Henry Hazlitt once wrote in his famous Economics in One Lesson that "Economics is haunted by more fallacies than any other study known to man." Indeed, I am supposed to teach fallacies in my classroom as part of modern economic orthodoxy.
Along with Hazlitt’s declaration comes the opening line in Carl Menger’s path breaking 1871 edition of Principles of Economics: "All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary." The key issue here is understanding the difference between cause and effect.
I write this because we are seeing a lot of supposedly intelligent people confusing cause with effect and declaring that the effect is the cause, and government must act upon that "cause" immediately. That, not surprisingly, is a recipe for disaster.
Many times a day, I receive emails from an outfit called Newsmax, and while I usually trash those mails quickly, I received one from its financial division that declared:
Bond guru Bill Gross says the government must move in support of home prices to make sure the credit markets don’t melt down.
Gross manages Pacific Investment Management Co.’s Total Return Fund, the world’s biggest bond fund. Gross has increased his weighting of mortgage debt to the highest level since 2000, betting against Treasuries in the biggest way since at least that year.
In his April letter to investors, Gross blasts his competitors in the credit markets.
“In my opinion, the private credit markets have forfeited their privileged right to operate relatively autonomously because of incompetence, excessive greed, and in minor instances, fraudulent activities," he writes.
“As a result, the deflating private market’s balance sheet is being re-nationalized, in some cases with increased regulation, in others with outright guarantees and agency lending.
“Ultimately, government programs which support private credit market assets may be required in order to prevent an asset deflation of significant proportions."
Translation: the government must act to lift home prices — and quickly.
“Since homes are the most highly levered and monetarily significant asset that American consumers own, if they decline much further, they will drag the rest of the economy with them," Gross argues.
“Home price declines of 20 percent are in fact much more of a shock to the American economy than the popping of the Internet bubble and the NASDAQ 5000, because the amount of homeowner leverage is so much greater."
Bottom line, according to Gross: “The [home price] decline needs to be stopped quickly to avert additional crises."
How to do it? Why, through inflation, of course! Thus, we read from a "financial guru" that like Vietnam and Iraq the government must destroy the economy via the printing press in order to save it.
Now, I make no claims of being a "bond guru," and I am sure that Mr. Gross’ financial knowledge is much greater than my own, and I am sure his net worth would exceed mine by an infinite number. However, the "guru" has confused cause with effect, and in so doing is calling for the equivalent of nuking New York in order to fix a leak in the sewer system.
Before going farther, however, I will say that I agree with Mr. Gross in that home prices are falling, including my own. (We purchased a house last summer and I have no doubt that I could not sell it today for what I paid for it, but we do hope to live in it for a long time, so I have no plans to walk away because of the fall in equity.) That is a given.
However, the fall in home book values is an effect, not a cause of the current economic downturn, and to miss that simple but profound principle is to miss what is going on. In fact, his subsequent statements regarding his belief that "the private credit markets have forfeited their privileged right to operate relatively autonomously because of incompetence, excessive greed, and in minor instances, fraudulent activities" further express his economic ignorance.
If one is to be a guru, one must understand not only the inner workings of markets, but also the outer structure that guides their activities. This man has made millions in trading of bonds, but he also fails to understand why the credit markets plunged over the cliff.
It is politically popular to blame "greed and incompetence" and the like for the failings here, but the "greed and incompetence" of which he speaks did not suddenly appear like magic. Instead, it was government-created. And, it was inevitable, given the perverse incentives that government has created in those markets.
How did the freefall in housing book values come about? If you read Gross, you would think that it just happened, or if there was a problem, it was due to "greedy markets." Instead, we are seeing the classic effects of a financial bubble, be it in housing, the stock market, or the infamous Tulip Mania in the Netherlands nearly 400 years ago. Furthermore, this particular bubble could not have occurred without the backing of the government.
To give an analogy, I have a student who is an avid snowboarder. He told me about "powder days," which are days when several inches of new snow (called "powder") have fallen on the slopes, which means that he can do a number of moves and tricks that might be inherently dangerous, but are mitigated by the fact that when he falls, the landing is soft.
