Steve Forbes, Bubble Boy

Today's Krugmaniad (Time$elect)

The Sum of Some Fears

By PAUL KRUGMAN

Yesterday’s scary ride in the markets wasn’t a full-fledged panic. The interest rate on 10-year U.S. government bonds — a much better indicator than stock prices of what investors think will happen to the economy — fell sharply, but even so, it ended the day higher than its level as recently as mid-May, and well above its levels earlier in the year. This tells us that investors still consider a recession, which would cause the Fed to cut interest rates, fairly unlikely.

So it wasn’t the sum of all fears. But it was the sum of some fears — three, in particular.

The first is fear of bad credit. Back in March, after another market plunge, I spun a fantasy about how a global financial meltdown could take place: people would suddenly remember that bad stuff sometimes happens, risk premiums — the extra return people demand for holding bonds that aren’t government guaranteed — would soar, and credit would dry up.

Well, some of that happened yesterday. “The risk premium on corporate bonds soared the most in five years,” reported Bloomberg News. “And debt sales faltered as investors shunned all but the safest debt.” Mark Zandi of Moody’s Economy.com said that if another major hedge fund stumbles, “That could elicit a crisis of confidence and a global shock.”

I saw that one coming. But what’s really striking is how much of the current angst in the market is over two things that I thought had been obvious for a long time: the magnitude of the housing slump and the persistence of high oil prices.

I’ve written a lot about housing over the past couple of years, so let me just repeat the basics. Back in 2002 and 2003, low interest rates made buying a house look like a very good deal. As people piled into housing, however, prices rose — and people began assuming that they would keep on rising. So the boom fed on itself: borrowers began taking out loans they couldn’t really afford and lenders began relaxing their standards.

Eventually the bubble had to burst, and when it did it left us with prices way out of line with reality and a huge overhang of unsold properties. This in turn has caused a plunge in housing construction and a lot of mortgage defaults. And the experience of past boom-and-bust cycles in housing tells us that it should be several years at least before things return to normal.

I’ve written less about oil prices, so let me emphasize two points about the oil situation. First, we’re now in our third year of very high oil prices by historical standards — prices as high, even when adjusted for inflation, as those that prevailed in the early 1980s, after the Islamic revolution in Iran. Second, unlike the energy crises of the past, this price surge has happened even though there hasn’t been any major disruption in world oil supply.

It’s pretty clear what’s happening: economic development is colliding with geology.

The “peak oil” theorists may or may not be right in asserting that world oil production is already as high as it will ever go — anyone who really knows what’s going in Saudi Arabia’s fields, please drop me a line — but finding new oil is getting a lot harder. Meanwhile, emerging economies, especially in Asia, are burning ever more oil as they get richer. With demand soaring and supply growth sluggish at best, high prices are what you get.

So why did people seem so shocked by a few more bad housing and oil numbers? What I guess I didn’t realize was how deep the denial still runs.

Over the last couple of years a peculiar conviction emerged among some analysts — mainly, for some reason, among those with right-wing political leanings — that the housing bubble was a myth and that the real bubble was in oil prices.

Each new peak in oil prices was met with declarations that it was all speculation — like the 2005 prediction by Steve Forbes that oil was in a “huge bubble” and that its price would be down to $35 or $40 a barrel within a year. And on the other side, as recently as this January, National Review’s Buzzcharts column declared that we were having a “pop-free” housing slowdown.

I didn’t think many people believed this stuff, but the market’s sudden freakout over housing and oil suggests that I was wrong.

Anyway, now reality is settling in. And there’s one more thing worth mentioning: the economic expansion that began in 2001, while it has been great for corporate profits, has yet to produce any significant gains for ordinary working Americans. And now it looks as if it never will.

© 2007 The New York Times Company

On a related note, Floyd Norris (also behind the firewall) reminds us of the Oracle at Delphi's role in all of this.

In Mr. Poole’s [William Poole, the president of the Federal Reserve Bank of St. Louis] view, it was obvious from 2002 to 2004 that short-term interest rates were all but certain to rise, thus driving up the cost of ARMs. But the bankers did not point that out to their customers.

“Apparently driven by the prospects of high fee income,” said Mr. Poole in a speech a week ago, “mortgage originators persuaded many relatively unsophisticated borrowers to take out these mortgages; then, investors willingly purchased them when they were securitized. Many of these mortgages are now in default, some of the lenders are bankrupt, and the mortgage-backed securities are trading at deep discounts to face value.”

In 2004, however, the Fed sent a different signal. Mr. Greenspan, speaking to Credit Union executives on Feb. 23, said “recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable rate mortgages rather than fixed rate mortgages during the past decade.”

He conceded that they might suffer if rates rose, but that was not the point he emphasized. Instead, he used option pricing theory to conclude that homeowners were paying a very steep price when they took out fixed rate mortgages.

“American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed rate mortgage,” said the Fed chairman.

Rarely has an industry done a better job of following a regulator’s suggestion. The bankers came up with mortgages that took 40 years to pay off, rather than the customary 30-year amortization period. If that was not enough, they offered loans with negative amortization, so that every month a borrower owed more than he had the month before. People could get mortgages without anyone’s checking to see if they had lied about their income.

Mr. Greenspan may have come to regret his 2004 remarks. In the fall of 2005, he told a group of mortgage bankers that the “apparent froth in housing markets may have spilled over into mortgage markets.” He voiced concern over “more exotic forms of adjustable rate mortgages,” but said nothing to indicate banks should stop offering them.

Had Mr. Poole been willing to talk to me, I would have asked if he thought the Fed bore any responsibility.

[...]

Actually, there were forecasts of disaster. But Mr. Poole was not among the Cassandras.

In March of last year, a few months before home prices peaked, he said a housing bubble might be brewing, but that Fed research indicated home prices were not unreasonable.

“So, if you have an academic interest in house prices, I recommend that you wait a few years,” he said. “If you have a direct financial interest, I can’t help much — you’re on your own!”

That exclamation point was in the text released by the Fed.

Good times. Good times.