Update on the Housing Bubble: How Bailouts Cause Depressions

0:00I originally came to Auburn in 1982 to graduate school in economics and the Mises Institute showed up the next year and I've been affiliated with them on and off various roles ever since. And we were directly affiliated with the university and on campus for a number of years until we sort of outgrew the office space here in the College of Business and so we set up shop www.mises.org www.mises.org

0:59Where you need to get some information or get an alternative viewpoint on something, just about anything. You can search our site and find out something about it. Something I hope that would be very interesting to you. And one of those things that you'll find a lot about is the housing bubble. And the most recent material about the bailout packages and the financial crisis, we have A very active economics blog that has been sort of red hot lately. And almost all of it is talk about the housing crisis, the financial crisis, and the bailout packages that are being pressed forward in Washington, D.C.

1:45But to the housing bubble, I want to just do a quick recap of where we stand on the the Housing Bubble at the Institute and the scholars that are affiliated with it. We started publishing articles about the Housing Bubble in 2003. My first article about the Housing Bubble occurred in 2004. I had another one in 2005 which showed that the Housing Construction Price Index, the Philadelphia Housing Index, topping out in July, late July of 2005. In 2006, I gave a seminar here, it might have been in this room actually, about the housing bubble and some unknown, unnamed person was badgering me about whether he thought my prediction was going to come true.

2:35He's not here tonight to defend himself, fortunately for me. That paper is still on our website, the economics of the housing bubble, so if you want to go check that or any of these references, it's on there. In February of 2007, I gave a talk to the AU Libertarian Club here on campus. It was called Game Day Condominiums, The Housing Bubble Comes to Auburn. And so we've been on this topic basically from the very beginning describing the bubble, its cause, and its ultimate consequences that we're in the midst of today. In 2007, the economics editor of the Financial Times in London was giving a speech to the The American Academy of Architects and City Planners or something like that.

3:22And he noted that the best research on the real estate market was in Auburn, Alabama at the Mises Institute, which came as a shock, not only to everyone there in attendance, but also to myself, actually. I didn't think that somebody in London would have taken notice. So we've had this housing bubble going for quite a while, actually. The housing price index that I mentioned earlier, in 2003 it started at 100. The index increased by 200% over the next two and a half years to mid-2005, and now it has declined two-thirds in its value since then, since July of 2005, and is basically The Real Estate Investment Trusts, which are sort of like mutual funds of real estate holdings, have also seen a dramatic decline.

4:23And you know, for all the talk about a depression in the American economy, we have not even gotten an official NBER recession. The National Bureau of Economic Research, which tells us whether or not we're in a recession, has yet to issue its call that the American economy has sunk into recession, and this is very unusual, especially for leaders, policy leaders, political leaders, to be talking about an economic depression before the economic recession even starts. They really specialize in denying any kind of economic troubles, and basically that's what they've been doing. They've denied throughout this whole bubble period and the initial phases of the collapse that there was any economic problem whatsoever, but recently they've gone hysterical basically with all this talk of economic depression and the need for economic bailouts.

5:21Now the Austrian economists who are affiliated with the institute, the Mises Institute, have seen this problem coming for a long time. As I mentioned, the article started appearing in early 2003, and they all see the problem is basically caused by the Federal Reserve. That is the source of economic problems, and a lot of economists see the Federal Reserve as a source of economic problems, but the Austrians have a very particular view which shows the Fed causing the problem before it actually occurs. The Fed produced very low interest rates in 2002, 2003, 2004, setting the federal funds rate for an extended period of time as low as 1%, which basically means if you take inflation into consideration that interest rates for banks were actually negative, so they could borrow essentially at negative rates.

6:19Credit was easy basically from 2001 through most of 2005. In addition to easy credit and low interest rates, there was also what is sometimes referred to as the Greenspan or Bernanke put. And basically what that means is that if the economy got in trouble, that Greenspan and then Bernanke would provide some kind of bailout. And that's basically what we saw under Alan Greenspan is that anytime there was any trouble, financial trouble around the world, Alan Greenspan would ride in to try to save the Today. In many cases, he did successfully bail out particular financial entities. Bernanke is on public record saying that he's not going to let it ever happen again, meaning an economic depression.

