Where was I in 2005?

by Russ Roberts on November 17, 2008

in Financial Markets, Government Intervention

Reader Tim Allen asks a very good question. I’m going to quote his entire email and then try to answer his question:

I am a frequent visitor of your blog, Cafe Hayek. I saw your post
about the new collection of essays about the financial meltdown. I feel
compelled to write to you and Don although up to this point I have
restrained myself. I have to admit that I have this unfocused anger
about the financial meltdown and I confess has presently coalesced
around you. Much like when I am aggravated at a product or service from
some random company, I know better than to unload on the customer
service person whose only fault is being the next in the queue to
answer my phone call.
With that in mind, I need to ask of a person with a publication, a
popular blog and such access to media outlets like NPR, (not to mention
a PhD in economics) how is it that this financial meltdown only gets
analyzed by you and your profession ex post facto?
I promised myself that I wouldn’t bore you with how well I
followed this financial crisis between 2003 and now. The no name blogs
by averages Joes that I read… How hard it was from 2003 to 2006 to
find anyone other than the regular people with no economics PhD that
were writing about the housing bubble. And then, when in late 2006 when
the housing bubble was self evident, how hard it was to find anyone
talking about what the ramifications would be for the banks and
financial structure of the world.
What really really bugs me is that I was drinking beers with my
brother telling him how I didn’t think that capitalism, which I truly
love, would survive this pending financial imploding back in 2005. So I
guess, what I really want to know, is where were you in 2005 and where
was everyone in your profession?

You’re right, Tim. I didn’t see this coming. And I wasn’t alone. People a lot smarter than I am didn’t see it coming either. So what happened?

I should mention first that the few people who did see it coming were not necessarily any wiser than anyone else. Some of them had predicted nine of the last five recessions. A stopped clock is right twice a day. Even those who claim to have foreseen this mess couldn’t make the case well enough to alarm very many other people. And if you want to know if they were really wise or just selling a different story because the market was less crowded on the pessimistic side, you’d have to look at their bank accounts. Did they put their money where their mouth was?

But back to the rest of us. Why were so many people blind about what was going on until it was too late? I’ll talk about myself. First, this problem began in the housing sector. I knew very little about housing. I don’t know a single economist who specializes in housing the way I know people who specialize in trade or labor economics or health care issues. More importantly, I was oblivious to government’s role in housing markets.

Oh, I knew about the deductibility of mortgage interest. I knew there was something called the FHA that helped poor people buy houses. But I knew nothing about Fannie Mae or Freddie Mac. I’d heard of them, but I didn’t know what they really did. I didn’t know anything about their quasi-public status. I didn’t know how HUD leaned on them to get more involved in "affordable housing." I had no idea of the magnitude of Fannie and Freddie’s involvement in the mortgage market, generally. I didn’t pay close attention to the Taxpayer Relief Act of 1997 that changed the tax treatment of housing. And that’s just the beginning.

More disturbing perhaps, is that there is no public record of Fannie and Freddie’s involvement in the subprime market. I’ve seen claims in the New York Times and the Washington Post but they are extremely difficult to verify.

Having said all that, when home ownership went from 64% to an all time high of 69%, I foolishly attributed it to our growing standard of living and Wall St. innovation. I was right about part of it. We do have a growing standard of living (contrary to the claims that the average American isn’t sharing in the economy’s expansion) and Wall St. innovation did reduce the risk of lending to people who otherwise wouldn’t have gotten a loan. But I, like others, didn’t see the unsustainability of that rise. And most people thought that if the rise slowed or fell, then some people would lose their houses and others who invested in those mortgages would lose their money. We didn’t see the systemic risk.  We didn’t pay enough attention to the magnitudes. Prices are unlikely to double in ten years solely because of fundamentals. The explosion of subprime securitization in 2004 and 2005 should have set off alarm bells.

A deeper question that I have not seen adequately answered is why people who specialized in the housing market, people who were paying attention, people who put their life’s wealth on the line, were equally oblivious. What were they thinking? That housing prices would keep doubling? Or just keep going up? Were they comforted by the AAA rating of the CDO they had purchased? The credit default swap they had purchased? Should that have been enough? The standard answer that they were greedy is not an answer.

Which brings us to another reason I and others were silent in 2005. Financial markets are incredibly complicated. Even today, ex post, it’s hard to know what really happened that spiraled downward so dramatically. There are a lot of culprits. The ratings agencies. Fannie and Freddie. Greed. Innovative products that were too complicated to understand. Tax policy. Monetary policy. Mark-to-market accounting. How do all of these effects interact? The ex post story isn’t straightforward. Ex ante is much much harder.

The bottom line is that the ability of economics to anticipate disaster or to understand the full playing out of the complex system known as the economy is very limited. We are pretty good at microeconomics–the incentives created by a particular policy. We are not very good at macroeconomics. And we don’t have much to suggest for getting out of the mess we’re in. We know the conditions that are necessary–some optimism for the future, functioning credit markets, incentives to invest. But we don’t know much about how to create those conditions. At this point,  I think our value as economists lies in helping policy makers avoid mistakes. Not so helpful but better than nothing.

Finally, you might listen to this podcast with Robert Barro. It was taped in August when things weren’t going well but very few people thought we’d be where we are today. Barro basically argues that we have a disaster like this once every 50 to 100 years. Maybe that’s the best we can hope for. Events that occur that erratically are hard to understand in a systematic way. And maybe if we’re lucky, this will just turn out to be a bad recession and not something worse. But nobody knows. Certainly not us economists.

