Some bubble

by Russ Roberts on September 23, 2008

in Government Intervention, Taxes

I have mentioned the argument of Robert Shiller’s that the housing boom of the last ten years was a bubble, a result of social contagion.
Caseshiller So what I have been doing over the last week is educating myself. Not being a housing expert, I’ve been digging around, trying to find out the role of government in the housing market and how it might have changed since 1997 when the "bubble" took off to see what role public policy might have had in the housing price increases and the subprime meltdown. Maybe it wasn’t speculative mania. Maybe much of it was due to changes in public policy.

I am embarrassed to say that I missed a huge factor. Reader (and EconTalk listener) Russ Wood pointed out that in 1997, the tax on capital gains for housing was dramatically relaxed. As a real estate site describes the change, looking back from the present:

  • First, by now you should have long ago forgotten the old $125,000
    tax exclusion on capital gains for home owners older than 55 and the
    "rollover" law that allowed you to defer paying capital gains taxes
    provided you purchased another, more expensive home in time.

    Those laws are history. Forget them.
       

  • The relief act’s primary provision for home sellers is the capital gains tax exclusion
    – when you sell your home, if you qualify, you can keep, tax free,
    capital gains of up to $500,000 if you are married filing jointly or
    $250,000 for single taxpayers, or married taxpayers who file separately.

Do you think that had any effect on the price of housing? You bet it did. Vernon Smith pointed out the impact in December 2007:

The joint housing and mortgage-market crisis once again reminds us
that all financial implosions stem from the same cause: borrowing short
and lending long without enough equity to weather periodic storms in
the gap between.

But this bubble was different. Besides being fueled by housing
purchases and repackaged loans, each with inadequate equity — doubling
down with other people’s money — at the end of the capital-gains
rainbow was the right to take up to $500,000 of profit, tax free.

Thank you President Bill Clinton for your 1997 action, applauded by
the banks, the realtors and all citizens in search of half-millionaire
status from an investment they could understand and self deceptively
believe to be low risk; thank you for fueling the mother of all housing
bubbles; thank you for enabling so many of us who bought second or
third homes, and homes before construction began, which we then sold to
someone else who dreamed of riches from owning homes long enough to
sell to another fool.

Once again, try as we might and in spite of our political rhetoric,
we have failed to help the poor in applauding government action
intended to help ourselves.

The consumption binge is now over, and there is more than enough
blame and souring loans to spread around. Congress, if its members can
stop squabbling, wants desperately to sanctify it all with actions sure
to launch at some future date the grandmother of all housing and
mortgage-market bubbles. This august body has long forgotten that it
set the stage for housing bubbles by creating those implicitly
taxpayer-backed agencies, Fannie Mae and Freddie Mac, as housing
lenders of last resort.

Financial market innovators who invented securitization as a
mechanism for creating a liquid national market for mortgages are now
criticized for having caused an "agency problem." This is jargon for
management not having good incentives to provide investors with "truth
in packaging" of the underlying economic risk. But what does truth
matter at the height of a bubble? These critics would solve the agency
problem with more government regulation. Excuse me, but does not the
political process have the biggest agency problem of all?

And Chris Farrell at Business Week did a very nice job discussing it back in 2005:


What accounts for the housing boom? Economists have cited a number of
fundamental factors, including low interest rates, favorable
demographics, and restrictions on development. But the unappreciated
force that may have infected a strong housing market with home-buying
mania is bad tax policy. Specifically, I mean the Taxpayer Relief Act
of 1997, signed by President Clinton.

He continues with the real cost:

…capital gains on
stocks and bonds carry a 15% levy (the capital gains tax rate had been
20% until the tax law change of 2003.). The powerful lure of tax-free
profit is one reason that home prices have risen at a nearly 7% annual
rate, vs. about 4% for the stock market since 1997. Sell a home with a
$500,000 profit and owe Uncle Sam nothing. But realize a $500,000 gain
on Nextbreakthroughtechnology.com and the federal government takes 15%.
That’s the kind of math most people can figure out.