7:09He's more or less guaranteed the market participants from actually before he became chairman that he was going to bail out with a great deal of vigor. And you know, the Austrians see this sort of situation. And we say, well, all this extra credit that's going into the economy, that's being created by the Federal Reserve, it has to go somewhere. If you double, let's say you double the amount of credit going into the economy at any one point in time, that has to go somewhere. Your bank may say, well, I understand the Fed, I'm not going to go recklessly out there and lending money to just anybody just because it's available to me. But somebody will. Money will come along, someone with a C average, and say, hey, it's there, why not lend it out to somebody, especially if we can package it up and then get rid of the loans to somebody else.

8:00So the extra credit, the extra loans, are going to go somewhere. Someone is going to sell it. There are a lot of contributing factors that have been discussed in the media. The CRA, the Community Redevelopment Act, where the government sort of pushes financial firms to make loans to low-income and minority applicants, to make loans into distressed urban areas. And gradually over time, there's been more and more pressure to make those kind of loans, to make loans to people who otherwise wouldn't qualify, people who don't have good enough credit. And you'll find basically that the Republicans now are pointing to the Community Reinvestment Act as a democratic program that caused this whole crisis to take place.

8:52On the other hand, other people are pointing to legislation in 1999, the year 2000, 1999, Graham, Leahy, Blythe, can never get their name straight except for Graham. That legislation was deregulation of the financial institutions. It brought down the Glass-Steagall wall between investment banking and commercial banking. The Democrats in this campaign are pointing to that legislation saying, aha, they're the ones. The Republicans pushed that, sponsored that legislation, got it passed, and that's what caused the problem. The Austrians look at that, although we're not a political party, the Austrians look at that and say, you know, both of these sets of legislation were contributing factors.

9:46The Fed is the main problem, but this legislation are both contributing factors. They sort of opened the doors to economic problems a little further. They widened the pathway for all this credit to take place. The Democrats created a larger pool of unqualified borrowers and the Republicans opened up the flexibility on Wall Street to expand the types of credit and loans that individual banks could make because the scope of banking for banks became larger. So basically what I'm pointing out to you today is that the Austrians saw this problem coming. We saw the housing bubble, we documented it, we identified what the cause was, the primary cause and we identified what the ultimate problem would be and that is contraction in housing which ultimately would bleed over to the real economy into the financial markets and send the American economy into a severe recession.

10:50Now basically everyone else did not. You can find exceptions, Robert Shiller, who's a finance professor, also identified a housing bubble fairly early on. But he is somebody, even though he's classified as an economist, he doesn't really believe in economics. He's very famous for saying that economists have spent all of their time learning tools which don't allow them to understand problems such as this, because this housing thing is is all psychological. So he said that economists should go back and start to study psychology rather than economics. Others did not see it or refuse to admit the truth. Alan Greenspan, for example, during his tenure at the Fed said that there was no housing bubble. During the height of the housing bubble in 2005, he said there was no housing bubble. He said said that all of these new fancy mortgage products were actually contributing to the growth in the economy because it was allowing people to get these low interest loans, allowing them to take equity out of their homes and to spend it on important things like RVs and

12:01bass boats and vacations and $100,000 weddings. When Alan Greenspan stepped down, he said that there was some apparent froth in the in the Housing Market, and then one month after he resigned as Chairman of the Fed, he said that the housing bubble is over. So all along he denies it and then he steps down. His first major speech, which he got paid a lot of money for, he admitted that there was a housing bubble but declared that it was already over. Ben Bernanke, the current Chairman of the Fed, while Vice Chairman of the Fed, was put He was put in charge of a routine investigation into mortgage and lending practices and he stated in 2005 that his investigators had thoroughly researched mortgage lending, borrowing practices, all the aspects of the housing bubble basically within the banks and he said that there was no problem and as a matter of fact everything was much better in terms

13:32So precisely, when all of these problems were most manifest in the economy, Ben Bernanke was saying things were better than ever as far as regulatory oversight of mortgage lending. And of course, this also goes down to Fed economists, prominently Federal Reserve economists Economists at the Fed Bank of Boston investigated this with a team of investigators and found that there was no housing bubble in 2005 or 2006. Of course, the same can be said of economists on Wall Street. There was an economist named David Laria, who was the chief economist of the Real Estate Association.

