Monday, April 06, 2009
In this commentary in today's Wall Street Journal, economists Steven Gjerstad and Vernon Smith offer a theory about why we could again be going from a bubble into a depression.
Over the years, there have been quite a few bubbles, but not all of them cause the sort of economy-wide damage that was seen in the 1930s or over the last year or so. Why?
Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.Most people forget that it wasn't just a stock market bubble in 1929 that led to America's last lost decade. There was an enormous housing and credit bubble in the mid-1920s during which Groucho Marx and others lost a good deal of money on Florida swampland.
As has been the case thoughout history, you can't get a really good bubble going until you get broad participation from the public - preferably lots of people at the lower end of the socio-economic scale levered up courtesy of a banking system that is gushing with easy money.
That pretty much described the situation in the 1920s and in the 2000s.
The entire piece is worth a look as they go through the recent history of financial bubbles in the U.S., a sequence that really accelerated about 20 years ago when you-know-who started sitting in the big chair at the Federal Reserve boardroom.
Interestingly, they touch on one of my all-time favorite subjects since this blog began a few years ago - how owners' equivalent rent duped the Fed.
During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.Yes, "an important component of inflation remained outside the index" - that sort of thing almost always ends badly as noted here on many occasions before.
Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!
By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.
With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.
After years of writing on this subject, yours truly still comes out high in a simple Gooogle search on the phrase owners' equivalent rent - right there in second place, behind the Bureau of Labor Statistics with "How owners' equivalent rent duped the Fed" and then again in fifth place with the memorable "The complete and utter failure of owners' equivalent rent".