The issue goes way beyond tax fairness. A growing number of
economists are deeply concerned that residential real estate is
absorbing far too many economic resources. Money is pouring into
concrete foundations rather than high-tech innovation. "Residential
investment accounted for 35% of private investment in the past year, a
level not seen since the early 1970s," notes Martin Barnes, the
perceptive financial-market observer at Bank Credit Analyst.

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{ 43 comments }

vincent September 23, 2008 at 4:54 pm

Don't forget that

1 – Housing bubble carries wide regional disparities

2 – California actually lost residents and knew a housing bubble in the last years, but big metro areas like Houston, Dallas, Atlanta, and other mid america "smaller" metro areas didn't know the same bubble, although they experienced exactly the same macro-economices conditions, the same tax rebates, and so on. More, these cities experienced an actual demographic boom, and prices didn't surge (surely, they experienced such a boom because prices didn't soar).

3 – so "demand side" explanations are only one side of the explanation.

4 – The second side is the difference between state who mandate a struggling of housing supply through more or less tough smart growth policies, and those who don't practice this kind of policies.

Ed Glaeser extensively reserched on this topic, just google "glaeser gyourko". Other studies jump to the same conclusion (including mine for France).

If every state, every metro area had the same free-market land use laws than texas, the borrowers in the 12-15 states that have known a major housing price hike would have been much less exposed to a risk of bankrutpcy. All that Mess could have been perhaps not avoided, but reduced to much lower proprotions, if land use regulations were abiding property rights throuh-ghout the whole country.

Russ Roberts September 23, 2008 at 5:06 pm

vincent,

Excellent points. But part of the reason I wrote the post was to suggest that fundamentals (such as incentives due to tax law and other factors I've been noting here recently) were driving housing prices, not just speculative mania. So the word bubble is misleading. As you point out, whether it is a bubble or fundamentally driven, the effects will differ by region due to supply-side effects. I have edited the original post to try to make it clearer that I am skeptical about the speculative argument on its own as the explanation for rising housing prices over the last ten years.

Don September 23, 2008 at 5:47 pm

Thanks to that 1997 law, housing was the least taxed of the widely held asset classes. That is powerful enough, but add to that 9/11 and Enron and stocks became toxic in the public's perception. So what about bonds? Yields were piddly in the early aughts, so there was little competition for investment dollars from financial assets. So everybody piled into housing all the more.

Methinks September 23, 2008 at 5:51 pm

Thank you for addressing this on your blog. So few people talk about this very large incentive.

jp September 23, 2008 at 6:04 pm

Check out Ben Stein's column today at Yahoo Finance. It's pretty scary but he tries to explain how 250 billion in bad mortgages has turned into a 30 plu TRILLION problem.

http://finance.yahoo.com/expert/article/yourlife/109609

Jim Dittmer September 23, 2008 at 6:27 pm

Thanks for a perspective I haven't heard in any of the mass media outlets.I suspect the motivation for the tax policy change was to spur home ownership and to assist the lower and middle class in amassing wealth, perhaps to put less strain on the social welfare systems of Social Security and Medicare; perhaps to allow the reduction of benefits and increased taxes to "wealthier" individual recipients. Or perhaps it wasn't Machiavellian at all, maybe they were just playing to the crowd…

Stephen Kirchner September 23, 2008 at 6:35 pm

Russ, New Zealand has no general capital gains tax and experienced a pronounced house price inflation, followed by deflation more recently. House price inflation was shared throughout the Anglo-American world and in some parts of Europe, all with widely varying tax arrangements. A more plausible explanation is relative price changes and substitution between asset classes, which tend to be highly correlated across the developed world.

Martin Brock September 23, 2008 at 7:08 pm

Sure. How does this perverse incentive in the tax code imply that the rise in house prices is not a "bubble"? Congress and Clinton say, "Buy more houses now and pay less tax!". People buy more houses. I believe that. Politicians say the same thing with the mortgage interest deduction (which I oppose). I can't deduct the interest if I borrow to buy shares of Google. I would sooner support a mortgage equity deduction.