14:25And, of course, he denied the existence of a housing bubble or downturn in housing or a housing crisis until the day after he resigned as chief economist of the Real Estate Association. Well, you know, these are pretty much the same people at the Federal Reserve, at Goldman Sachs, at Treasury and so forth. These are the same people who got us into the problem and denied the existence of the These are the same people who are now telling us that the way out of this problem are bailouts, that in order to solve this problem, we have to take the taxpayers' money and credit and future and give it to the people who have been so financially irresponsible, sometimes not knowingly, but still, objectively, financially irresponsible They now get to propose the solution.

15:27That seems a little odd, doesn't it? You know, say for example, if you were a football coach and you were in charge of, like, the offense and the offense couldn't score any points, who would you turn to to come up with a solution to that? The offensive coordinator? No, you would fire the offensive coordinator. Well, what do they come up with as a solution to this problem, this depression, this impending depression? Well, they recommend that what we need here is more credit. We need more credit, and we need more debt. Debt is key here. We've got to put the government in debt, the taxpayer in debt. We've got to increase the amount of unbacked insurance in the economy, and we have to increase the amount of taxpayer-backed insurance in the economy.

16:15That's basically the four things that these bailouts cumulatively offer. More credit, more debt, more unbacked and taxpayer-backed insurance. Those are the four things that are the pieces of the problem. Too much credit being lent, too much debt being taken on, too much insurance, assurances from the Fed, for example, that people would be bailed out, insurance by the FDIC, which is unbacked, except that the taxpayers. If the banks go bad, the FDIC, I don't know if they have any money left at this point, so any banks going forward that go under, the taxpayers are going to have to pay that. So we have a very unusual situation.

17:01This would be like, again, the football example, okay, you take the ball down to the five yard line, you've got first and goal to get five yards. And so what you try is to hand the ball off to the running back who runs right up the and so what you try is the exact same thing and it doesn't work and so what I argue is that the market can handle problems as severe as a severe economic crisis and that government bailouts cannot solve the problem and that that government bailouts actually make things worse, and that systemic government bailouts can turn a severe financial and economic crisis into a long-lasting economic depression.

17:59Let's look at the market. What can the market do to solve a huge problem like this? Well, we can look at what the market's already done to try to solve this problem, especially Prior to the bailouts becoming so large and so comprehensive and complicated, I've stopped even following the bailouts because they seem to change them every day. And I'm not sure if they're changing one to a new one or they're just adding on. It's very complex. But in the market, when the market sees problems, basically people change their plans. Changers change their plans, workers change their plans, businesses change their plans, entrepreneurs, investors, they all change their plans in order to deal with a changing economic environment.

18:50And that's what an economic crisis is, it's just a changing economic environment. For example, if businesses see that their business is slowing, they cut their prices. Individuals, businesses, institutions will very often raise cash. They'll save money and they'll put it aside to help them through the emergency situation. Large businesses, banks, financial institutions attempt to raise capital as a way of protecting themselves against economic uncertainty. And we certainly saw that with American banks and financial and Social Institutions Raising Cash from the Sovereign Wealth Funds, from Warren Buffett, from various other institutions and entities.

19:37A very important thing that market participants do is they sell losers. Whether that's an individual selling a stock that's a loser, whether that's a business that says, you know, the $4 gasoline, the Hummer, just probably isn't going to be a good idea. And so GM said, we're selling the Hummer Division. As a matter of fact, we'll give it away, probably, to anybody who's willing to take it. Businesses and individuals cut their investment plans. Businesses attempt to cut wages. They cut expenses. Individuals cut expenses. Businesses cut expenses. Institutions, Auburn University, cuts expenses. Well, maybe not Auburn, but all the rest. There's a general tend towards downsizing.

