Monday, the WSJ posted a pretty significant article in its opinion pages by Steven Gjerstad and Vernon Smith (the latter a Nobel laureate) which touches on several of the topics I've been harping on here repeatedly: the fact that asset price increases ARE inflation, that Fed policy and, get that, tax cuts (yes, tax cuts! in the WSJ!), were to blame, and that the current crisis was, at heart, caused by over-indebted middle classes.
In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000.
On hidden inflation:
In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.
With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.
By the way, Alan Greenspan, who was given a second column in as many days in the Financial Times last week basically agrees... He argues that the bailout with public money is a good thing because it creates capital gains and asset price growth (ie a new bubble), which he sees as a good thing, because, he argues, the drop in asset values is causing dangerous deflation. Unless I'm completely mistaken, this amounts to an acknowledgement that, symetrically, asset bubbles DO cause inflation too... and that, by failing to fight the asset price inflation when he was at the helm, he failed in his core mission of controlling inflation.
And indeed, Gjerstad and Smith firmly point the Fed's responsibility:
The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.
(...)
During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate.
On the problems associated with over-indebted households:
How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?
In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.
(...)
Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.
You know my theory: pro-rich policies (in the form first and foremost of expansionary monetary policies that inflate asset prices and nicely push highly concetrated wealth ever upwards and tax cuts that allow the wealthy to hold on to their gains, and, almost as a secondary item, of poor-bashing, greed-lauding, deregulation and odes to entrepreneurial "freedom") cause middle class incomes to stagnate or decline; this is nicely mitigated by giving them access to cheap debt and to easy real estate speculation which allow to keep on spending as if incomes were following GDP. Debt profiles become more aggressive until they become absurdly imprudent and, at some point, collapse.
This article agrees with the main thrust of that theory, noting the role of both loose monetary policy and tax cuts, and provides an additional link, which explains the violence of the crisis for the financial sector: the piling up of leverage on fundamentally broke households means that it is the banks, and not the investors, that take most of the hit as the bubble collapses - many households had little other than their house/mortgage, and thus, in reality, little "real" equity to lose.
It would be ironic if this were a case of the the rich going bankrupt by irresponsibly lending to the poor, but of course, the reality is that the haves and havemores did very well during the boom years, capturing most of the officially measured (but imaginary) income growth, and they are bringing down everybody with them now... Oh, sure, they are taking big hits as asset prices collapse, but losing half your millions is not as damaging to one's wellbeing as losing your house and job.
But hey, it's in the WSJ opinion pages: blame tax cuts.
An Anglo Disease story