These incentives persuade lots of people to drive up house prices, and other people seeing prices rise say, "I want a piece of this action," so the demand feeds on itself, and prices rise further, beyond sustainable values. That is a bubble.

Why do you focus so exclusively on the demand side of this leverage rather than the supply side? I'm not disagreeing with your conclusions, only with the one sided focus.

Demand generated by tax incentives isn't enough. People needed credit to buy these houses. Without it, regardless of the incentives to buy, they couldn't have bought. Why did people lend to them? That's the question. The proposals on the table now largely bail out the lenders, not the borrowers.

I say it's about pension funds. They're flush with so much cash that they can't effectively invest it all profitably.

Economically, why should everyone desiring to retire (consume without producing) in the last twenty years of life achieve this goal even as the proportion of people in the last twenty years of life reaches historically unprecedented levels? Why? Ignore this question, and your analysis is utterly meaningless.

The payroll tax surplus is peaking. It probably peaked this year. This fact is significant in itself for the Federal budget, but the peak signals far more than an even larger Federal budget squeeze. It signals the beginning of an imbalance between the entitlements of the young and the old, and this imbalance certainly is not limited to the Social Security system. For the record, I'm 46 and soon to be 47, so I'm a late boomer myself. The denial of this problem at this point by my generation is nauseating.

Again, Bush signed the Pension Protection Act in 2006. This act effectively required pension funds to add half a trillion dollars in assets to their portfolios. These "assets" are entitlements to rents, like mortgage backed securities, and pension funds presumably are big buyers of credit default swaps, since they promise "security".

This act alone isn't the problem. It's only a symptom. The problem I'm discussing is demographic, and it certainly doesn't exist in a vacuum, but it's presumably a big part of the problem we're discussing.

Again, I know for a fact that corporations sell pension obligations to insurance companies. I've personally experienced it. I know that insurance companies buy bonds and sell annuities. I know that AIG also sold credit default swaps on bonds.

kebko September 23, 2008 at 7:25 pm

I think Congress has to pass laws before the president can sign them. What party in Congress was behind this law? I'd like to know. Just citing Clinton seems biased to me.

Oil Shock September 23, 2008 at 7:34 pm

Good point Kebko. Republicans are still the party of choice for most "libertarians".

A strong libertarian party will be in the best interest of the libertarian principles. Look at the Green Party for instance. The fact that they poll 3-4% tend to pull the Democrats further to the left.

BoscoH September 23, 2008 at 7:51 pm

Cafe favorite Mike Munger argues against the bailout here:

http://www.charlotteobserver.com/opinion/story/208837.html

Dr. T September 23, 2008 at 7:55 pm

Kebko:

Congress was controlled by the Republican Party throughout Clinton's presidency. A good number of Republicans supported the 1997 bill changing the capital gains rule for home sales.

All of the recent financial catastrophes can be boiled down to two causes: too much government and too much greed (home buyers, lenders, insurers, etc.) We'll never eliminate greed, so we need to cut down on government. But, looking at our track record for the last 50 years, I'd say the likelihood of that is lower than my changes of winning a state lottery without buying a ticket.

bengrayen September 23, 2008 at 8:48 pm

Re: resources in housing

Take a look at how the average size of a new home has exploded since about 1990

stupid question September 23, 2008 at 9:07 pm

It seems to me that it's generally assumed that capital gains should be taxed at a lower rate than, e.g., wages, or not taxed at all. If that's so, why is not taxing housing gains so bad? I can understand an argument that all gains should be taxed the same to avoid distorting the market, but if that's so, then why should capital gains be taxed differently at all?

SteveO September 23, 2008 at 9:50 pm

Someone in class today mentioned something about RTC(?) and the S&L crisis in the '80s. Something about buying up houses from the S&L meltdown, and selling them off, eventually earning the government a profit.

I don't know much about this, but I have to be highly skeptical. Apparently some are mentioning this as a forerunner of a possible solution for the current problem.

I'm burried in calculus all day, and really am robbing myself to take the time to post here- I won't get to look this up till later this week. If anyone is familiar enough to explain it here simply, I'd appreciate it.

