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Acknowledgments
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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11 - Summary: What Have We Learned?
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp 268-286
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Summary
Balance Sheet Crises and Housing: Definition and Occurrence
In the United States, balance sheet crises have occurred as a consequence of a decline in housing market values against fixed mortgage debt. Many household balance sheets are thereby plunged into negative equity, and the lenders suffer parallel balance sheet damage as the underlying value of their mortgage loans declines in step with house prices. Under these conditions, households have strong precautionary incentives to reduce their expenditures and banks to reduce their lending as both sectors seek to rebuild their lost equity and avoid incurring new risks. Although this net-debt-reduction process increases the availability of funds for investment, those channels are simultaneously experiencing expectations of declining returns to new investment opportunities and falling interest rates, even in advance of policy shifts toward monetary ease.
Fortunately, such crises are rare, having occurred in the United States only twice in seventy-eight years – the downturn in 1929 and again in 2008 – culminating in the Great Depression and the Great Recession. Both episodes were preceded by three-year substantial declines in new housing expenditures in 1927–1929 and again in 2006–2008. Perhaps because of their rarity, they are not part of standard macroeconomic or general microeconomic equilibrium models; neither are they part of conventional thinking in monetary and fiscal policy.
4 - The Great Depression
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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Summary
As explanations of the so-called business cycle, or cycles, when these are really serious, I doubt the adequacy of over-production,…over-confidence, over-investment, over-saving, over-spending, and the discrepancy between saving and investment. I venture the opinion…that in the great booms and depressions each of the above-named factors played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after.
Over-investment and over-speculation are often important, but they would have far less serious results were they not conducted with borrowed money.
The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when…it beguiles its victims into debt.
– Irving Fisher (1933, pp. 340–1)Interpretations of the Great Depression
Similarities between the financial crisis in September 2008 and the collapse of the financial system during the Great Depression are widely noted. Yet, the comparability of the origins and transmission of the crises have been neglected. The recent downturn, which originated with a pronounced housing boom and collapse, led to severe household balance sheet problems that were transmitted to lenders and mortgage security investors. Damage to household balance sheets weakened household demand – especially for housing and durable goods – which adversely affected employment, production, and nonresidential fixed investment. This pattern, however, is not recognized in the dominant view as a possible cause of the Great Depression. Contrary to prevailing views of its origins, we argue in this chapter that changes in the levels of mortgage finance and residential construction and the broader economy preceding and during the initial phases of the Great Depression shared many features with the recent Great Recession. Based on data collected by Wickens (1937), we estimate that by the end of the Great Depression, losses onmortgage loans exceeded estimates of losses in the Great Recession, either as a percentage of loans outstanding or as a percentage of aggregate output.
Contents
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp v-xii
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1 - Economic Crises, Economic Policy, and Economic Analysis
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp 1-19
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Summary
The committee determined that a trough in business activity occurred in the U.S. economy in June 2009. The trough marks the end of the recession that began in December 2007 and the beginning of an expansion. The recession lasted 18 months, which makes it the longest of any recession since World War II.
– Business Cycle Dating Committee, National Bureau of Economic Research, September 20, 2010The crisis showed that the standard macroeconomic models used by central bankers and other policymakers…contain…no banks. They were omitted because macroeconomists thought of them as a simple “veil” between savers and borrowers.
– The Economist, January 19, 2013Macroeconomic Policy: Failed Expectations
In a speech on January 10, 2008, when the National Bureau of Economic Research (NBER) had yet to declare that a recession had begun in the previous month, Chairman of the Federal Reserve Ben Bernanke stated: “We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.” Then, in response to a question following his speech, Bernanke replied that “The Federal Reserve is not currently forecasting a recession” but noted that it was, however, “forecasting slow growth.”
9 - What Might Be Done?
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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This is the paradox at the heart of the financial crisis. In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying. Today, however, our problem is exactly the opposite.
The President’s recovery strategy is addressing the housing market. The vicious cycle of rising foreclosures leading to declining home prices, leading to rising foreclosures – must be contained. This problem is at the heart of our economic crisis.
Through direct interventions, using the GSEs to bring down mortgage rates and make possible refinancings for creditworthy borrowers who have lost their home equity as house prices decline, and through setting standards and providing significant financial subsidies for measures directed at payment relief to prevent foreclosures, we are achieving several objectives.
– Lawrence Summers at The Brookings Institution, March 13, 2009The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.
– Friedrich A. Hayek, The Fatal Conceit, 1988, p. 76
Frontmatter
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp i-iv
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5 - The Postwar Recessions
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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“[T]he investment component of output is about six times as volatile as the consumption component.”
– Edward C. Prescott (1986a)“[T]echnology shocks account for more than half the fluctuations in the postwar period, with a best point estimate near 75 percent.”
– Edward C. Prescott (1986b)“[R]esidential investment causes, but is not caused by GDP [movements], while non-residential investment does not cause, but is caused by GDP [movements].”
