Businessweek.com, April 12, 2004
As the stock market bubble ballooned to its pre-crash peak four years ago, those who held to the philosophy of "Don't Worry, Be Happy" put forth a variety of alternatives to the laws of arithmetic. Most of the journalists that I talked to told me that stocks were worth whatever people were willing to pay for them. It's a new economy, argued others: stocks are less risky, so they will be held at a lower return and therefore a higher price.
They were wrong, and although it wasn't that difficult to prove it, few bothered to try. My colleague Dean Baker was the first and practically the only economist in the country to do the requisite math. He showed that there were no believable projections for the growth of the economy or profits that would allow for the stock prices of the late 1990s to be sustained. Few paid attention -- although it is now fashionable to say, "yeah, everybody knew there was a bubble." But if everybody really did know there was a bubble, they would not have lost over $7 trillion dollars when the stock market crashed.
Now Baker has discovered another bubble, and more people are listening this time. The arithmetic of this bubble is even simpler than the last one: just look at what has happened to housing prices since 1995. Nationally, they have increased more than 35 percentage points beyond the overall rate of inflation. Is that unusual? You bet it is. If we look at housing prices from 1951-1995, they increased at the same rate of inflation. Then housing prices took off.
There is no plausible explanation for this sudden increase other than a bubble. Part of the bubble's expansion is explained by the enormous wealth of the stock market spilling over into real estate, as happened in Japan during the 1980s. Even after the stock market crashed in 2000-2002, financial "experts" -- the same ones who mistakenly counseled unfortunate 401 (k) investors that there was "no way" anyone investing in the stock market for the long run could lose -- recommended housing as the next big thing.
Of course, that is exactly what a bubble is -- people buy an asset because its price is rising, and that pulls more buyers into the market. Prices rise further, and the cycle continues, without regard to the real value of the asset -- whether it is stocks, housing or tulip bulbs in the 17th century.
But all bubbles must eventually burst, although it is very difficult to predict the timing. Our stock market bubble could conceivably have continued for years longer than it did. To see an example of what that would have looked like, consider Japan: in 1989 their Nikkei stock index hit a bubble peak at 39,000. Today, more than 14 years later, it is less than 12,000. Imagine the Dow dropping to less than a third of its peak value and still sitting there 14 years later.
Although the crash is hard to forecast, we do know that the longer a bubble persists and the bigger it grows, the more likely it is to burst sooner rather than later. In the case of the housing bubble, there are signs that it is getting close to breaking. One is the large divergence between the rise in rental prices versus home prices. This cannot persist for long, because people can choose whether to buy or rent.
Over the last year, housing prices increased by 8 percent while rental prices increased by only about 2 percent. In some of the bubble areas, such as Seattle and San Francisco, rents are actually falling. And rental vacancy rates are at a record high nationally. These are indications that the bubble's end is near.
A rise in long-term interest rates, which would push up mortgage interest rates, could collapse the housing bubble faster than anything else. Even after the recent jump in interest rates -- to 4.23 percent on the 10-year Treasury note -- long-term rates are still very low by historical standards. But inflation has been rising: the Consumer Price Index is up 3.7 percent at an annual rate over the past three months, as compared to 1.7 percent over the last year. And the dollar's decline portends more inflation in the near future, especially as the dollar remains quite overvalued (another bubble) -- as witness our current account deficit, which stands at more than 5 percent of GDP.
The Fed has been uncharacteristically indifferent to the prospects of increasing inflation. It has not only kept short-term rates at a 46-year low of 1.0 percent, but in its last statement the Fed said that the risk of "an unwelcome fall in inflation" now "appears almost equal to that of a rise in inflation." Alan Greenspan has also denied the existence of the housing bubble; it's hard to imagine that he really believes either of those two things.
More likely, Mr. Greenspan would probably like to postpone the inevitable bursting of the housing bubble. The Fed chairman did the same with the stock market bubble: after a brief comment about "irrational exuberance" at the end of 1996, he retreated and allowed the bubble to expand enormously, with the Dow growing by 80 percent and the NASDAQ nearly quadrupling before the crash.
This raises an important question: what is the responsibility of political leaders and policy-makers with regard to bubbles in asset markets? Mr. Greenspan could have prevented the stock market bubble from reaching its distended proportions, simply by explaining the basic arithmetic to the public. A number of political leaders from either party presumably could have done the same.
The collapse of the stock market bubble caused a recession in 2001, followed by a jobless recovery of unprecedented weakness in the labor market. We are still experiencing the fallout, including the aftermath of a corporate crime wave currently working its way through the courts. Millions lost much of their retirement savings; the government's latest household survey of employment reported last week showed that people over 55 accounted for an incredible 103 percent of jobs gained over the last year.
Economists at the International Monetary Fund -- which to its credit has been warning about our housing bubble for some time -- have estimated that its collapse could have as much as twice the negative impact on the U.S. economy as did the stock market crash in 2000-2002.
It makes no sense to remain in denial when so much is at stake. Even from the most libertarian, "free-market" approach to policy, there is a public interest in disseminating accurate information so that markets can function efficiently. Bubbles are not examples of markets operating efficiently -- in fact they are the opposite. And the bigger they grow, the harder they fall.
From Sunday's New York Times, an article by the Times' Pulitzer Prize winner and best-selling author David Cay Johnston about CEPR's contest, in which CEPR awarded $1000 for the best essay arguing that there is *not* a housing bubble. You can find the article here.