20:22We saw this in the American economy as we were entering into this crisis over the last 12 months. We've seen companies attempt to insulate themselves by merging with other companies. So as you find yourself falling towards bankruptcy, you want to merge yourself with another firm that has more solid financial footing and that they can combine their assets and abilities so that some of the firm that was in trouble survive. Some of their jobs survive. Some of their offices survive. Not everything, but at least some of it will through the process of merger. And then finally, there's bankruptcy. And bankruptcy is something that takes place all the time. It's a very natural process. When a company doesn't have the financial wherewithal to meet, doesn't have the assets to meet their liabilities, you go into bankruptcy Court, you get bankruptcy protection, the stockholders lose their money usually, bondholders normally take control, assets are sold off and the remaining viable part of the firms reemerge or are just kaput.

21:36But essentially assets are sold off to meet part of the liabilities and the result is that everything else goes forward. Customers aren't disrupted. If it's a viable firm, customers aren't disrupted. You still get your cable service or your electricity or whatever it happens to be. Now with a government bailout, with the prospects of a government bailout, everything changes. Instead of changing your plans, the question becomes, should we change our plans? Bailouts tend to be burdens on good firms, firms that did everything that was necessary going into the crisis to make to make sure their balance sheets were in good shape. At the same point that Washington was announcing a financial crisis leading to a Great Depression, there were some bank stocks that same week which were reaching 52-week highs.

22:29Not everybody took the bait. And so you bail out some firms with the taxpayer money, which means that some of these good firms are actually going to have to cough up money in one form or another to bail out the firms, the bad firms. Why bother selling out? Why bother merging? Why bother downsizing? Those are all the questions you have to ask as a firm or an institution when the government is proposing bailouts. And of course, it's not just an attack on the taxpayer. It's not just an attack on our future standard of living. It's also something that disadvantages good firms in the industry as well as vulture investors. Vulture investors are there with capital and money to deploy when things get extremely bad and they go in and pick up the pieces at pennies on the dollar.

23:24But there's a role for vulture investors. Those are exactly the types of investors you need to get market started. They say that, well, there's no market for these mortgage-backed securities. Well, if you let the firms go under and those mortgage-backed securities have to be thrown onto the auction market, the vulture investors come in, pick up these things on pennies on the dollar, and then other investors follow them into the market noticing that there's extreme profits to be made and markets are established. So you can't establish a market if you're offering bailouts to the people who are holding the problem assets. So all this bailout does is, first of all, it delays adjustments into the economy, into the economic correction.

24:13It's a burden to responsible borrowers, and there's plenty of people who took out the old-fashioned loans where you put down 20 percent, you take a 30-year fixed-rate mortgage, and they're making their payments. They haven't been late, and yet now we're saying, well, it's right across the political Let's bail out these irresponsible borrowers as well as the irresponsible lenders. You have to really ask yourself, does the government know which companies should survive? What information, what basis do they have on deciding which companies should and should not survive? I can't think of any basis on which they can make that decision, except political.

24:59And given that we have the CEO of Goldman Sachs running this whole bailout package, the former CEO of Goldman Sachs is now the Secretary of Treasury, Henry Paulson. He's the guy who wanted the $700 billion blank check, which has now only gotten bigger. And when they say Treasury sends in a team of experts into these institutions to find out what the status is, it's a team of Goldman Sachs experts. And there's just a tremendous problem of moral hazard that all of these bailouts cause. And this bailout is just one in a series of bailouts. So if we look at the market, what I see is that the market quickly corrects for these problems. The mortgage companies that came into existence during this bubble are now all gone.

25:49They've been gone for a long time. I think there was something on the internet called implodometer or something like that which detailed mortgage brokers that went out of business and it all happened extremely quickly. They're all gone. The market does a pretty good job at destroying unnecessary and harmful firms and institutions. The market tends to start the recovery very quickly and very cleanly. In fact, I suspect that if we had no bailouts, we would already be past the bottom in all this problem. And you know the world doesn't come to an end. Bailouts on the other hand only slow corrections, sometimes they even reverse the correction process. Bailouts save the nasty elements of the bubble, some of them anyway, and bailouts can actually prevent the economy from recovering.