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nbdubya November 17, 2008 at 1:44 pm

I'm a fan of Austrian economics, Herr Hayek, and this blog … but what a lame whiny excuse. I know you can do better.

David November 17, 2008 at 1:45 pm

Tim should have been reading http://www.mises.org in 2005.

BoscoH November 17, 2008 at 2:04 pm

This is where Taleb shines. You can apply his analysis of hot fund managers to prognosticators of the current disaster. That is, if you have tens of thousands of people coming to Wall Street each year and assign trading strategies to them randomly, you'll end up with about the number of "hot" traders at the end of some shake-out period. It's not that these winners are particularly knowledgeable. They're really just lucky, and random distribution tells us that someone has to be.

Same with the people who predicted today's problems. I guarantee that in ten years, the people running around touting the gold standard in any way beyond an academic curiosity will look like complete crack-pots again. The reason the gold standard is not a good idea is because it won't ever be implemented again. The reason the academic economists didn't see this coming is because there was no way to actually see it coming. Those who did were the lucky few who arbitrarily staked their claim on a particularly disaster scenario.

Russ interviewed Taleb for EconTalk in 2007, if it matters.

Tim Allen November 17, 2008 at 2:10 pm

I was reading the Mises blog. I also read Seeking Alpha, cafe Hayek, Coyote blog, Irving Bubble blog, real homes of genius and everything else I could lay my hands on. I was convinced the bubble was there when it made a lot more sense to rent than to buy a house. That was back in 04. When the bubble became self evident, I spent months trying to figure out what the ramifications would be. The first time I heard of a "Liquidity Glut" was in 2006 in the fall, and after that was the first time I read the words "Sub Prime". I am not the smartest guy but I promised myself after the dot.com implosion, I would see the next thing coming and I did. If I had been smarter, I would have known how to short the stocks that were dropping. I was, however smart enough to sell everything in the summer of 2007. I am still mad though. I think we are looking at a repeat of 1929 complete with the ignorant laws it saddled us with and the 50 years of work to get back to a free market.

T L Holaday November 17, 2008 at 2:10 pm

From the conversation at EconTalk, it appears that economists do not understand derivitives: interest rate swaps, credit default swaps, collateralized mortgage obligations, all appear to be things about which you and your guests are uncertain. Even Arnold Kling was not confidant that he had properly labeled a position "long" and "short." It's troubling, in the way that someone who confuses "buy" and "sell," "creditor" and "debitor", or "customer" and "investor" is troubling.

I think if economists want to understand what happened, and be in a position to predict trouble, it would behoove them to learn enough about what is being traded to lead a ten-minute discussion. Otherwise they will have nothing but restatements of received doctrine: "lending to the poor, politicians seeking election," etc., which is just so much chaff.

When two politicians expressed concern about the economy in March, a professional economist dismissed them with these words:

Almost all that any politician says on any topic other than political strategy should be treated with even less respect than would be accorded a professional circus-clown's speculations about string theory.

What can one say, after indulging in such mockery, when the target turns out to have been correct?

Oil Shock November 17, 2008 at 2:14 pm

People who are knowledgeable in the Mises-Hayek Business cycle theory would be tempered in their exuberance when the hot money runs into a particular sector.

As for the paper standard versus gold standard, one needs to ask the question, cui bono?. Just as politicians are unlikely to give up their power voluntarily, they are unlikely to put a straight jacket on themselves and their spending habits.

Libertarianism is very unlikely to be adopted by the political establishment 10 years from now, and doesn't make it a bad idea.

Oil Shock November 17, 2008 at 2:19 pm

My interest in economics was stimulated in 2004, when I first noticed a budding housing bubble in silicon valley, which was still reeling from the aftermath of the techbubble bust. That is how landed up learning about Austrian theory of business cycle. Which goes to show you that, very often, it is not the professional economist who shows curiosity in matters related to economics.

Tim Allen November 17, 2008 at 2:22 pm


You are wrong, there were at least hundreds of voices on the internet for years predicting that this would happen. The difference was they were all just people like me, not like Don or Russ. When you could buy a house for $500K or you could rent the very same house for $1500 per month, there is something very wrong. Anyone with a degree one of iota of skepticism about the world, could have seen this coming. When 3 cable tv channels run shows about how to "Flip this house" there is a problem. When down-payments for real estate go from 20% to 5% to zero and then to where they will pay you money at the closing, there is a problem. This wasn't an invisible thing that snuck up on us, it was there disguised as something good. If you break your arm the pain tells you it's bad. If someone serves you chocolate cake for every meal and you love chocolate cake, how long does it take before you realize that something is very wrong. A year later when you way 500 pounds? We were all making paper money, how could that be wrong? It was wrong because it was too easy and anything that is real takes hard work.

Sam Grove November 17, 2008 at 2:22 pm

Libertarianism is very unlikely to be adopted by the political establishment 10 years from now until it is first adopted by a majority of citizens.

JSeabold November 17, 2008 at 2:27 pm

Peter Schiff, a fellow member of the Austrian school, is one person who saw it coming. It's tough to say it was just a lucky/arbitrary guess too, when he was sitting there pointing to the broad data in a historical context.