Mace September 23, 2008 at 10:12 pm

These sorts of bad outcomes are not surprising given the gargantuan size of our government, populated by politicians that feel compelled to extend their influence into every nook and cranny of our lives for the "common good."

Martin Brock September 23, 2008 at 10:22 pm

AIG's annuties

"AIG Annuity Insurance Company is the largest issuer of fixed annuities in the United States and the leading provider of annuities sold through financial institutions."

AIG's mortgage backed securities

"At the end of June, AIG said it had $77.5 billion of residential mortgage-backed securities, $22.9 billion of commercial mortgage-backed securities and $11.2 billion of collateralized debt obligations and other asset-backed securities."

AIG's swaps

"Credit default swaps written by AIG cover more than $440 billion in bonds."

Mortgages are a diversion. We're discussing mortgages instead of discussing pensions, and that's a problem, because questionable rents are not limited to mortgage backed securities or probably aren't the largest part.

We aren't much discussing bailouts of home buyers defaulting on mortgages at this point, and hopefully, we won't. We are discussing bailouts of lenders, and the lenders ultimately are rent seekers. That rent seeking reaches a crisis at this point is utterly unremarkable. The payroll tax surplus peaked this year.

Russ Wood September 23, 2008 at 10:23 pm

To answer Stupid Question, I don't think the point was being made that low capital gains taxes on housing was a bad move. The point is simply when the tax rate is reduced, especially by the amount of the 1997 cut, higher home values would be justified and not a "bubble" as generally accepted.
The intent of the 1997 change was an effort by Republicans to reduce and simplify capital gains taxes, including housing. With a Democrat in the White House, the compromise was a restucturing of the capital gains tas on houses.
We should not fault the tax cut as it had very strong pro-growth features, as demonstrated by the rise in home prices and growth in the residential industry. It also greatly simplified the tax on housing.
We should continue to push down capital gains taxes (to zero) and simply the entire tax code, but we should understand the impact of the positive incentives created by such tax cuts.

Martin Brock September 23, 2008 at 10:24 pm

… questionable rents are not limited to mortgage backed securities, and these securities are probably only the tip of an iceberg.

Martin Brock September 23, 2008 at 10:42 pm

The point is simply when the tax rate is reduced, especially by the amount of the 1997 cut, higher home values would be justified and not a "bubble" as generally accepted.

I don't see many people claiming that a bubble started in '97. I see claims that it started in 2002-2003. If it's all about fundamentals, what happened in 2006? Did Congress repeal the capital gains exemption in 2006? The upside is not the observation demanding an explanation at this point. If half a million dollars really is a sustainable value for a 1400 square foot house in the Bay area, why have prices fallen?

Oil Shock September 23, 2008 at 10:50 pm

Martin,

I live in the bay area. EVen now, you won't get a shack for half a million.

Russ Wood September 23, 2008 at 11:34 pm

Martin,
If you read the main post by Russ Roberts, and if you read Shiller's words, you'll find 1997 pegged as the beginning of the housing boom.
You seem to now be accepting my premise for the boom, but you seek an explanation for the decline. Russ Roberts has chronicled a laundry list of market distortions enacted in the past 10 years which have brought us to this point. I simply add mismanagement of the money supply by the Fed, which dramatically raised the cost of capital from 2004 to 2006, negatively impacting the marginal borrower and the entrepreneur. The resulting inflation is creating real bracket creep for capital gains, including housing, which are not indexed for inflation.
The crises we are witnessing today is not about housing. Look at the chart in the main post. Housing has fallen, but not by much compared to the unprecedented gains of the past decade. Based on CaseShiller, we are about back to 2006 levels, hardly armageddon. The crisis is about a lot of things but a housing bubble is way down the list.

Oil Shock September 24, 2008 at 12:04 am

Russ…..

I simply add mismanagement of the money supply by the Fed, which dramatically raised the cost of capital from 2004 to 2006, negatively impacting the marginal borrower and the entrepreneur. The resulting inflation is creating real bracket creep for capital gains, including housing, which are not indexed for inflation.

