Here’s an, erm, brave discussion paper out from the Boston Fed.
In it, authors Kristopher S. Gerardi, Christopher L. Foote, and Paul S. Willen examine “optimism” and “pessimism” about the US housing market before the recent crash. In other words, they’re looking at why some people missed the imminent house price implosion entirely and why some didn’t.
The first camp, we’d add, includes quite a few economists along with the Federal Reserve. The latter, according to the paper, includes people like Paul Krugman, Robert Shiller, and the blog Calculated Risk.
It’s an interesting rundown of who made the housing crash call, but it’s also ‘interesting’ because the paper’s authors go further than just identifying the prescient. They also break down their then-arguments and conclude that, actually, many of them were wrong from a pure economics perspective.
For instance, from the paper:
. . . we review the arguments of a prominent pessimist, Paul Krugman. Although his arguments were made in his widely read New York Times column rather than in a formal academic paper, Krugman, now a Nobel Prize-winning economist, has substantial credibility. He argued that because it is difficult to build in coastal areas of the United States, those areas are more “bubble-prone.” Consequently, the rapid price increases on the coasts but not elsewhere were prima facie evidence that there was a bubble and that prices would eventually collapse.
It is tempting to call Krugman prescient because beginning in late 2006 prices did indeed crash. But his arguments were problematic both ex ante and ex post. Ex ante, it is unclear why Krugman thinks the coasts are more “bubble-prone.” The models we have of asset-price bubbles do a reasonable job explaining why they can persist but have little to say about where we might expect them to start. As one prominent researcher in the field writes, “we do not have many convincing models that explain when and why bubbles start.” Krugman’s thesis seems to hinge on the idea that scarce coastal land is valuable and bubbles can only happen when assets are in short supply, but the whole point about bubbles is that the fundamentals of supply and demand do not matter. Thus, there is no reason why land in places where it is easy to build could not experience bubbles. Ex post, as we will explore at length, the places in the United States where the housing market most resembled a bubble were Phoenix and Las Vegas. According to recent research, both locations are characterized by relatively high housing-supply elasticities; unlike certain coastal areas, the two cities have an abundance of surrounding land on which to accommodate new construction.
Moreover:
Ultimately, our paper argues that the academic research available in 2006 was basically inconclusive and could not convincingly support or refute any hypothesis about the future path of asset prices. Thus, investors who believed that house prices were going to fall could find evidence to support their position, while those who wanted to believe that house prices would continue to rise could not be dissuaded either. There were reasonable arguments on both sides.
And from the conclusion:
From our review of the pre-crisis housing literature from the early-to-mid-2000s, it is apparent that well-trained and well-respected economists with the best of motives could and did look at the same data and come to vastly different conclusions about the future trajectory of U.S. housing prices. This is not such a surprising observation once one realizes that the state-of-the-art tools of economic science were not capable of predicting with any degree of certainty the collapse of U.S. house prices that started in 2006. The asset-pricing literature does not yet have a firm grasp on when and why prices can deviate from market fundamentals for long periods of time. Even the best models have a difficult time explaining many of the extremely large movements in asset prices that have characterized our financial markets in the past, including the stock-market crashes of 1929, 1987, and 2000–2002. One wonders how market participants might have responded to a consensus in the economics profession that housing prices were unsustainable, meaning that highly leveraged bets on housing would be likely to end disastrously. But as this paper shows, market participants were never forced to respond to such a consensus because consensus did not exist.
Got that, everyone? We can summarise:
IT’S NOT ECONOMISTS’ FAULT IF THEY FAILED TO MISS THE HOUSING BUBBLE BECAUSE THE EVIDENCE COULD HAVE GONE EITHER WAY, AND ANYWAY ECONOMICS IS NOT MEANT TO IDENTIFY ASSET BUBBLES, AND BESIDES EVEN IF WE HAD PREDICTED A BUBBLE NO ONE WOULD HAVE LISTENED TO US. AND PAUL KRUGMAN’S COASTAL ARGUMENT WAS WRONG.
SO THERE.
Related links:
Call for housing duty to prick bubbles – FT
Bloggers can’t do economics. Discuss. – FT Alphaville
The need for greater realism in monetary policy – FT Alphaville
WaMu examiner ridiculed, called “Housing ‘bubble’ boy” – Calculated Risk