However, when the slopes are hard-packed or even icy, there is no "powder safety net," and he is much more reluctant to be a hot dogger for fear of injury. Likewise, the financial markets are much more likely to act recklessly when they know that someone "has their back." That "someone," of course, is the U.S. Government and more specifically, the Federal Reserve System.
The government has covered the mortgage markets in a number of ways. First, to promote home ownership, Congress during the New Deal created the Federal National Mortgage Association ("Fannie Mae") in 1938 and 30 years later created the Federal Home Loan Mortgage Company ("Freddie Mac") to bolster the mortgage industry by offering guarantees and to create so-called mortgage securities. These "securities" really are mortgages sold in the secondary market at their present value, and then bundled into larger securities to be sold to the public.
The principle behind these securities is to spread the risk, as they are based upon the assumption that most people will pay their mortgages in a timely manner and defaults will be random, so the good mortgages would outweigh the bad ones. However, one wonders why if this is such a good investment idea, why did private investors did not seek to create such companies themselves?
(Private investors have made much money on these securities, and while both outfits now are officially private organizations, nonetheless they exist only because the government guarantees their financial backsides. We shall see just how credible that "guarantee" really is.)
Both Fannie Mae and Freddie Mac have made Austrian economists quite nervous, given their huge unfunded liabilities, but as long as people could pay their mortgages, those outfits could operate in relative peace. Unfortunately, the past several years have been anything but peaceful in mortgage markets, and only now are the real bills coming due. How we got to this point is instructive.
In 2001, the U.S. economy had fallen into recession. The Clinton-era stock bubble had burst, but the dollar still was strong against foreign currencies. Then came the 9/11 attacks, which I believe had much more effect than most people understand.
After the attacks, the American economy was stagnant, which should not have been surprising, since the economy still was in recession on top of the vicious hit that it received from the terror attacks. Yet, at this point, the George W. Bush Administration could have been heroic and dealt correctly with the situation at hand. First, it should have done nothing to "stimulate" the economy as opposed to what it did do: convince Alan Greenspan to have the Fed lower interest rates to ridiculous levels (1.0%).
At first, the boom in the housing market started very slowly — as these things usually do. Soon, however, Americans were being bombarded with calls at the dinner hour and in their emails by mortgage brokers to refinance their houses, and then the cascade began. It seemed quite reasonable at the beginning. Interest rates were quite low, and it made sense to borrow money against the increasing equity of one’s house, and maybe even borrow a few thousand more to buy cars, vacations, refrigerators, or whatever — and still have lower house payments.
Columnist Steven Greenhut three years ago understood what was happening in California and other "hot" real estate markets, and said so:
Now, everyone is banking on appreciation. One friend, shopping for a house in Palm Desert, told me the $875,000 price is a bargain because it will be worth a million next year. I don’t know, but I warned that it could just as likely be worth $500,000. Yet, people are tapping into their home equity, which is driving a consumer-based economy. It’s also creating a false sense of wealth. People might not always use their equity to buy things, but knowing it is there helps them justify buying those $75,000 BMWs, Hummers and Mercedes that I drive by in my Ford Focus every day. My suspicion is the opposite will happen this time around. Instead of the economy killing home prices, falling home prices will kill the economy.
As booms always go, this was unsustainable. What made it unique, however, was the fact that the Fed and its acolytes in the financial markets were throwing newly-printed dollars around, and people selling things overseas were willing to hold them. Although we hear the neoconservatives regularly bash China, nonetheless the central bank of China was willing to scoop up billions of dollars of U.S. bonds that were being floated, in part, to pay for a war that China says it opposes and that the neocons support.
Chinese consumer goods have flowed ever since to these shores, while Americans have sent the Chinese and Japanese and others green pieces of paper that the holders have hoped to redeem sometime in the future for something. Indeed, the housing boom really was driving the U.S. economy, much more so than anything else, including the false "stimulus" that came from the disastrous war in Iraq.