I don't disagree with Taleb (though I think he loves to sell books, and his point is, or should be, completely obvious to any statistician…), but it seems a shame to say that someone who recognizes broader trends with a good understanding and a solid thesis is just lucky.

Mainstream economics has all too often become an exercise in formalism and mathematical "self-gratification". In this respect, it's not hard to see how (really smart) people miss the big picture suggested by both the data AND a consideration of historical context.


Brian Shelley November 17, 2008 at 2:27 pm

I think this exchange speaks volumes as to why we must embrace the free market, and eschew intervention. The economy is so big and vast that the likelihood that an individual or group could possibly have a handle on the entire thing at any given moment of time is zero.

As we sift through data after this crisis, it becomes more and more apparent that government interference made things much worse than otherwise. Government planning without unforeseen consequences is impossible because we are humans with limited faculties.

Kevin November 17, 2008 at 2:32 pm

Interesting question. Tim requested and received an ex post analysis of the thinking that resulted in your ex post analysis. Can I get an explanation for why we are hearing about this thinking ex post? I hope it's not anything along the lines of "Nobody can know the future," because I totally can.

Michael November 17, 2008 at 2:34 pm

Here's a book written by a credit analyst that explains what was going on leading up to the housing crash:


Chris O'Leary November 17, 2008 at 2:46 pm

I think a lot of people knew there was a housing bubble, but most of those people didn't understand how many people were apparently betting against the bubble bursting (in the form of derivatives, CDSes, and such).

IMO, that's one reason why the bursting of the housing bubble had a seemingly disproportionate effect.

The problems the Japanese have been having over the past 10+ years since their real estate bubble burst may hold some information for us about how long it may take for things to get back to normal and how to deal with the transition.

Martin Brock November 17, 2008 at 2:58 pm

A deeper question that I have not seen adequately answered is why people who specialized in the housing market, people who were paying attention, people who put their life's wealth on the line, were equally oblivious. What were they thinking?

Greenspan claims that slashing the Fed Funds rate after 9/11 doesn't account for the very low long term interest rates we've seen in the U.S. for a decade, and he further claims that low long term rates, which were not and are not an artifact of recent Fed policy, not short rates, fuel bubbles. Kicking Greenspan is a national pastime these days, but he has a point here.

So why did investors believe the rating agencies and the default swap salesmen? They wanted to invest for income, rather than growth, and they had no better options with even an appearance of similarly negligible default risk.

Why so much demand for income now?

Why did the payroll tax surplus peak this year?

Why do I read today the "alarming" news that Japan's GDP fell at an annual rate of 0.4% in the last quarter?

Well, for one thing, the size of Japan's labor force (population of persons between 15 and 64) is expected to fall 0.7% per year between now and 2010.

Japanese population (1000s) between 15 and 64
2007 83051
2010 81265 (projected)

I prefer the 20-64 cohort as a marker for "labor force", but 15-64 is the cohort Japan's Statistics Bureau (JSB) publishes here. I suspect that the 20-64 contraction is even faster over this period. Also, I'm not sure that the population statistics include "guest workers" or to what extent Japanese GDP reflects the labor of non-citizens.

So a 0.4% fall in GDP is equivalent to a rise in productivity at full employment. Rising productivity at full employment is a "recession" in conventional parlance.

Look at the "population pyramid" at the JSB web site. Compare it to the pyramid (actually shaped like a pyramid) in 1935. Look further down the page at the inverted pyramid projected for 2050. How much do I need to know about economics to sense the profound economic consequences of this demographic change?

We've never had a sustained labor force slow down/contraction of this magnitude in the history of the industrial revolution. Forget Peak Oil. I suppose we'll develop other sources of energy. Forget peak anything else. Labor is the most valuable resource, and we won't go back in time and have more children. That's what I learned from Julian Simon.

This explanation seems so obvious to me, and the statistics are so incontrovertible. Why are so few economists interested in this subject?

Why does the "alarming" article linked above not even mention the fact that Japan's labor force is shrinking faster than GDP?

Why all the focus on competing political policies and financial innovations instead?

Why the deafening conspiracy of silence on this issue?

How can anyone expect to make sense of economic change while ignoring a factor as fundamental as the size of the labor force?

Billy November 17, 2008 at 3:03 pm

To the extent that Austrians make predictions that sound falsifiable, they tend to be like Paul Krugman (who is not an Austrian), repeating a mantra "bad times are coming, bad times are coming" every year. Then, when bad times come they can say, "See, I told you so." It would be more interesting if every once in a while they predicted good times.


Billy November 17, 2008 at 3:04 pm

Sorry, the paragraph above is from Arnold Kling.

John Dewey November 17, 2008 at 3:05 pm

"When home ownership went from 64% to an all time high of 69%, I foolishly attributed it to our growing standard of living and Wall St. innovation. … But I, like others, didn't see the unsustainability of that rise."

I don't understand this. If the U.S. population is aging – as Boomers are aging – why shouldn't we expect home ownership to rise to all time highs?

Was the problem truly that too many bad credit risks bought homes? or was it that too many bought more homes than they could afford? I'll accept that a few home buyers should not have been given loans at all. But many who have or will default would not if their loans more closely matched their ability to repay.

tom November 17, 2008 at 3:11 pm

I didn't know economists were supposed to be in the business of knowing in advance which firms are going to fail and which are going to succeed. The fact that economists didn't know in advance that Lehman Brothers, Bear Stearns, AIG, or Wachovia were going to be in trouble because of the subprime mess doesn't bother me. One probably could have made a lot of money knowing that information in advance, so why give that information away?