Are you suggesting that Fed followed an inflationary policy between 2004 and 2006 and a tight monetary policy from 1997-2004?

Where did the margin money needed to drive up the dotcom stocks come from? Where did the money for the houses come from? 1997 was interesting, because thats the year the prices reached the early 1990s high, at least here in california.

The fact that the early stages of the boom in housing coincided with the bubble in stock market is very interesting. Yes, taxes provided a big distortion, but the fact that the housing really took off as the interest rates dropped to 1% is significant as well.

The basic assumption behind 120% LTV subprime mortages, Liar loans, Negam loans, Ninja loans etc. was a perpetually rising home prices. The assumption was fundamentally wrong. Pyramiding of derivatives on top of such a house of cards was a disaster waiting to happen. The collapse would have happened, regardless of 2004-06 policy of the Fed, it may have come later, in which case the bust would have been a lot more severe.

Whether you accept it or not, there really is a glut of new homes in places like Miami, Southern California, Las Vegas, Phoenix etc. This is classic Austrian mal investment.

Just because fools believed that their houses will go up 10% every year doesn't mean that it really would. At that rate, a median California home of $600,000 ( a couple of years ago ) would have cost close to $4,000,000 20 years from now. That is totally disconnected from fundamentals. If you don't like the word, bubble then call it something else, but that doesn't change reality.

maximus September 24, 2008 at 1:57 am

"I don't see many people claiming that a bubble started in '97. I see claims that it started in 2002-2003."

Martin, I think you might be looking at prices in the aggregate. You need to look at relative prices especially in real estate. The prices in the bay area in California did indeed start to escalate in the late 90's. My parents sold their house in 2 days and had so many offers they actually sold it for more than what it was listed for, (this was a common occurence in SoCal and the bay area then). On the other hand, I was about a year earlier looking at houses in Northern California (near the Oregon border)and it was a buyers market.I was looking at houses that were on the market for several months to over a year and could pretty much lowball my bid.

vidyohs September 24, 2008 at 6:11 am

vincent,

Randal O'Toole of the CATO Institute makes the same convincing land use case in his article "The dog that did not bark" published in Liberty magazine.

His article and your comments show that someone out there is thinking beneath the surface. Thank you.

Martin Brock September 24, 2008 at 7:43 am

If you read the main post by Russ Roberts, and if you read Shiller's words, you'll find 1997 pegged as the beginning of the housing boom.

You're referring to the interview with Shiller on EconTalk? I don't see him there saying that a bubble started in 1997. That Russ mentions 1997 in this post is hardly relevant, because he's addressing your theory.

Precisely when a "bubble" begins is obviously a matter of subjective judgment, because the arguably irrational (disproportionate) bids of countless bidders in a capital market are subjective judgments. If we want a more quantitative assessment of when a capital market becomes a bubble, we might look at the ratio of recent sale prices to rents on comparable properties, essentially a P/E ratio. Regardless, the observation begging explanation at this point is the sharp fall in Shiller's index since '06. What is your fundamentalist explanation? How have house values changed fundamentally since '06?

Are only falling prices irrational? I can't take this idea seriously.

Keith September 24, 2008 at 7:51 am

Quote from Russ Wood: "We should continue to push down capital gains taxes (to zero) and simply the entire tax code, …"

I agree. The tone of the article, or at least of those cited in the article, is that if we had kept on taxing capital gains from housing the same as other capital gains, then somehow the bubble wouldn't be so bad. The obvious response from the leftist will be that we need to tax all capital gains the same (and obviously raise them all, not lower them).

This whole "crisis" will only result in less liberty, bigger fascist government, with the free market scapegoated as the problem. Politically, it's 1929 again, and Bush and his minions are playing the part of Hoover perfectly. The question is, how much of an FDR will we get in November.

Martin Brock September 24, 2008 at 7:59 am

You seem to now be accepting my premise for the boom, but you seek an explanation for the decline. Russ Roberts has chronicled a laundry list of market distortions enacted in the past 10 years which have brought us to this point.

