Monday, April 2, 2018

Housing: Part 291 - Learning the wrong lessons

Frequently, Dean Baker has interesting observations, and there are some interesting observations in this post at CEPR.  But, the post caught my attention because it contains a nice example of the wrong lessons of the financial crisis.

Baker is reacting against a columnist who uses stock prices as a measure of national economic well being.  Baker says, "The stock market is not a measure of economic well-being even in principle. It is ostensibly a measure of the value of future corporate profits, nothing more."

This is an unfortunate position, because clearly, economic well being is strongly related to equity valuations, both in cyclical and secular terms.  It's hard to know what the motivation is behind every single move in equity values, and increasingly, equity markets are global, so that equities aren't a pure measure of domestic economic trends.  But, every single unemployment shock is preceded by a decline in equity values.  The drop in equities always comes first.  The wide-spread dismissal of equity valuations as a measure of shifting economic fortunes is an exercise in cutting off one's nose to spite one's face.

It is unfortunate that Baker takes this position, because he has engaged in some good pushback against the idea that labor incomes have stagnated at the hands of some sort of naturally rising level of corporate profits.  Limits to entry are the primary cause of excessively high profits, and Baker has made that case.

Here, I think he is being thrown off by the standard story of the housing bubble.  He asks what would have happened if our wise leaders had explained to the fickle market that "market valuations did not make sense and that prices were likely to fall back to earth".  He writes:
In the first case, Clinton would have been showing that unless stockholders were willing to hold stock for returns that were far smaller than had been the case historically (and were roughly the same as the returns available on government bonds at the time) or future profits rose way faster than anyone economists were projecting, stock prices at the time could not be justified. 
Bush would have been showing how nationwide house prices had diverged from a century long pattern in which they had just kept pace with inflation. He could have also pointed out that this did not appear to be driven by the fundamentals of the housing market since rents continued to rise pretty much in step with inflation and we were seeing record vacancy rates. He also could have talked about the explosion of bad loans, which were widely talked about in the business press even before the collapse of the bubble. 
In both cases, the Lowensteins of the world could have blamed the president for tanking their stock portfolios and they would be right. Their truth telling would have destroyed trillions of dollars in paper wealth and it would have been a very good thing.
It is true that a 20 year investment in the S&P 500 in March 1998 would have barely returned more than an investment in 20 year treasuries.  But, this has come during 20 years with low real and nominal GDP growth.  Hindsight is 20/20, but long term forward returns were not pre-determined.  Even if they were optimistic at the time, equity holders have indeed been held back by real shocks to economic growth since then.  Unanticipated real shocks are almost always more important for equity holders than valuations.  What does it mean that this was only "paper" wealth?  Equity holders at the time expected at least 8% or 9% nominal returns, which is about what they generally expect, and it is about what they would have received if GDP growth over the following 20 years had been normal.

Where does wealth stop being real, and start being "paper"?  When they expect 7% returns? 10%?  Where is the line in the sand where wealth isn't real anymore?  I don't think the evidence suggests that this expectation changes much over time, but what if it did?  Do we really want to base our public economic policies on the idea that any equity prices based on returns under 8% are fake and prices must be tamped down until capital gets a higher return?

There are two ideas that support these ideas about high asset prices coming at labor's expense. (1) That corporate values are based on future operating incomes which come at the expense of labor share of income. and (2) that corporate values are just flying around willy-nilly, unrelated to anything, and when they are up, capital owners get to act wealthier than they are until the crash comes, and then laborers get brought down with them.

Both of these ideas are wrong, and these wrong ideas are both reinforced by factual and conceptual inaccuracies about the housing bubble.

(1) is reinforced by the complaint that labor share of national income has been falling.  But, labor share is falling because rents for housing are rising, not because operating incomes of firms are rising.

(2) is reinforced by the idea that we had a stock market bubble followed by a housing market bubble, and that neither market was justified by the fundamentals.  Readers of this blog know that housing prices were largely justified by the fundamentals, and that a key error that is usually made is to think that prices had nothing to do with rents.  We know that prices have been highly related to rents.  The bubble happened in California, New York, and Boston because rents in those places were rising so sharply.  And, the bubble happened in Arizona, Nevada, and Florida because so many households were moving out of California, New York, and Boston.

And, Baker is correct that the press had many stories of bad loans before the collapse of the bubble, but empirically, defaults were triggered by falling prices, which first hit households with high incomes and only much later hit households that were default risks for economic reasons.

This notion that asset prices were unmoored from fundamentals is largely a product of fallacies.  So, it is true that equity holders would have been right to blame the president for tanking their portfolios.  It is Baker that is wrong that this would be a "very good thing."  Baker is hardly alone in this position.  And, really, do we need to know any more than that to understand why the American economy has been running on three cyclinders for the past decade?

Home prices are inflated because of monopolistic legal barriers to new homes, and we resolve to make them unaffordable by removing the means for purchasing them until those prices relent.  It turns out that important factors for making homes affordable include being employed, receiving growing wages, and having a healthy banking system.

One last comment I would make is that there are two different things going on here.  The stock market bubble was based on optimism about the economy in general.  But, the housing bubble was based on monopoly rents going to holders of capital.  Yet, Baker says that in both cases, valuations were outside historical norms and didn't make sense.

Housing prices did make sense because of legislated monopoly of real estate owners in the "Closed Access" coastal metropolises.  Baker should recognize that as clearly as anyone, but there is no voice within his earshot correcting the errors that have built up around the explanations of the bubble.

So, just like the country's opinion leaders went whistling past the graveyard in 2007 when house prices started to collapse, we will do it again this time when nominal incomes start to stagnate, until the right lessons are learned.


  1. Baker has some excellent views of patents and letting doctors in.
    But his views on housing are wrong. He wrote a paper in August of 2002 about the housing bubble and said housing prices in 2002 needed to fall 11% to 22% to get back to the historical averages. Since then, prices are up more than inflation, and of course, the people who didn't sell in Sept of 2002 also got to live in the houses in addition to getting positive real returns.
    Separate thought. Oftentimes, people have said to me, "well, the stock market has predicted 9 of the last 5 recessions." I say, that's because the Fed listened 4 times.

  2. Excellent blogging.

    I keep trying to get modern macroeconomists to figure artificially tight housing markets into their scenarios in a much more prominent way.

    The Cleveland Browns also try to get into the Super Bowl.