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Source link: http://archive.mises.org/5175/working-paper-on-housing-bubbles/

Working Paper on Housing Bubbles

June 12, 2006 by

The purpose of this paper is to show how the “system” works, why it generates bubbles, why they eventually burst, and the macroeconomic effects of bubbles. Here we apply the economic understanding of bubbles derived from the Austrian business cycle theory (ABC theory) to the current case of the housing bubble and show that this aspect of the housing crisis is the result of government failure—the inevitable failure of a government bureaucracy (i.e. the Fed) to manage the money supply and interest rates in an economically rational manner. However, the same reasoning can be applied to historical bubbles, from the Tulip mania in 17th century Holland (see French 2006) to the dot.com tech bubble of the late 1990s (see Callahan and Garrison 2003), and to future bubbles.



edhopper June 12, 2006 at 10:15 am

A well reasoned, thought out paper.
I do not disagree with your analysis or conclusions.
Having read Shiller and Krugman, I think you put in a bit of a straw man argument here. While both men do emphasize the psychological component of the bubble, they do not discount the real factors. Especially the roll of the Feds. I think they believe many economist do not consider the psychology of the market and therefore they are making a stronger case for it.

I also think you let Greenspan off the hook by saying
“The lesson of the housing bubble is that what at first appeared to be the government trying to help improve home ownership for Americans has been a giant government failure”

I think this is far too benign. It is hard for my to accept that Greenspan did not know he was creating a new asset bubble to replace the tech bubble that had collapsed.

These are minor differences to the overall well written piece.

Dr. Mark Thornton June 12, 2006 at 10:25 am

Thanks for your comments.

The Keynesians emphasize the psychological forces in order to “motivate” their preferred policy remedy which is more government intervention. I didn’t want to get into that debate in this paper. I wanted to present an easy to understand “trichotomy” for readers.

As far a Greenspan is concerned, I agree with you. That is why I coined the term “Greenspam” and mentioned it in this paper.

edhopper June 12, 2006 at 11:16 am

I think you did a very good job of presenting the situation in very accessible fashion.
I think the point I was trying to make is that Shiller and Krugman probably agree with you a great deal on the components of the bubble. Though of course, you probably differ on how to react to the coming housing collapse.

Dennis Sperduto June 12, 2006 at 11:59 am

Regarding the alleged effect of psychological forces, there still must be a lowering of the rate of interest below its market level through the creation of additional loanable funds by the Fed and the banking system in order for these psychological preferences to be translated into concrete actions. Without the actions of the interventionist and inflationary Federal Reserve and banking system, these psychological “factors” would remain just that, unable to be manifested in action. There are many things that I would love to purchase, that I have the psychological desire to purchase, but I can not because I lack the purchasing power. Similar to just about everything else in Keynesian “economics”, the psychological forces argument is a straw man.

More generally, attempting to explain economic phenomena using psychological factors fallaciously conflates two separate and distinct fields of knowledge. Economic phenomena require praxeological analysis to explain. Economics analyzes the means used to obtain ends, and not what causes or motivates individuals to choose certain ends.

edhopper June 12, 2006 at 12:40 pm

I understand your take on the psychological factors.
I think what Shiller is saying that given the economic underpinnings of a bubble, like low interest rates, there are also reason people continue to buy assets at inflated prices.
For instance, as this real estate bubble reach historic heights, investors still thought they would see continued growth in the value of their property into the foreseeable future. On a strict economic bases (rent to own, afford-ability index) this did not make sense.
But psychologically they thought “this time it’s different.”

I am too much of a economics piker to argue and tell you are wrong. (and we largely agree on the current bubble). I just think there is some veracity to Shiller’s idea. Especially since he was almost alone in his early call of the tech bubble.

Dennis Sperduto June 12, 2006 at 2:06 pm

If Shiller’s use of psychological explanations is correct, then the general boom phase of the trade cycle, not only the specific examples of the housing or high-tech stock bubbles, should also be influenced by psychological factors. However, entrepreneurial errors will always be made, both by businessmen, and by individual participants in the housing or high-tech stock markets. But what explains the relatively large cluster of errors that become apparent in and characterize the downturn phase of the trade cycle? Again, the Keynesians argue that it is the animal spirits and greed of the capitalist (i.e., psychological factors) that are a significant, if not the major, cause of the trade cycle. In contrast, ABCT argues that in the boom phase of the trade cycle, economic calculation, and hence investment decisions, have been distorted due to a rate of interest that has been artificially lowered by the central bank and/or the fractional reserve banking system.

Dennis Sperduto June 12, 2006 at 8:03 pm

Regarding my above postings critical of the role of psychological factors as causing and/or contributing to the trade cycle, Rothbard certainly can explain the topic better than me; from the last section of the third chapter of “America’s Great Depression”:

“Overoptimism and Overpessimism
Another popular theory attributes business cycles to alternating psychological waves of “overoptimism” and “overpessimism.” This view neglects the fact that the market is geared to reward correct forecasting and penalize poor forecasting. Entrepreneurs do not have to rely on their own psychology; they can always refer their actions to the objective tests of profit and loss. Profits indicate that their decisions have borne out well; losses indicate that they have made grave mistakes. These objective market tests check any psychological errors that may be made. Furthermore, the successful entrepreneurs on the market will be precisely those, over the years, who are best equipped to make correct forecasts and use good judgment in analyzing market conditions. Under these conditions, it is absurd to suppose that the entire mass of entrepreneurs will make such errors, unless objective facts of the market are distorted over a considerable period of time. Such distortion will hobble the objective “signals” of the market and mislead the great bulk of entrepreneurs. This is the distortion explained by Mises’s theory of the cycle. The prevailing optimism is not the cause of the boom; it is the reflection of events that seem to offer boundless prosperity. There is, furthermore, no reason for general overoptimism to shift suddenly to overpessimism; in fact, as Schumpeter has pointed out (and this was certainly true after 1929) businessmen usually persist in dogged and unwarranted optimism for quite a while after a depression breaks out.[30] Business psychology is, therefore, derivative from, rather than causal to, the objective business situation. Economic expectations are therefore self-correcting, not self-aggravating.”

Ohhh Henry June 13, 2006 at 9:37 pm

Everyone should stop worrying about bubbles – I just heard Arthur Laffer and Larry Kudlow assure John Batchelor on his radio show that the inflation threat is vastly exaggerated, the Fed is acting “perfectly correctly”, gold at $750 is “ridiculous”, the greenback has been suffering from only a little bit of “benign neglect”, this is “the greatest economy in history”, Snow will “talk up the dollar to the rest of the world” and Bernanke will “back him up by printing less dollars”, and finally, “there isn’t going to be an recession, only an adjustment to the stock market that is going to knock the inflation out”.

I wanted Batchelor to ask them what they were smoking, but you know how it is, they never ask the questions you really want to hear.

Peter June 14, 2006 at 12:27 am

It seems they’re having some effect. Gold’s heading back below $500 now. I’ve long suspected that would be the first sign of the beginning of the Big Crunch – the last great buy opportunity before $1000+/oz? Hang on to your seats, ladies and gentlemen!

billwald June 14, 2006 at 7:45 pm

I think two prime reasons for the bubble are, first, because people go where the jobs are. I don’t think there is any bubble in most of the Dakota’s, Montana . . . .

Second, the change in IRS rules that allows people to trade down houses without paying a tax. This permits people to sell in the cold north and retire to the sunny south.

The bubble is mostly where the jobs are and/or where the weather is warm in the winter. Arizona meets both conditions. Some years ago someone asked why new private colleges are being built in the south and not the north. Should be obvious.

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