I accept your explanation for an increase in upward pressure on house prices beginning in '97.

The change in the capital gains tax exclusion in '97 was a market distortion. The mortgage interest deduction is a market distortion. Market distortions certainly play a role. The point is that house prices rose beyond a sustainable level and then fell back.

I simply add mismanagement of the money supply by the Fed, which dramatically raised the cost of capital from 2004 to 2006, negatively impacting the marginal borrower and the entrepreneur.

The Fed raised short term interest rates on T-Bills and (it hoped) on overnight, interbank lending from one percent to five percent, a far more precedented level. Mortgage interest rates still quite low today, lower than they were in '02 and throughout the nineties.

The crises we are witnessing today is not about housing. Look at the chart in the main post. Housing has fallen, but not by much compared to the unprecedented gains of the past decade. Based on CaseShiller, we are about back to 2006 levels, hardly armageddon. The crisis is about a lot of things but a housing bubble is way down the list.

I agree. Housing is a diversion, bubble or no bubble. It's about the lenders, not the borrowers and what they're buying.

Martin Brock September 24, 2008 at 8:51 am

This is classic Austrian mal investment.

It is.

On the other hand, if the sellers of many goods we now buy were permitted to buy goods we've historically produced proportionately, we might have no housing crisis now.

In the past, we bought far less, as a fraction of GDP, from China and other foreign suppliers while selling houses to domestic producers. Now, we buy far more from foreign producers, but the foreign producers do not (and may not) purchase houses here as domestic producers did.

We could allow more liberal immigration from nations with which we have a large trade deficit.

floccina September 24, 2008 at 9:07 am

How about this in 1997 Alan Greenspan was already expressing worry that money supply had grown too fast and was causing a stock market bubble but the Asian financial crisis kept him from raising interest rates. After a couple of years Asian financial crisis was over but he was afraid to raise interest rates because of y2k fears. Then he raised rates in 2000 which burst the stock market bubble to which he reacted with lower rates. Then he over reacted to 9-11 with very low rates feeding the already growing home price bubble. People look at payments to decide what house they can afford so low interest rates, particularly in areas with slow growth policies drive prices of existing homes up leading people to speculate in housing borrowing more that they otherwise would.

Martin Brock September 24, 2008 at 9:10 am

The obvious response from the leftist will be that we need to tax all capital gains the same (and obviously raise them all, not lower them).

How is it "leftist" to tax all capital gains the same?

We might simplify the tax code by taxing all income the same, with a progressive consumption tax. We'd all have tax deferred, individual investment accounts with unlimited contributions and no early withdrawal penalties. The value of all income (wages, fringe benefits, interest, rents, dividends, capital gains and the rest) flows into this account, and you pay the consumption tax on withdrawals. If you're a billionaire and will reinvest most of your income, you may pay no more tax than I.

Russ Wood September 24, 2008 at 9:52 am

Martin,
I admire the volume and detail of your posts. I don't know how you do it.
The FED was inflationary in 2004 to 2006. It is a misconception that a rising FFR means tightening of policy. I'll skip the explanation and just point you to the dollar price of gold during the Fed's rate hike campaign. Gold also shows a deflationary Fed from 1997 to about 2002.
I never said the falling house prices were irrational. In fact, it was a proper response to the economic and regulatory conditions. My basic point is that conditions justified both the rise and the subsequent decline in housing. Calling it a bubble just because it went up fast and then came down is intellectually lazy.

Phil September 24, 2008 at 11:51 am

Another contributor is the tax treatment of mortgage interest versus consumer interest. Since the late 1980's mortgage interest and business interest have been deductible but consumer interest (credit cards, car loans, etc) has not. As a result many homeowners used their home equity to access cash for consumer purchases. This served to overleverage homes even more than prior to the tax law changes.
Incentives work.Only sometimes not in the way they're intended to.

Martin Brock September 24, 2008 at 12:25 pm

I don't know how you do it.

Obsessive/compulsive disorder?

