Research AreasFinance, Jobs & MacroeconomicsSAFER Financial ReformFocal Points for Commission InquiriesThe Housing Bubble

The Housing Bubble

Dean Baker, Center for Economic and Policy Research

The Commission should ask the executives of banks and other financial institutions whether they ever considered the possibility that there was a bubble in the housing market. Inflation-adjusted housing prices nationwide had risen by more than 70 percent between 1996 and 2006 after staying virtually flat for the prior century. There was no plausible explanation for this sudden run-up on either the supply or demand side of the market. And, there was no remotely comparable increase in rents, providing further evidence that the run-up in prices was not being driven by the fundamentals of the housing market.

So, the executives of the banks should be pressed on whether they ever considered this evidence. If the answer is “no,” then they should be pressed about how they could ignore something that was so central to their business. They should then be asked if people were fired at their banks for this incredible incompetence, and if not, why not?

If the answer is “yes,” then they should be pressed on how they decided that the run-up was not a bubble. They should then be asked if they now recognize how badly mistaken they were. They should then be asked if people were fired at their banks for this incredible incompetence, and if not, why not?

If the Commission has the opportunity to question top regulators, like Alan Greenspan and Ben Bernanke, they should be pressed on how they could have failed to recognize the bubble. They should also point out to them that the country had just seen a stock bubble, so the idea that the economy might be subject to asset bubbles should not have been alien to them. The Commission also should note that the downturn caused by the collapse from the stock bubble was quite serious, it took three full years to regain the jobs lost from the downturn. Did they have any reason for believing that the economy would recover more quickly from the collapse of a housing bubble that was an even larger factor in driving economic growth?

Bernanke and Greenspan have both claimed there was a worldwide savings glut in the last decade. Doesn’t this undermine standard economic theory, which assumes that economies self-adjust to full employment?

If they actually thought there was a worldwide savings glut why didn’t they advocate appropriate policies to respond? In the case of the United States, the implication of the “savings glut” was that the dollar was hugely over-valued leading to record high trade deficits. The high trade deficits logically implied that the economy would be below full employment (this is an accounting identity – they know this).

Given the size of the trade deficit, to get to full employment it was necessary either for the government to have very large budget deficits or for the private sector to have very low savings. They opted for the latter, which was brought about by the consumption induced by $8 trillion of housing-bubble wealth. In the context of the savings glut that they touted, wouldn’t it have made more sense for the government to undertake a massive public investment program in infrastructure, research and development, and education, since savings were available at such low cost? Why did they never even mention this as a possible way to address the “savings glut?

Subprime and Alt-A loans exploded in the bubble years. Subprime grew from 8 percent of the market at the beginning of the decade to almost 25 percent of the market at the peak of the bubble in 2006. Alt-A grew from 1-2 percent of the market to 15 percent at the peak of the bubble. Alan Greenspan was quoted in the Washington Post as saying he was not aware of the explosion in subprime lending until just before he left the Fed in January of 2006. If this is true, how could he possibly have been so ignorant of developments in the housing market?

Alt-A loans are generally distinguished by the fact that they involve incomplete documentation. Did Greenspan and Bernanke really believe the number of people who could not fully document their assets and income had increased ten-fold between 2000 and 2006? There were numerous accounts in the media of bogus loans being issued by mortgage brokers who were being told to lie about people’s income so they could qualify for loans. Did Greenspan and Bernanke have no knowledge of these accounts? Did no one at the Fed try to bring this issue to their attention? Given that this fraud involved millions of loans how could they possibly be ignorant of it?

Greenspan and Bernanke should be asked whether it is important in a market economy to be able to fire workers who do not perform their jobs adequately? They should then be asked how it is possible for a Fed chair to fail more completely than they did in allowing a housing bubble to grow to such enormous dimensions?

The commission should acknowledge that it would have been difficult politically for the Fed to have cracked down on the bubble, since this would have hurt the profits of politically powerful banks like Goldman Sachs and Citigroup. Therefore, it will always be the easiest course for the Fed to ignore asset bubbles even when they do pose enormous danger to the economy.

Since no one at the Fed was fired for this disaster the Commission should ask whether we are providing the right incentives for future Fed chairmen or chairwomen to do their job? The precedents of the past two decades tell them they will incur serious opposition if they try to combat an asset bubble and they will not be held accountable if they just let the bubble grow and it then wrecks the economy. Given this structure of incentives, wouldn’t economic theory predict that future Fed chairs will also allow asset bubbles to grow to dangerous levels rather than rein them in?

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“You won’t hear me use the B-word to describe this remarkable activity [in housing markets]. Instead, I believe fundamental factors can fully explain the expansion we’ve seen in the demand for housing, particularly rising incomes, rising population, favorable tax treatment, and very low interest rates…Looking ahead, it seems reasonable to expect the housing market to remain strong, even as some further tapering off in sales and production takes place. The key point I would like to emphasize is that the housing phenomenon was not a mysterious, independent boost to the economy, driven by some sort of animal spirits, but instead was a rational response by households to the economic fundamentals, especially very low real interest rates. Thus, going forward, the adjustment of the housing market to evolving fundamentals will continue to fit comfortably within the standard economic framework. My assessment is that plausible rates of moderation in housing activity will not pose a problem for overall activity this year or next. Moreover, I don’t see diminished housing price appreciation as a major problem for consumer spending…”
– Jeffrey Lacker, President, Federal Reserve Bank of Richmond, “The Economic Outlook,” April 4, 2006