What bothers me is that most economists don't argue that troubled firms and banks should be allowed to go bankrupt and instead of needing to be bailed out. If banks and insurance companies make bad business decisions, like purchasing subprime mortgages, then those banks and insurance companies need to take the financial responsibility for their losses and not expect a taxpayer bailout. Wouldn't the market be able to reallocate resources effectively if the trouble firms went out of business and the good firms had been able to come in and buy those bankrupt assets and bargain prices? I would have liked to have heard more economists argue forcefully against a bailout and for letting failed firms go in to bankruptcy.

I am no more angry at letting Lehman Brother go bankrupt than I would be letting GM go bankrupt or letting Sam’s Dinner go bankrupt. If I worked at Sam’s Diner or owned Sam’s Diner I would be angry, but otherwise resources are going to be reallocated out of Sam’s hands into someone else’s more capable hands. If Sam is a poor business man, why should I the taxpayer prop him up with a bailout? Resources would then remain in Sam’s poorly managed hands. This is not good. And if it is not good to bailout Sam then it is a million times worse to bailout GM or AIG.

Don November 17, 2008 at 3:17 pm

I am NOT a paid spokesman for WSJ. Now that I have that out of the way, I can tell you that the WSJ saw this coming a mile away (the Fannie and Freddie part at least). If you read the WSJ everyday for the last few years you have seen clearly the large and growing threat that Fannie and Freddie posed. Many folks used this info to do some basic snooping into the details and made a killing by shorting Fannie and Freddie stock. I myself have seen many powerpoint presentations outlining how a housing meltdown will impact the broader financial markets. This thesis was all over the investment world in the last few years. Tim is perhaps looking in the wrong place for answers. Why would he assume that academic economists have these answers? First, I am not sure that an academic economist would be in a position to see the whole picture in real time and then, with all due respect to you and your profession, I am not sure an academic economist has the orientation to "make a call" by issuing the warning that Tim felt he needed. If you had those things, you wouldn't be an academic economist working at GMU, you'd be a market economist working at, say, JP Morgan. While the economics profession is populated with decent and smart people, the world of academe is hopelessly subjective and does not have the incentive structure or culture for such a market call to be made. If Tim had read The Black Swan and any of numerous histories of US financial markets, he would have been perhaps somewhat prepared and would not be frustratedly barking up the wrong tree.

Martin Brock November 17, 2008 at 3:27 pm

If the U.S. population is aging – as Boomers are aging – why shouldn't we expect home ownership to rise to all time highs?

Good point, but I suspect something else is going on too. People don't always remain in the same house throughout their lives. As children leave the nest, parents move into smaller quarters, both because they don't need or want the space anymore and because they want to cash in some home equity in retirement.

And as people approach retirement, they cash out of growth investments and into income investments, out of stocks and into bonds or rental property. They can also cash out of their homes entirely and rent themselves or move into a retirement home that they effectively rent. If I only expect to live another ten years, I can consume my home equity this way. This must be happening at an accelerating rate.

John V November 17, 2008 at 3:29 pm

Not for nothing Dr. Roberts but, like them or dislike them, the economists posting at Mises.org have been correctly beating the bubble drum since 2003.

Adam November 17, 2008 at 3:44 pm

Personally, I think the main problem is in being able to sift the useful information from the distractions. To have seen this before hand one would have had to have access to a lot of data from a lot of disparate sources. Kudos to those who were able to find the right information in the right places at the right time, but economics is a very big area of study.

Also, economics is a field with a constant chorus of doomsayers, of whom only a tiny fraction are right at any given time. It's easy to get lulled into complacence because the boys have been crying wolf for years.

Martin Brock November 17, 2008 at 3:56 pm

… the economists posting at Mises.org have been correctly beating the bubble drum since 2003.

I like mises.org and lewrockwell.com, but the Rothbardians have beaten this drum since 1973 at least, not to mention the Federal Reserve Act in 1913. Like Kling says above, a stopped clock is right twice a day.

I sympathize a lot with the Rothbardians, but frankly, their theory of money is nonsense. A gold standard with a 100% reserve requirement for bankers is ludicrous.

Under a gold standard, a bank note lent to finance the purchase of a house denominates the value of the house, relative to the value of gold, not the value of gold in the creditor's vault. The house is the asset worth some weight of gold. Expecting the bank's assets to include both the house and the gold is incredible.

A bank lending notes promising twice the weight of its banked gold against real estate promises to sell the real estate, or the mortgages, to raise the required gold if necessary. This business model can be perilous, but it certainly is not "fraudulent" fundamentally.

Tim Allen November 17, 2008 at 4:03 pm

You guys are totally missing my point.

What I was asking in one sentence is why did the protectors of capitalism at GMU and other economics departments across America let capitalism take such a monumental kick to the balls??

This implosion was completely forseeable, I did it and I am no economist. If I had NPR willing to put me on the air at the drop of a hat, I would be screaming bloody murder about this.