I'll skip the explanation and just point you to the dollar price of gold during the Fed's rate hike campaign. Gold also shows a deflationary Fed from 1997 to about 2002.

Even if the price of gold signals inflation/deflation (and it doesn't always), we can't simply assume that any signal it sends reflects Fed policy, unless we simply assume that only the Fed can inflate. That's not true. Nothing fundamentally prevents everyone from simultaneously doubling the price of everything tomorrow, and we're all trying to raise our own prices all the time.

So I need the explanation you skipped.

My basic point is that conditions justified both the rise and the subsequent decline in housing.

But you aren't specifying the fundamental reasons for the decline. You specify the '97 change in capital gains treatment to account for the rise, but you don't specify anything else. That's not intellectually lazy?

Methinks September 24, 2008 at 1:21 pm

If that's so, why is not taxing housing gains so bad?

It isn't by itself the cause of the housing bubble. The real bubble wasn't housing. The real bubble was in credit. Credit spreads tightened to unprecedented levels – in other words, investors were willing to accept much less return for a given level of risk (until they had to take losses – then, they all went screaming to congress). Politicians (Repubs and Dems alike) pushed for looser lending standards – often wielding sticks, in the form of the CRA, for example, to push their "home ownership" agenda. Incentives such as a lack of capital gains tax on houses versus a tax on other investments further pushed speculators out of a broad spectrum of investments and into house flipping.

You know, when LTCM blew up we were all shocked to learn that it was extended 70x leverage by its prime brokers. We all gasped when we discovered the investment banks were levered 30x. But, lenders were levering people who were not as savvy as the LTCM managers 100x or even infinity (zero down) in the purchase of the single largest and most illiquid asset these people will ever own. Without this immense leverage, a large portion of these borrowers would not have been able to obtain a mortgage. Thus, my position is that the real bubble is in credit and it explains Jim Dittmer's point that there was asset inflation across the board whether or not there were tax incentives.

Methinks September 24, 2008 at 1:25 pm

"Thus, my position is that the real bubble is in credit and it explains Jim Dittmer's point that there was asset inflation across the board whether or not there were tax incentives."

To clarify, by "asset inflation" I meant specifically housing as an asset class (which was Stephen Kirschner's point, not Jim Dittmer's). Sorry about that.

Oil Shock September 24, 2008 at 1:31 pm

Nothing fundamentally prevents everyone from simultaneously doubling the price of everything tomorrow, and we're all trying to raise our own prices all the time.

That is ridiculous. Sure you can double prices on the sticker, but you can't force people to buy. A doubling of the price of everything without the concomitant doubling of the money supply is impossible.

Methinks September 24, 2008 at 2:25 pm

That is ridiculous. Sure you can double prices on the sticker, but you can't force people to buy.

Unless you happen to be a bank selling mortgages (and an array of other bad loans) to TARP buyers. Then, you can force the taxpayers to buy your toxic waste for any price you want by threatening bankruptcy.

Martin Brock September 24, 2008 at 4:30 pm

That is ridiculous. Sure you can double prices on the sticker, but you can't force people to buy.

You don't understand. You are part of "everyone". Your wage is a price. It would double too. Of course, you'd go on buying, and you'd hardly notice. Would you go on an eating strike to protest the multiplication by two?

A doubling of the price of everything without the concomitant doubling of the money supply is impossible.

Yes, the nominal money supply would double. It would double simply because all the prices double, including the price of bonds and thus the amount of your debts as well as the interest due on your loans (but not the percentage rate).

Money does not obey a conservation law like mass or energy. That's just not how money operates. We continually create money by extending one another credit. We extend the credit (ideally), not the central bank. The central bank only regulates the extension of credit. It's only a central clearing house for records, creating (and destroying) only as many records of credit as we require. Money is a record of credit. That's all.

[Real central banks cooperate with states to create taxpayer debts by fiat, but that's a separate issue.]

You may extend me credit right here, right now, without any involvement from the Fed. You produce some valuable good, like a music recording. You give me a copy in exchange for a promise to pay you five bucks plus interest, or something you value as much, within a year. That's it. You've created money and lent it to me. I've used this money to buy the music.

