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How to Wreck an Economy

The Trouble With Bubbles


The United States has more than 20 million people unemployed, underemployed or out of the workforce altogether because of a burst housing bubble. We also have more than 10 million homeowners who are underwater in their mortgages. And, we have tens of millions of people approaching retirement who have seen most of their life’s savings disappear when plunging house prices eliminated most or all of the equity in their home.

This situation could have been prevented if the government had taken steps to stem the growth of the housing bubble before it reached such dangerous levels. It is incredible that the Bush administration’s economics team failed to see the dangers of the bubble. It is even more remarkable that Alan Greenspan, Ben Bernanke and the Fed ignored the growth of the housing bubble. But even more astounding is the fact that no one in a position of authority has learned any lessons from this disaster.

At the moment, there are housing bubbles in the United Kingdom, Canada, and Australia that are arguably larger, relative to the size of their economies, than the one that collapsed and wrecked the U.S. economy. The basis for saying that house prices in these countries are in a bubble is that there has been a sharp increase in the sale prices of homes that has not been matched by a remotely corresponding increase in rents.

In the case of the U.K., house sale prices increased more than 115 percent in excess of inflation between 1996 and 2010. Over this period, rents pretty much kept even with the overall rate of inflation. In Australia house prices rose by more than 80 percent between the start of 2002 and end of 2009, a period in which rents rose by roughly 30 percent. Canada has a similar story.

The average house price in the U.K. is now almost 60 percent higher than in the U.S. It had been 20 percent lower in the mid-90s. In Canada the average house price is more than 70 percent higher than in the United States. The price of the median house in Australia is more than 225 percent of the median house price in the United States.

Given that wages in the United States are the same or higher than in all three countries, it is difficult to see how this huge gap in house prices can make sense. Furthermore, since rents have not notably outpaced inflation in any of these countries, it does not appear that the price increases are being driven by the fundamentals of the housing market. If there was a serious shortage of housing we should expect it to be showing up in rents as well.

In short, there is good reason to believe that house prices in these countries will not be sustained anywhere near current levels. All three are likely to see the same sort of house price collapse that has wreaked so much havoc on the U.S. economy. It’s impossible to know what will be the triggering event; a rise in interest rates could certainly deflate a bubble quickly.

Alternatively, a sharp increase in supply could eventually swamp demand. A glut of supply was the factor that eventually burst the U.S. bubble. After five years of near-record rates of construction, vacancy rates reached levels never before seen. Once prices began falling, potential buyers and lenders no longer assumed that prices would continue to go up indefinitely and the bubble quickly deflated.

It is fair to assume that a collapsed bubble will have the same sort of devastating impact on the economies of these countries and the lives of their citizens as it has in the United States. Bubbles generate demand in the economy both directly and indirectly. They directly create demand by increasing construction. They indirectly create demand through the wealth effect on consumption. People will consume more when they see the value of their home rise, thereby making homeowners wealthier.

These sources of demand will disappear when a housing bubble bursts. Five years ago, it was standard thinking among economists that the demand generated by a bubble can be easily replaced; anyone who has been paying attention over this period should know that this is not true. There is no easy way to replace the 5-10 percentage points of GDP that is bubble-driven demand. That is why the effects of the downturn in the United States have been so severe.

In addition to the macro story there is also the impact on people’s lives. A housing bubble leads homeowners to believe that they have much more money than is actually the case. Therefore they spend more and save less than would otherwise be the case. When the bubble bursts, reality sets in and homeowners discover that they are now near retirement with almost nothing by way of savings.  That cannot be a good situation for a formerly middle class family to find itself in.

For these reasons, governments and central banks should be focused on preventing bubbles before they grow large enough to be so dangerous and disruptive. Central banks in particular are well-situated to take action, since central banks are designed to be less susceptible to short-term political considerations. This means that they can take steps to burst a bubble, which will likely be unpopular.

The tool box for central banks in this regard is extensive. First, clear warnings from a central bank using evidence to document the existence of a bubble will be difficult for actors in the financial sector to ignore. Bank executives will likely be forced to explain why they think the central bank is wrong if they keep lending. In the case of the U.S. bubble, they had no story that passed the laugh test.

Second, central banks and other regulatory authorities could use regulatory pressure to limit mortgage issuance. At the peak of the U.S. housing bubble, the largest mortgage issuers practically had neon signs on their buildings advertising fraudulent mortgages. It would not have been hard for the regulators to crack down on abuses, if they had chosen.

Finally, higher interest rates will sink any bubble. If a central bank announced a rate increase and that further hikes will follow until house prices have dropped by 30 percent (or whatever amount seems appropriate) it is likely that the housing market will take the warning very seriously.

There is probably no way at this point to deflate the bubbles in Australia, Canada, and the U.K. without causing considerable pain. It would probably still be better to take steps now than allow for even more people to become caught up in the bubble.

Perhaps more importantly, the public has to demand that central banks put bubble prevention at the top of their agenda. These banks have been ignoring economy-wrecking bubbles everywhere, somehow thinking they have down their job because they kept inflation at 2.0 percent. It’s wonderful that the central banks met their inflation target, but why should anyone give a damn?

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy and False Profits: Recoverying From the Bubble Economy.

This column originally appeared in Al Jazeera.



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