At first, the new mortgage money was spent mostly refinancing existing mortgages, but soon enough, Americans got real estate fever, and there was no stopping the lemmings as they raced toward the cliff. I could see the effects where I lived, and ours was not a "hot" market by any means. However, as "investors" found housing prices around Washington, D.C., accelerating, they decided that places like Cumberland and Frostburg were virgin territory and proceeded to bid up prices well beyond the reach of average-income families here. By 2005, even backwaters were part of the frenzy.
By 2006, it should have been obvious in places like California and elsewhere on the two coasts that the party was over. The tipoff was that companies were dealing almost exclusively in the "interest-only" mortgages with their special "teaser" rates. Would-be homeowners would borrow huge sums of money, but start out paying only the interest at low introductory rates.
The reason they put themselves in such vulnerable positions was that this was the only way that most of them could begin to afford the sky-high house payments that with the accelerating housing prices. Borrowers would console themselves with the false belief that within a year, they would "flip" their houses, have new equity, and have money to put down on a new place, with a conventional mortgage and lower payments.
Unfortunately, for most of these late-comers, "later" never arrived, at least in the version of the phantom house "flip." Instead, "later" meant that the teaser rates morphed into substantially higher interest, and principal payments came due. The "almost-affordable" payments rose to payments that were ridiculously unaffordable, and the foreclosure rush was on.
As in all financial bubbles, those who enter at the top of the bubble have the most to lose, as the value of the asset in which they spent so much to obtain falls well below that original amount. Those of us who purchased houses near the end of the frenzy are well aware that the current values are not what our mortgages say they are supposed to be, and in some places, people have just walked away.
Yet, to deal with the original purpose of this article, we have a "financial guru" claiming that unless government finds a way to prop up the housing values to prices that existed at the top of the boom, the economy is doomed. To that I say, "Nonsense."
Gross makes the false assumption that declining prices are a never-ending spiral of misery. Now, if one is a disciple of John Maynard Keynes, such beliefs are fundamental tenets of what we call Keynesianism. However, if one is not a Keynesian or even a True Believer in that fiction called "aggregate demand," then there are plenty of very good reasons to believe that it is necessary to permit housing prices to fall to their true market values.
To take my disagreement with this "financial guru" one step farther, I will say that if the government follows his advice and tries to prop up housing prices to unsustainable levels, the fallout will be far worse than what he can imagine. The last time the U.S. Government aggressively attempted to prevent falling prices across the economy was the 1930s, a time which the ancients once called the Great Depression.
The reasoning here brings us back to Menger and the "law of cause and effect." Declining prices, whether they be in the housing market or the stock market in 2000, or commodities markets in 1982, are a market response to the real-live conditions that exist after a period of malinvestment in those particular markets. Austrian economists recognize that government attempts to pump up particular markets only invite inevitable havoc. Falling prices are an effect of markets re-adjusting after the previously unsustainable booms ran their course and had nowhere to go.
According to Paul Krugman, the real problem is lack of regulation, and it seems that the talking heads, plus some people on Wall Street, heartily agree. I would dissent from that point of view, noting that the problem was not that markets were free, but rather that financial markets constantly had Uncle Fed whispering, "Got your back!" We are about to find out the very hard way that our rich "uncle" cannot sustain any market with just a printing press.
(I remind my students that every time Ben Bernanke promises even more "liquidity" to the markets, gasoline prices tick upward. We now see the same in food prices and other commodities. The new money must go somewhere, and investors realize that the only game in town is pork bellies and the like.)
If we want the economy to become viable again, the last thing the government needs to do is to try to pump up housing prices, as the markets will make sure that every new attempt to "create liquidity" will translate into even higher commodity prices — even as housing prices continue to tank. Murray Rothbard and other Austrians have had the right prescription, one that the Bill Grosses of the world don’t want to hear: Governments should do nothing except permit the markets to adjust to levels that are sustainable. Anything else only will prolong the financial agony and ultimately make the economic downturn even worse.
Unfortunately, policymakers are listening to the Grosses and not the Rothbards. And for that, we will pay dearly.
April 26, 2008
William L. Anderson, Ph.D. [send him mail], teaches economics at Frostburg State University in Maryland, and is an adjunct scholar of the Ludwig von Mises Institute. He also is a consultant with American Economic Services.