If we choose to involve a central bank, the process works like this. I borrow five bucks from a less bank that has borrowed five bucks from the central bank. I give you the five bucks for the recording. Within a year, I collect five bucks and return it to the less central bank with interest, and the less bank returns the five bucks to the central bank with less interest, and that's it.

The central bank only responds to demands for credit, creating as many records of credit as required. The less central bank provides you an accounting/credit insurance service. That's all.

Russ Wood September 24, 2008 at 10:10 pm

Martin,
The discussion of why gold signals a change in the unit of account is off-topic, long, and not necessary for my original claim.
So as not to duck the question, let me state that the Fed is solely responsible for the money supply. There are myriad actors and factors that can create changes to the demand for money, but only the Fed supplies it. Thus it is their job, their responsibility to supply the proper amount of money so that there is neither inflation or deflation. If either occurs it is a direct result of the Fed's errors in managing the money supply. This is why the use of a Fed Funds Rate target fails, it can impact supply of dollars and demand for dollars at the same time. For example, higher rates, under the right circumstances, reduce the amount of economic activity at the margin, which means a lower demand for dollars. This lower demand can swamp the change in supply created by the higher FFR. Thus, supply rises relative to demand and the dollar devalues when conventional wisdom suggests it would strengthen.

Regarding the decline in housing prices, I have nothing more to add. I've posted twice now on how economic fundamentals changed which justified lower home values. You may not follow or even agree, but you can't claim I haven't tried.

Keith September 25, 2008 at 6:50 am

Quote from Martin Brock: "How is it "leftist" to tax all capital gains the same?"

The point is that this situation will be used as an excuse to raise taxes, not lower them, nor even leave them the same. This situation will not result in any simplification of the tax code.

Including changes in the capital gains tax as a reason, no matter how significant or insignificant, is a distraction. It's a bit like saying the floor was at fault for making you fall off a ladder simply because that's where you landed. We should be focusing on the real causes (e.g., fractional banking, the Fed, government interference in the market, etc.).

Martin Brock September 25, 2008 at 10:36 am

The point is that this situation will be used as an excuse to raise taxes, not lower them …

And how is that "leftist"? The nominal "right" has raised taxes (in the future by selling bonds in the present) to an incredible extent in recent decades. They say they're "cutting taxes", but course, they're lying very deliberately.

We should be focusing on the real causes (e.g., fractional banking, the Fed, government interference in the market, etc.).

"Fractional banking" is not the problem, because something like it is an inevitable part of extending monetary credit. Maybe we can do without monetary credit altogether (using tokens of credit monopolized by a state), but we can't do it with a gold standard, because gold standards always involved fractional reserves and necessarily must.

Forcing creditors to extend credit only in Rothbardian fashion is incredibly restrictive. Limiting credit this way when demand for gold explodes is insane as well as monstrously authoritarian.

"Government interference in the market" says next to nothing, because any imaginable system of forcible propriety involves "government interference". Capital markets presume property, and the "property" question always necessarily involves the particular variety of government interference we have. Capitalism without government interference is an oxymoron.

The real factors in play today include an historically unprecedented demand for rents spurred by the unprecedented expectation of retirement of an unprecedented duration by an unprecedented proportion of a unprecedentedly large generation, both in absolute terms and relative to the generation following it.

And the silence is deafening.

Peak Oil is real too. This resource constraint, though not catastrophic, certainly complicates the picture, since it coincides so closely with Peak Rent.

Sam Grove September 25, 2008 at 3:09 pm

Bush says that if the proposed plan is not put in place, there will be a deep and long recession.

That may be true, but if so, then it is also true that if the plan is put in place, there will also be a deep and long recession.

Yes Martin, libertarians and others have been pointing out the problems of retirement entitlements for as long as I have been involved (30 years) and no doubt before I paid any attention to the issue. The problem is that most people only pay attention to impending crises.

The government will issue credit and our standard of living will go down…countered only by any increase in productivity.

Politicians will dissemble and voters will continue to vote against the other party.

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