FacebookTwitterGoogle+RedditEmail

The Trouble With Bubbles

by DEAN BAKER

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.

 

SAVE BLACK MESA:

The Poster That Ignited the Radical Environmental Movement, signed by photographer Marc Gaede, available now at the CounterPunch Online Auction!

 

 

Dean Baker is a macroeconomist and co-director of the Center for Economic and Policy Research in Washington, DC. He previously worked as a senior economist at the Economic Policy Institute and an assistant professor at Bucknell University.

More articles by:
May 31, 2016
Miguel A. Cruz-Díaz
Imperial Blues: On Whitewashing Dictatorship in the 21st Century
Vijay Prashad
Stoking the Fires: Trump and His Legions
Patrick Howlett-Martin
Libya: How to Bring Down a Nation
Uri Avnery
What Happened to Netanyahu?
Corey Payne
Reentry Through Resistance: Détente with Cuba was Accomplished Through Resistance and Solidarity, Not Imperial Benevolence
Bill Quigley
From Tehran to Atlanta: Social Justice Lawyer Azadeh Shahshahani’s Fight for Human Rights
Manuel E. Yepe
Trump, Sanders and the Exhaustion of a Political Model
Bruce Lerro
“Network” 40 Years Later: Capitalism in Retrospect and Prospect and Elite Politics Today
Robert Hunziker
Chile’s Robocops
Aidan O'Brien
What’ll It be Folks: Xenophobia or Genocide?
Binoy Kampmark
Emailgate: the Clinton Spin Doctors In Action
Colin Todhunter
The Unique Risks of GM Crops: Science Trumps PR, Fraud and Smear Campaigns
Dave Welsh
Jessica Williams, 29: Another Black Woman Gunned Down By Police
Gary Leupp
Rules for TV News Anchors, on Memorial Day and Every Day
May 30, 2016
Ron Jacobs
The State of the Left: Many Movements, Too Many Goals?
James Abourezk
The Intricacies of Language
Porfirio Quintano
Hillary, Honduras, and the Murder of My Friend Berta
Patrick Cockburn
Airstrikes on ISIS are Reducing Their Cities to Ruins
Uri Avnery
The Center Doesn’t Hold
Raouf Halaby
The Sailors of the USS Liberty: They, Too, Deserve to Be Honored
Rodrigue Tremblay
Barack Obama’s Legacy: What Happened?
Matt Peppe
Just the Facts: The Speech Obama Should Have Given at Hiroshima
Deborah James
Trade Pacts and Deregulation: Latest Leaks Reveal Core Problem with TISA
Michael Donnelly
Still Wavy After All These Years: Flower Geezer Turns 80
Ralph Nader
The Funny Business of Farm Credit
Paul Craig Roberts
Memorial Day and the Glorification of Past Wars
Colin Todhunter
From Albrecht to Monsanto: A System Not Run for the Public Good Can Never Serve the Public Good
Rivera Sun
White Rose Begins Leaflet Campaigns June 1942
Tom H. Hastings
Field Report from the Dick Cheney Hunting Instruction Manual
Weekend Edition
May 27, 2016
Friday - Sunday
John Pilger
Silencing America as It Prepares for War
Rob Urie
By the Numbers: Hillary Clinton and Donald Trump are Fringe Candidates
Paul Street
Feel the Hate
Daniel Raventós - Julie Wark
Basic Income Gathers Steam Across Europe
Andrew Levine
Hillary’s Gun Gambit
Jeffrey St. Clair
Hand Jobs: Heidegger, Hitler and Trump
S. Brian Willson
Remembering All the Deaths From All of Our Wars
Dave Lindorff
With Clinton’s Nixonian Email Scandal Deepening, Sanders Must Demand Answers
Pete Dolack
Millions for the Boss, Cuts for You!
Gunnar Westberg
Close Calls: We Were Much Closer to Nuclear Annihilation Than We Ever Knew
Peter Lee
To Hell and Back: Hiroshima and Nagasaki
Karl Grossman
Long Island as a Nuclear Park
Binoy Kampmark
Sweden’s Assange Problem: The District Court Ruling
Robert Fisk
Why the US Dropped Its Demand That Assad Must Go
Martha Rosenberg – Ronnie Cummins
Bayer and Monsanto: a Marriage Made in Hell
Brian Cloughley
Pivoting to War
FacebookTwitterGoogle+RedditEmail