We, all of us, allowed the socialists to gloat and the statists to nationalize because nobody had their eyes on the ball even if they did have the news media on their speed-dial. I am angry, sad and disappointed and mark this as a failure for all of us that love free markets. We should have been screaming louder so we could scream that we-told-you-so, so that we could claim the moral high ground over the socialists. By not seeing this coming, those of us the love free markets look ignorant and that (may be) a (death) blow to free markets.

Brad Warbiany November 17, 2008 at 4:17 pm


I think one problem is that we expect economists (theoreticians) to be experts on financials (empirical), because they both tend to have to do with numbers and money. That's like asking a physicist who is an expert in superstring theory why he couldn't predict that your car's engine died. As someone else pointed out, the fact that Russ had Arnold Kling on Econtalk in order to explain credit default swaps is an indication that Russ' specialty is not financial markets.


Despite that excuse, I'm surprised you didn't see this coming. Perhaps, though, you can claim rational ignorance? I, for example, am young (30), and so over the last few years have been watching as myself and my friends are all in a typical home-buying age. We've had boots on the ground watching friends who we thought were idiots buying $600K houses that were only worth $350K three or four years ago. Intuitively, that seems unsustainable.

So for me, I looked at the intuitive side of things and saw that "hey, this doesn't make any sense!" I then worked backward and started to investigate, and the structural flaws were obvious. I couldn't have predicted how it was going to fall apart, but it was pretty easy to see that it was going to fall apart.

I think Tim is speaking from the same place I am. When people started saying "hey, housing can't fall because people always need a place to live", I knew we were screwed. It was the same thing we heard in 1999 when people were talking about the "new economy" that ensured that it wasn't a bubble. I was stuck in the middle of the tech crunch (had moved to San Jose right out of college with an electrical engineering degree, only to be laid off a year after being hired), and like Tim I vowed not to be caught off guard like that again.

All it took to understand that there was a problem was to look and see that people were behaving like reality had ceased. I understand and forgive you if — because of your age, point in life, etc — you weren't keeping close tabs on it. But despite your claim that it's too complex, you're more than intelligent enough to have seen in coming.

Whether you would have understood everything to know what the causative mechanism of failure would be, I doubt. For that matter, neither did I. The ex post narrative is a lot simpler than the ex ante, and it would have taken expertise in financial instruments that neither you, nor I, and perhaps not even Tim can claim. But you could have seen the general trend coming.

Oil Shock November 17, 2008 at 4:20 pm

Not everyone who write for mises.org are for a gold standard with 100% reserves. Take George Segin for example, he is for free banking.

Charlie November 17, 2008 at 4:22 pm

I think a couple of points need to be made.

1. It's not Russ's job to know what the market is going to do next. Russ has never made claims that he could do that, nor has Russ ever made money that way. He is not specialized in such a way that one should even think he'd be good at that. From what I've gathered reading and listening over the years, Russ doesn't bet his own money on his intuition either; he invests in index funds. I think if you asked Russ how much some company should trade for he would defer to the market's aggregated knowledge over his own judgement.

2. Economist does not mean knower of all things economic. A PhD does not make you an expert stock picker, legal scholar, policy advisor, and every other thing conceivably related to economics. Economists specialize, their opinions are not equal in all areas. Russ has specialized in explaining economic concepts in a simple way to general non-technical audiences. Don has specialized in the intersection of law and economics. You shouldn't expect them to be experts outside their specialty any more than you'd expect your family doctor to be able to perform open heart surgery on you. When you read a blog, one of the first things you should do is learn what the person's background/expertise is in. It is usually one click away. (not that experts as a whole did much better, but why are you mad at Russ for not telling you this would happen and not your dentist?).

3. If you really saw this whole thing coming, but didn't understand how to make money off of it, that's kind of embarrassing.


John Dewey November 17, 2008 at 4:32 pm

Tim Allen,

How are the economists at GMU the "protectors of capitalism"? If you mean that they advocate free markets, then I haven't seen any evidence that they stopped doing so. But I never saw any indication they viewed their role as protecting a particular industry from itself. Perhaps you view them that way, but I doubt they do.

How did capitalism "take such a monumental kick to the balls"? I thought it was government sponsored enterprises, Freddie Mac and Fannie Mae – and the firms feeding at the government assumption of risk trough – that took that kick.

If capitalism is now taking a "kick to the balls", it is not because any group was silent before August. Rather, it's because we're now allowing the mainstream media and the politicians to get away with calling this a failure of free markets.

English Professor November 17, 2008 at 4:35 pm

A couple of reflections:

I too had been reading about a housing bubble. The most interesting argument in its favor was mentioned by Tim Allen: the cost of a house was way out of line with the potential cash stream (i.e., rent income) that it might generate. My only concern was that I be careful not to buy property at an inflated price. Many people expected a correction, but, according to Arnold Kling and others, both the bankers and the economists mistakenly thought that risk was sufficiently diversified. They were wrong, but I didn't read anyone before the crisis claiming that the problem was insufficiently diversified (or insufficiently understood) credit risk.

N. Roubini is currently being hailed as a genius, and he certainly deserves credit for predicting a major financial crisis. But I also seem to recall reading blog posts by him for the last 5 years or so that suggested that our unsustainable trade imbalances were going to bring down the economy. (Do others recall this, or am I misremembering something? And of course, according to one theory of the current crisis, the trade imbalance is at its root: a superabundance of international capital created excessive demand for AAA-rated securities, many of which ended up being less than AAA.) N.R. now predicts a very bad recession, plus much further declines in the stock market. We'll have to see how accurate he is. If you believe him and if you have any money in the market, you should pull it out now before the market drops another 20 or 30 percent. There's a small part of me that goes along with Taleb (as explained above)–someone, perhaps not randomly selected, but not necessarily a possessor of unique insight, had to be right.