– Richard K. Green (1997)In this chapter, we examine the ten postwar recessions from 1948–9 to 2001 that preceded the Great Recession. The role of housing investment expenditures in both the Great Recession and the Depression is also manifest in the post–World War II period but with less catastrophic consequences. Recurrent patterns of interaction between housing investment and monetary policy are prominent elements of postwar U.S. economic cycles. Examination of these interactions clarifies one of the primary channels through which monetary policy affects output, especially in the period immediately preceding a recession, during the recession, and in the immediate aftermath of a recession.
8 - Blindsided Experts
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp 203-222
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Summary
The rise in subprime mortgage lending likely boosted home sales somewhat, and curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters. Moreover, we are likely to see further increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face interest-rate resets. All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.
– Ben Bernanke, May 17, 2007Although I was concerned about the potential fallout from a collapse of the housing market, I think that it is fair to say that these costs have turned out to be much greater than I and many other observers imagined. In particular, I and other observers underestimated the potential for house prices to decline substantially, the degree to which such a decline would create difficulties for homeowners, and, most important, the vulnerability of the broader financial system to these events.
– Donald L. Kohn, Board of Governors of the Federal Reserve System, November 19, 2008I got back and I called some friends in the Federal Reserve. “How big is this subprime mortgage thing?” I must admit, the answer I got from them first was, “I don’t know.” Then, they called me back later, and they told me, “Well, it looks like it’s over a trillion dollars.” I had no imagination that this subprime mortgage thing was over a trillion dollars.
– Paul Volcker interview (Feldstein, 2013, p. 114)
3 - Asset Performance
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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[B]eing the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which…(they) frequently watch over their own.
– Adam Smith (Wealth of Nations, Book V, Chap. 1, Part III)In the 1950s, I went to work for a mortgage brokerage firm in LA. When my father learned about my new job, he expressed concern. “You’re not going to bundle them, are you? That’s what brought on the Depression.”
– Personal correspondence from William A. Fraser, Jr., April 7, 2009Real estate bubbles occurred frequently during the past thirty years in both developing and advanced economies. Reinhart and Rogoff (2008) evaluated five major developed-country financial crises: Spain in 1977, Norway in 1987, Finland and Sweden in 1991, and Japan in 1992. They found that, averaged across the five crises, residential real estate prices peaked a year before the onset of the financial crisis; house prices had fallen by 22 percent four years after they had peaked. Rogoff and Reinhart (2009) extended their earlier analysis to twenty-two financial crises in both developed and developing countries and found that real estate prices fell in all of them, with a median decline of 35.5 percent. House prices declined more than 10 percent in twenty of the twenty-two crises. They also found that a typical financial crisis is associated with a substantial increase in unemployment and a decline in GDP that lasts for several years, followed by a large increase in government debt. Although their analyses indicated that house-price declines, unemployment, and equity market declines are all associated with financial crises, they did not indicate which factor or factors might have triggered the downturns and which are effects.
Rethinking Housing Bubbles
- The Role of Household and Bank Balance Sheets in Modeling Economic Cycles
- Steven D. Gjerstad, Vernon L. Smith
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In this highly original piece of work, Steven D. Gjerstad and Nobel Laureate Vernon L. Smith analyze the role of housing and its associated mortgage financing as a key element of economic cycles. The authors combine data from both laboratory and real markets to provide insight into the bubble propensity of real-world economic actors and use novel historical analysis on the Great Recession, the Great Depression, and all of the post-World War II recessions to establish the critical roles of housing, private-capital investment, and household and private institutional balance sheets in economic cycles. They develop a model that incorporates household balance sheets and bank balance sheets and offers insights based on this analysis concerning policy going forward, effectively changing the way economists think about economic cycles.
7 - The Bubble Bursts
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp 173-202
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Summary
The parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.
– Lawrence Summers, Congressional testimony, July 30, 1998With respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve’s responsibility is to make sure that the institutions it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well managed and do not create excessive risk in their institutions.
– Ben Bernanke, Senate confirmation hearings, November 15, 2005We were on the March 22 call with Fitch regarding the subprime securitization market’s difficulties. My associate asked several questions. “What are the key drivers of your rating model?” They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past fifty years. My associate then asked, “What if HPA was flat for an extended period of time?” They responded that their model would start to break down. He then asked, “What if HPA were to decline 1 percent to 2 percent for an extended period of time?” He then asked, “With 2 percent depreciation, how far up the rating’s scale would it harm?” They responded that it might go as high as the AA or AAA tranches.
– Robert Rodriguez, June 28, 2007Every time there’s been a fire, these guys [derivatives traders] have been around it.
– Nicholas Brady (Lowenstein, 2000, p. 105)The collapse of the housing finance market is in many ways the most fascinating – and certainly the most painful – part of the story of the bubble’s unraveling. In previous chapters, we present a brief primer on the private mortgage market as it developed following the popular initiatives of the Clinton and Bush administrations to expand homeownership and eliminate the capital gains tax (capped at $500,000 for each sale) on homes, the policy actions of government sponsored enterprises (GSE), the continuing large inflows of foreign capital, and the unprecedented (at the time) monetary ease of 2002–2004. The focus now turns to the private housing-mortgage market institutions that served to amplify the housing price run-up, particularly in the period after 2001.
