is this. Last time we spoke, I mentioned to you the Carmen Reinhart-Kenneth Rogoff statistic that major housing busts take four to six years on average from peak to trough, which is longer than most or all stock market crashes. Why do you think housing busts are so drawn out? Well, the way I describe it historically is that's the price discovery process.

It takes a long time to find a new price equilibrium when you've had an elevated prices. So while that's occurring, volumes are going to stay low. You've got to get people feeling there's going to be appreciation again in the home before the housing market can become regular again. So it's the price discovery process has historically been very sluggish. Now it wasn't sluggish at all in the most recent recession. But just explain that a little bit more for people who have no training in economics. Like, why does a sluggish or opaque price discovery process necessarily lead to a drawn-out

bust? Well, imagine you're thinking about buying a home, and for each of the last three years, prices have fallen by about 5%. You're thinking, boy, the interest rates are high enough, but in addition, I have to pay another 5% and people say, no, I'm not going to buy a home under those circumstances. So the optimism is going to come back to the housing market when you hit the bottom, when there's really some great buys and people, buyers recognize that and create a bottom on home prices. And when that happens, then the volumes start to elevate again. Until you get appreciation, until you get to this new equilibrium price

and you get some appreciation in the market, the volumes are going to stay very low, both volumes of sales of existing homes and volumes of building and sales of new homes. You make a lot of sense, Ed Lehmer. Okay, that's good to hear. My final question is this. Macroeconomic stability is an important goal for policymakers and economists to aim for. We want to avoid those periods of unwanted idleness that you spoke about so articulately because of the human costs. It's something that we should want to avoid entirely. What can policymakers, central banks, governments, regulators, economists, what can we do to smooth out these cycles to get a grip on the housing cycle?

What would you do if you could wave your magic wand, Ed Leamer? Well, for the United States, and when they're high and getting higher, that's the time to raise interest rates, to slow down the building of a mountain of homes. And if you eliminate that mountain of homes, then there's no valley either. So that was my recommendation. The reason I use the word housing is the business cycle, that's my way of communicating to our Fed that they ought to take housing as one of their targets and when it's going up and they need to have some kind of

control put in place that prevents that from getting completely out of control now just let me challenge you on your policy recommendation there's something known as the tinbergen rule in economics which is that we should have one instrument, a single instrument for a single goal. And if you increase interest rates to put a dampener on the housing cycle, you might shut off positive economic activity in other sectors. So should we try and develop a more surgical approach if one is even available to us? Well, that's hypothetical about affecting other sectors. I think it's mostly the Fed, our U.S. Fed has its impact primarily through houses and consumer durables. So that interest rate, you think of it as affecting the spending on equipment and structures, but you can't see any evidence of that in the data. What probably is occurring, businesses are much more concerned about economic growth

and market share than small changes in interest rates that are affected by the Federal Reserve. So if what you said was true, that there was some other sector that was extremely interest rate sensitive, I would totally agree with that. You'd want to consider both. But I just see housing as the most important sector and it leads and contributes to the consumer durable problems as well. Ed Lemer, thank you so much for joining me. Thank you for having me. Thanks so much for listening. I hope you enjoyed that as much as I did.

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