Finally, as someone has already noted above, there are some who are simply constant doom sayers. Since the early 1990s William Rees-Mogg, the former editor of the Times of London, has been predicting the next depression. If you had listened to him, you would have put all your money in gold in 1992, at about $345 per ounce. Today, in the midst of a crisis, it would be worth a little more than double that in nominal dollars. But the dollar has also lost about a third of its value in that time. So if you put $1 million dollars in gold in 1992, it might now be worth about $2.2 million in 2008 dollars, or about $1.4 million in 1992 dollars (using the BLS deflator). Was the doom sayer right? Even in the middle of the current crisis one can reasonably ask, would having your money in gold have been better than being in the market in the 1990s?

Mcwop November 17, 2008 at 4:43 pm

I knew there was a housing bubble, and so did many others. But, I had no idea what to do with that info. I sold a house around the peak (April 2005), and moved to an apartment (not becuase of the bubble but other circumstances). In April 2007, I bought another house that had already been marked down $100,000, and seemed to me to be an ok deal. I have run the numbers against renting and buying is a slightly better deal for me assuming a home price increase on average of 1% per year.

With that said, had I waited, I may have been able to find an even better deal now? But i thought that the housing market already took a good hit at the time.

So you might know something is going to happen, but what one does not know is the extent, or timing of that event. I had no idea the stock market would go down even more in October than it did in September.

Predicting is the easier part, ACTING on a prediction is the really hard part. That action could be how to stop it, make money off of it, or position yourself for safety.

Michael Fernwood November 17, 2008 at 4:51 pm

"And if you want to know if they were really wise or just selling a different story because the market was less crowded on the pessimistic side, you'd have to look at their bank accounts. Did they put their money where their mouth was?"

In January of 2008 I about SKF, an ETF that is 2X short the Dow Jones Financials Index. Imagine well that ETF perfomred when the government banned short selling on financial stocks. Or how the price reacted when the TARP passed.

I am not a very sohisticated investor, but with 14 years in mortgage banking, I was willing to put my money where my mouth was.

Regime uncertainty made it just as impossible for me to hedge my retirement savings as it did for bozo's who were long financials. And yes, I do mean hedge. I was not trying hit the speculative jackpot. I was simply trying to protect my retirement savings from the overweight emphasis all indexes have on the financial sector.

Anonymous November 17, 2008 at 4:54 pm

You couldn't tell from the size of Fannie and Freddie there was a problem? From the lack of capital? People have been writing about it for the last 5 years or more. And their accounting scandals? You didn't know about the interest only and negative amortization mortgages? How about going over to the finance department and talking to some of those guys once in awhile? Try reading the WSJ sometimes…

John Dewey November 17, 2008 at 4:56 pm

Tim Allen; "I was drinking beers with my brother telling him how I didn't think that capitalism, which I truly love, would survive this pending financial imploding back in 2005."

Tim, I think you were mistaken in 2005 predicting the end of capitalism, and I think you are mistaken in 2008 if you're still doing so.

Capitalism survived FDR's Reconstruction Finance Corporation, which in 1932-1933 bought stock in 6,000 banks to keep the nation's financial system afloat.

Capitalism survived the nationalization of Penn Central in 1976.

Capitalism survived the bailout of Chrysler in 1979.

Capitalism survived the government takeover in 1984 of Continental Illinois Bank, one of the largest in the nation.

Capitalism survived massive interference in the transportation industry after 9/11.

Capitalism will survive whatever Congress, Bush, or Obama throw at it.

Mcwop November 17, 2008 at 5:02 pm

You want a prediction from me?

Ok, here it is:

The Fed's policy is currently inflationary. At some point I think we will see higher than average inflation more than 5%, and maybe a bigger uptick. It may last years.

Homeowners, that manage to keep their homes, will be better off than renters, even homeowners that may currently be underwater. Rents will increase at a fast clip in my inflation scenario, while homeowners with fixed mortgages "rent" stays the same.

I have no idea when exactly this plays out, or how long. There are major political and financial implications.

Martin Brock November 17, 2008 at 5:03 pm

Most of us here have been screaming like stuck pigs, Tim. If the implosion was completely foreseeable, then our markets are extremely inefficient, and I don't believe that, but I was a housing bubblist before it was popular too.

I didn't expect the stock market to crash so precipitously this year, but I've been almost entirely out of shares and in Treasuries since 1999. [Yes, the regulars can call me a terrible hypocrite for that.] For the record, I dove back into shares last week, head first, so I'm not a perpetual Cassandra. I essentially called the bottom of the housing market by mortgaging a house a few months ago too. I'm very long now, so I'm not just whistling Dixie.

I don't believe the Great Depression buzz, because I attribute recent economic trends largely to demography, and while the U.S. has some heavy demographic shocks ahead, we're still in better shape than most of the rest of the developed world. Our labor force growth will slow substantially in coming decades. Japan's labor force will shrink. It's already shrinking.

My greatest worry now involves the integrity of corporate earnings. I suspect that more corporations than we know have played a game of substituting debt service for dividends, unbeknownst to most shareholders, and I don't at all believe that mortgage backed securities are the end of the dubious CDO/CDS story. They could more like the tip of an iceberg.

