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Watching the Economy by Clint Burdett CMC® FIMC

January 24, 2012

Even Paul Krugman Grudgingly Optimistic,
But Don't Bet on Housing Prices Roaring Back

In Krugman's 1/22 NYT column "Is Our Economy Healing", he stated:

Why am I letting a bit of optimism break through the clouds? Recent economic data have been a bit better, but we’ve already had several false dawns on that front. More important, there’s evidence that the two great problems at the root of our slump — the housing bust and excessive private debt — are finally easing.

On housing: as everyone now knows (but oh, the abuse heaped on anyone pointing it out while it was happening!), we had a monstrous housing bubble between 2000 and 2006. Home prices soared, and there was clearly a lot of overbuilding. When the bubble burst, construction — which had been the economy’s main driver during the alleged “Bush boom” — plunged.

In an NBER working paper published this month, Getting Up to Speed on the Financial Crisis: a One-Weekend-Reader's Guide, Gorton and Metrick trace the cause of the Great Recession and recommend 16 analytical papers to read to understand the dynamics. Similar to Reinhart and Rogoff in This Time It's Different, they conclude that housing and credit bubbles warned of impending disaster:

The financial crisis of 2007-2009 was perhaps the most important economic event since the Great Depression. All professional economists need a working knowledge of the key details of this crisis. This paper summarizes these details using 16 papers, reports, and other documents. From these documents, a narrative emerges that is very similar to historical crises, while cloaked in institutional detail novel to this century.

One strong similarity to history comes in the acceleration of system-wide leverage just before the crisis, the strongest predictor of crises in the past two centuries.

Furthermore, the recent crisis was preceded by rapid increases in housing prices, also a feature of all major crises since World War II. At this macro level, the pattern (but not the scale) of our crisis is very ordinary.

The crisis was exacerbated by panics in the banking system, where various types of short-term debt suddenly became subject to runs. This, also, was a typical part of historical crises. The novelty here was in the location of runs, which took place mostly in the newly evolving 'shadow banking' system, including money-market mutual funds, commercial paper, securitized bonds, and repurchase agreements. This new source of systemic vulnerability came as a surprise to policymakers and economists, and some knowledge of its details is necessary for understanding the contagion that eventually spread to the real economy.

Reinhart and Rogoff's work is influencing every discussion about what to avoid.

Since so many reputations were destroyed, so much wealth lost, it is inconceivable that United States policy makers or politicians will let housing prices accelerate too fast or let the credit markets over-extend.

Not only is it going the be a slow recovery, it is going to take a long time as I expect the pols to be a bit gun shy. That is a good thing. Sorry Paul.

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