26:39So instead of the world not coming to an end, the scare tactics in bailouts only worsen, lengthen the economic problems and indeed can cause economic depressions. Now the bailouts, we've had four, now four major bailouts in history where the government has gone in and systematically and comprehensively tried to bail out the economy and the financial sector and the economy. The first was the 1930s, at least in the United States. The Austrians argue that Herbert Hoover was not a non-interventionist economy, not a non-interventionist

27:50bailing out one thing after another, propping up one thing after another, government supports, programs for everything. There's nothing I can think of that wasn't in some sense intervened in. And the economy was in depression, was in severe recessions during the 1930s. It never really worked itself out. World War II began and we shipped 10 million men, working age men, out of the country and the unemployment rate dropped. I'm not sure how that happened statistically, but that's what happened. In the 1970s, in the United States, we had a bubble economy during the 1960s, and we got in trouble in the early 1970s, 71, 72, and the government tried to bail out the economy.

28:41We had comprehensive wage and price controls. We went off the gold standard. I mean, these are serious changes in the overall economy. And then you have the Fed trying to revive the economy and, of course, deficit spending reared its ugly head during the 1970s for the first time, really, in any non-war situation. And the economy stagnated. We had the highest combinations of unemployment rates and inflation rates practically in our history. 1990s Japan stagnated economically with recessions, rolling recessions, no growth in their economy. They had a bubble during the 1980s and they tried to bail themselves out. They drove the federal funds rate in Japan anyways down to zero, to zero.

29:29They undertook the world's, probably one of the world's greatest public works projects and I don't mean it was great stuff, I mean it was just the biggest. And they went from one of the best countries in terms of national debt to one of the worst because they were running deficits the whole time. You got government, public works, public spending, Federal Reserve, or their central bank, the Bank of Japan, basically pressing all of the buttons possible to try to revive their economy and nothing happened for more than 10 years. Their housing market, housing prices in Japan declined for more than 15 years. where they had some demographic issues, but housing prices declining, real estate prices declining for more than 15 years.

30:18In each of those three cases, there was a bubble for a long period of time. There was an economic crisis which was addressed by government with massive bailouts. In each of those cases, the economy remained at crisis or stagnating levels for about a decade. In each three of those cases, there were cheerleaders, even amongst economists, that those bubbles would never break, that this was a new era in the 1920s. It was a new era in the 1960s. It was a new era in Japan in the 1980s. If we didn't adopt Japanese methods, we were told we would be buried economically. We would be playing second fiddle to Japan. And so that is essentially the backdrop to what we face today.

31:07We don't have many situations where the market was allowed to work unobstructed since the Federal Reserve came into being in 1913. The depression of 1921, Warren Harding was the president. Two most important things on his agenda was having his buddies over to the White House to drink and then to play cards. So he didn't do much about the depression. and it was over by sometime in 1921, I mean, excuse me, 1922. When Paul Volcker became the chairman of the Fed, he basically said, we're not going to help you. We're letting interest rates rise to wherever they need to, to choke out this inflation. Good luck. And about 12 months later, he had rung out the inflation out of the economy and the economy began to grow.

31:58in basically the 1980s was a relatively unobstructed period of economic growth. In 1946 after World War II, of course we've got those millions of working men who couldn't find a job when they left, they're all coming home. Everything in our economy was set up to produce war goods. The Keynesian economists said, we're doomed, we're going right back into the Great Depression. Fortunately, Harry Truman said, we're going to decontrol prices, we're going to allow for a pretty good sway of the market economy, we're going to go back onto the gold standard, and the economy recovered. And the late 1940s was one of the greatest periods of growth in per capita real consumption in American history.

32:45And then of course there are other minor little things like the Enron situation, which had become one of the biggest companies in the United States, it was part of the whole tech financial bubble, somebody noticed that, a market analyst noticed that, announced it, the stock price fell to practically zero, the company went out of business, its assets were transferred to other managers, didn't stop selling gas or cable services or anything, The prosecution of the so-called criminals took so long that two of the main criminals were dead before they could be punished. So that's the dichotomy I see, and so I don't think bailouts are necessary.

33:33I think that bailouts are very dangerous policy proposals and it really unnerves me to find every time I turn the TV on, either a new bailout is being proposed or put into place. That's all I have.