Still, after sitting on the sidelines while shares recovered from the post-9/11 crash and with the reported P/E ratio for the S&P 500 hovering around ten, I'm betting on a selling opportunity in the next few years even with the substantially slower labor force growth and the growing investor preference for income over growth. I'm a long term investor, not a market timer, and I don't think the long term value of U.S. companies has evaporated yet.

BoscoH November 17, 2008 at 5:08 pm

Tim, Like any downturn, the best thing you can have right now is cash to pick up the bargains, or at least have no debts and stellar credit. It's that simple. If you comb through the archives of Mark Cuban's blog, I think you'll see a consistent admonition of that kind of prudence. Most of us aren't in that kind of position, which is why big assets we all like will continue to slump. You have got to be very careful about accepting overly specific explanations and advice from charlatans who are "right" only in the sense of being lucky.

An example of someone who wasn't and isn't a charlatan, and got a big picture right but some specifics wrong is Arnold Kling back in the Internet bubble. He was totally on top of what was happening based on his pre-bubble experiences with HomeFair.com. He had very specific observations about, for example Netscape's server platform and scarcity of real talent among web programmers. But one thing he was dead wrong about at the time was YHOO. As Charlie suggested, anyone who saw this exact thing coming and isn't lighting their cigars with $100 gold coins is full of beans. Such people don't exist except as lucky prognosticators.

It seems wise for the discipline to admit that when it sees carnage on the ground, it may be too close to the ground to see how far and wide it extends, and when it's far enough away from the ground to see extents, it may not see any carnage. On the flip side, that suggests that remediation probably won't be terribly effective, or where it seems effective, may just coincide with rising tides. It suggests a more hands off, fundamental approach that disencumbers the free market so it can work its magic.

Martin Brock November 17, 2008 at 5:20 pm

Take George Segin for example, he is for free banking.

I'll look for his stuff. Don't get me wrong. I love much of the content there. Ralph Raico is worth his weight in any precious metal you can name. I also like Thomas Woods, and although I can't go along with his gold-nuttiness, I love hearing Lew Rockwell stick it to the man.

David Peterson November 17, 2008 at 5:35 pm

I think one thing that is unfortunate about this mess is that there are a lot of people wringing their hands and saying economists or various officials should have known about this bubble instead of contemplating the epistemology behind this knowledge and asking how we do know what we know. There are a lot of people making a lot of claims about various markets and some of them may be right and some may be wrong and it's hard to tell who is right and who is wrong in foresight. The question becomes how do you determine who is right and to what certainty and what is the possible damage that could be caused by listening to too many people who end up being wrong.

scott clark November 17, 2008 at 5:45 pm

Look, Russ owes no apologies to anyone. The principles of free markets and freedom from government interference have been around for a long time and Russ has done his damndest to promote them, to popularize them, to spread them in every media he can think of, in universities, on the internet, in fiction, on podcasts, and who knows what else. If Russ didn't explicitly apply those principles to the topic du jour when you wanted him to, that's not his fault.
The problem is way bigger than the housing market, the problem is the conceit of the annointed, the politics of narrow benefits and disbursed costs, disbursed and tacit knowledge vs. centralized power and decision making. Those are the very things Russ was talking about in 2005, and the things Hayek was talking about in 1955.

And I am with John Dewey, this is not the death knell for capitalism or freedom. Capitalism wins out because capitalism delivers. It just takes a really long time, and there are lots of setbacks along the way, but in the battle of ideas, to change peoples frames of reference, Russ and Don are some of the best allies we have.

muirgeo November 17, 2008 at 8:29 pm

"Where was I in 2005?"

How about where are you in 2008? Now with the advantage of hindsite I don't think many have learned a thing. I see calls to return to more of the same. Unregulated markets that allow for speculative bubbles economies with stagnating workers wages and concentrations of wealth at the top.

dg lesvic November 17, 2008 at 8:33 pm

Prof. Roberts,

Congratulations on your frankness and lack of the usual know-it-all pretension.

For one thing, your work on this and everything else I have seen has been absolutely first rate.

And, just as you said, in effect, economics is not a predictive but explanatory science. Demand going down as price goes up, all other things constant, does not mean that it will necessarily go down as price goes up, for all other things are not constant.

One thing or two I would add to the discussion:

The faith in "regulation" over the market, that political appointment confers saintly sagacity upon otherwise foolish sinners, is faith in fascism, or, as the old socialist, Lassalle, put it, that "The state is God."

The situation today is basically the same as in Germany in the Thirties, with the state blaming an unpopular minority for the consequences of its own failed policies.

It's all the same, regardless of the chosen people, for scapegoating greedy capitalists rather than greedy Jews is simply Nazism with a liberal face, and, the call for more "regulation," for more faith in "the god that failed," and the hardships of the Thirties and horrors of the Forties all over again.

Oil Shock November 17, 2008 at 9:01 pm

Republicans held majority in congress for less than 18 of the last 75 years. We were shaped as a nation, mostly by the democrats.

Muirgeo has quickly descended into the "deregulation" meme. I would like him to list all the laws and regulations that were wiped out from the constitution over the last 28 years, even though half of that time Democrats held majority the legislature.