Index
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp 287-293
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6 - What May Have Triggered or Sustained the Housing Bubble (1997–2006)?
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp 146-172
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Summary
As home prices rose and hunger for high-yield investments grew, Sadek [founder of Quick Loan Funding] found his niche pushing mortgages to borrowers with poor credit. Such subprime home loans grew to $600 billion, or 21 percent, of all U.S. mortgages last year from $160 billion, or 7 percent, in 2001, according to Inside Mortgage Finance, an industry newsletter. Banks drove that growth because they could bundle subprime loans into securities…“I never made a loan that Wall Street wouldn’t buy,” Sadek says. He worked hard to build the business, he says, and the company did nothing illegal…with the support of Citigroup, which funded the loans, he pioneered lending to homebuyers with credit scores of less than 450.
Citigroup spokesman Stephen Cohen said the bank doesn’t comment on its relationships with clients.
“We made most of our money from selling loans to banks,” Sadek says…like many subprime companies, [he] specialized in…thirty-year mortgages that start with lower “teaser” interest rates and ratchet higher after two years.
A key selling point was the 50 percent rise in home prices nationally from 2001 to 2006.
Bob Ivry, Bloomberg News, December 18, 2007Since late 1997, more than $2 billion worth of community reinvestment loans have been packaged and marketed into securities…Every dollar taken off the originator’s books through securitization is a dollar available for new loans…securitization reflects a growing confidence among secondary market investors – many of whom, after all, are under no CRA obligation of their own – in the quality of these loans. I think that it proves we’re on the right track.
John D. Hawke, Jr.; Comptroller of the Currency; May 5, 1999
10 - Learning from Foreign Economic Crises
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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- 12 May 2014, pp 251-267
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So, any interesting model must be a dynamic stochastic general equilibrium [DSGE] model. From this perspective, there is no other game in town. …If you have an interesting and a coherent story to tell, you can do so within a DSGE model. If you cannot, it probably is incoherent.
… [T]he models are not well suited to analyze extremely rare events.
– V. V. Chari, Testimony before the Committee on Science and Technology, U.S. House of Representatives, July 20, 2010All of the papers employ simple applied dynamic general equilibrium models … to decompose changes in output into three portions: one due to changes in inputs of labor, another due to changes in inputs of capital, and the third due to the changes in efficiency with which these factors are used.
–Timothy J. Kehoe and Edward C. Prescott, from the introduction to Great Depressions of the Twentieth CenturyIntroduction and Overview
Our overriding objective in this book has been to show that unusual credit flows frequently produce asset bubbles; when those assets are highly leveraged, immobile, and illiquid, borrowers and the financial system often suffer severe balance sheet deterioration in a collapse. Moreover, the economy is left saturated with an excess of produced assets, so that output is reduced. We have described the Great Recession as the result of a balance sheet crisis. In this chapter, we examine several even more severe downturns and show that all resulted from a collapse in the production of fixed assets. The opening quotes for this chapter argue for the view that the source of severe economic downturns lies in reductions to inputs of labor and capital and a reduction in the efficiency of these factors of production. Although this view is not “the only game in town,” it is arguably the dominant view in macroeconomics. In this book, we have sought to present evidence that supports an alternative view. Our argument is that when a bubble has pushed asset prices above fundamental value, production of those assets grows rapidly, but when asset prices become noticeably disconnected from fundamentals, financing for purchases of those assets collapses, asset prices collapse, and their production collapses too. When that happens, the economic downturn can be severe. The economic collapse does have noticeable effects on inputs of labor and capital and their efficiency, but changes to those factors are not causal.
2 - Goods and Services Markets versus Asset Markets
- Steven D. Gjerstad, Chapman University, California, Vernon L. Smith, Chapman University, California
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- Rethinking Housing Bubbles
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Cassano agreed to meet with all the big Wall Street firms and discuss the logic of their deals – to investigate how a bunch of shaky loans could be transformed into AAA-rated bonds. Together with [Eugene] Park and a few others, Cassano set out on a series of meetings with Morgan Stanley, Goldman Sachs, and the rest – all of whom argued how unlikely it was for housing prices to fall all at once. “They all said the same thing,” says one of the traders present. “They’d go back to historical real-estate prices over 60 years and say they had never fallen all at once.”
– Michael Lewis, Vanity Fair, July 2009It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though…
– Ben Bernanke, CNBC Interview, July 1, 2005Two Types of Markets: The Good and the Sometimes Ugly
This chapter summarizes findings from two distinct types of experimental markets that are directly relevant to understanding the sources of both stability and instability in the macroeconomy: (1) the class of nondurable consumed goods and services that constitute about 75 percent of U.S. private expenditures (i.e., GDP minus government expenditures); and (2) asset markets, particularly those in which the items traded have long lives and whose market value, therefore, may be importantly influenced by the future price expectations of the participants (prominent examples include houses, securities, and commercial real estate). The parallels between the laboratory and the economy in each of these two cases suggest underlying modes and principles of human behavior that are similar – conditional on the differing characteristics of the items being traded in these two broad categories of economic activity.