I would also like Muirgeo to list the number of departments that were eliminated and the total number of parasites ( employees ) of government that were fired as unnecessary.

Oil Shock November 17, 2008 at 9:02 pm

Also, the onus of proving that no new laws or regulations were not passed over those years rests on him.

Oil Shock November 17, 2008 at 9:02 pm

Also, the onus of proving that no new laws or regulations were not passed over those years rests on him.

Tim Allen November 17, 2008 at 10:11 pm

Right now, out there, there are millions of people who are writing the story of this financial implosion and laying it at the feet of capitalism, just like they did in the ex post analysis of the Great Depression. Right now, they hold the pen that writes the book of history and right or wrong all people will remember in 50 years is that laisse faire capitalism breeds depressions. Instead of having one data point (1929) they have two (2008). Capitalism may survive and may come back some day but it will be 50 years from now and I will be using a walker and pissing my pants frequently by then.

How much of history has been written, wrongly, but written in indelible ink? Once, it is written, the story is cast in stone. How much of what Russ and Don write in this blog attempts, feably, to rewrite that history?

The time for setting the record straight was 2005, from here on out, friends of free markets are the flat-earth-ers. Market interference from benevolent and paternalistic governments is the future. Wait until they start to roll back free trade, raise barriers to entry in markets, fix prices, fix labor costs, permit every business…

Methinks November 17, 2008 at 10:14 pm

The Fed's policy is currently inflationary. At some point I think we will see higher than average inflation more than 5%, and maybe a bigger uptick. It may last years.

Yet, the commodities keep tanking – unusual for an inflationary environment, no? I agree with you that the policy is inflationary, but the deflationary pressure seems stronger right now. Continued reductions in leverage are putting downward pressure on assets and, also as a result of deleveraging, there are no new bidders for the assets. The lower prices (even if they're too low) remain lower. In fact, they continue to fall. Of course, lower prices result in margin calls which beget even more selling, so prices fall further.

I haven't the faintest idea how long this will continue. I agree with you that in an inflationary environment home buyers will do better than renters (and that probably explains why all of government is in such a tizzy to re-inflate everything from home prices to the credit bubble). However, we're still seeing a lot of deflation.

I can't tell which force is going to win out – inflation or deflation. Government's overzealous intervention also point to stagnation. A lot of businesses I talk to (including mine) are pulling back expansion plans given the political uncertainty even if they think they can overcome or even find advantage in the economic downturn. I don't know about depression, but this feels like it's going to get ugly.

Methinks November 17, 2008 at 10:36 pm

The time for setting the record straight was 2005, from here on out, friends of free markets are the flat-earth-ers.


I'm a very cynical person. But there are too many average people who are still free market people for me to believe that. Note the disapproval of the Auto company bailouts and the bank bailouts. There were tons of articles about the housing bubble, the credit bubble, varying predictions of the collapse, CDO's, etc. It was mostly in the financial press as the average Joe only cared about accumulating more stuff on credit.

Even if someone prominent perfectly predicted all this, would that have stopped millions of actors? Would John Smith not have taken that zero-down ARM on his third house? House flipping had become a fad and his neighbour down the block made a fortune. John Smith doesn't want to be a chump – he doesn't want to miss out on all the "easy" profits in the housing market and he's not informed enough to even question if prices were growing at unsustainable levels. Cheap credit flowed like champagne on New Years eve and everybody who was anybody was flipping houses. Would a strongly worded warning from the hosts of Cafe Hayek have stopped all this from happening (assuming Don and Russ had perfect knowledge, for the sake of argument)? I don't think so.

IMO, the severity of the problem can be blamed on government. But when John Smith gets stuck with three mortgages he can't afford, he wants government to rob Harry Miller at the other end of the block (the one they all derided because Harry decided to just have the one house and the one mortgage and a well diversified portfolio – the chump). John Smith doesn't care about anything but what he thinks he's entitled to – guaranteed profits, or at least, not bankruptcy. He's not philosophizing about free markets and capitalism. He just wants what he can't afford. Fortunately for him, he's a big voting block. Unfortunately for him, he has no idea what he's trading for his false sense of security.

J Scott November 17, 2008 at 10:39 pm

Both the question and the response are balanced and well-thought. When the housing bubble started to "burst", I began to dig (not aggressively mind you), and I discovered the CRA and the efforts of some in the Bush administration to bring simply accountability to the fore.
Personally, as a result of a few exceptional years and personal tax exemptions finishing college, I looked at more expensive real estate as a method of reducing my tax exposure and long-term investment. What I found was shocking and illustrative. I have excellent credit and an above average annual salary and I was pilloried with "interest only", "no documentation loans", ARMs—you name it: by my friend (right) the real estate agent and mortgage companies he alerted. I used a little common sense when my current home was assessed and said, "this is ridiculous" and told my children to make sure their finances were battened down and ready for a storm. I had no idea "what" was coming, I just knew it wasn't going to be good. When banks are giving money away (the first time I'd ever seen anything like this—like most), it follows the old saw "if it's too good to be true, it probably is". The government got us into this mess and they're really doing a poor job as they continue to meddle.
All that to say; I'm not sure there's a better answer for Tim than the one offered. I believe it's fair to say there were many smart people surprised by the depth of duplicity in banks and investment houses where money was essentially "free".
Hope we can fix this mess, but more importantly that we've learned a lesson.
BTW, I'm not optimistic.

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