Arnold Kling  

Things I'm Glad I Never Said

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Paul Krugman, writing in August of 2002:


To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

Thanks to a this comment for the pointer.

Prophetic. You have to give him that.


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CATEGORIES: Macroeconomics



COMMENTS (38 to date)
JPIrving writes:

Good thing you didn't say that...they might have given you a Nobel...

silvermine writes:

...And Greenspan now works for PIMCO.

Jesse writes:

Oh God Krugman must be so embarassed.

Look at this 2005 op-ed when he also wrote about Paul McCulley and the housing bubble.

Remember the stock market bubble? With everything that's happened since 2000, it feels like ancient history. But a few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses.

I've never fully accepted that view. But looking at the housing market, I'm starting to reconsider.

In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. ''There is room,'' he wrote, ''for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing.''

As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst.

Now the question is what can replace the housing bubble.

Nobody thought the economy could rely forever on home buying and refinancing. But the hope was that by the time the housing boom petered out, it would no longer be needed.

But although the housing boom has lasted longer than anyone could have imagined, the economy would still be in big trouble if it came to an end. That is, if the hectic pace of home construction were to cool, and consumers were to stop borrowing against their houses, the economy would slow down sharply. If housing prices actually started falling, we'd be looking at a very nasty scene, in which both construction and consumer spending would plunge, pushing the economy right back into recession.

That's why it's so ominous to see signs that America's housing market, like the stock market at the end of the last decade, is approaching the final, feverish stages of a speculative bubble.

Oh God so humiliating. Who let this guy write in the New York Times???

Troy Camplin writes:

Honestly, when one makes comments like that, how can anyone take him seriously as an economist? I know more economics than that. It's almost as if Krugman made that one contribution that got him the Nobel, and then it's been nothing more than an expression of economic ignorance ever since.

baconbacon writes:

In a blog post today Krugman mocks Schumpeter on the GD. He quotes him- and immediately after the line Krugman cuts off is a profound insight that PK will probably never get.

Schumpter

"For the truouble is fundamentally not with money and credit, and policies of this class are particularly apt to keep up, and add to, maladjustment, and to produce additional trouble in the future."

True about the 30s, true now. The re-inflating of the Nasdaq bubble lead to greater issues and more malinvestment while Krugman supports ideas that lead to disaster.

Devin Snead writes:

It's getting harder and harder for me to see Krugman as a real economist anymore. I see him more as a hackonomist.

Selfreferencing writes:

Jesse,

First of all, the 2005 article doesn't suggest that the housing bubble had to burst. Instead, I presume that Krugman had the view then that he has now - keep the bubble going with credit creation.

And the 2002 column still makes him look bad. He was for the housing bubble before he was concerned about it. But his concern wouldn't lead him to recant the policies that created the bubble. After all, Krugman famously calls the view that booms are unsustainable and thus must come to an end 'the hangover theory'.

Anyway, Krugman doesn't look so bad if he can successfully argue that (a) the housing bubble should have been created, (b) that it should have been prevented from bursting, and (c) that now that it has burst, it should be re-inflated with credit expanding and fiscal policy.

But defending all three looks pretty hopeless. In fact, it looks insane. And that's why the 2002 piece makes him look so bad. Because he supported the housing bubble then and appears to have supported keeping it going until the present day and now supports re-inflating it.

Second, in any event, your '05 Krugman piece makes him look pretty inconsistent.

Jesse writes:

I really don't see the inconsistency between the 2002 and 2005 pieces. In 2005 Krugman says:

Nobody thought the economy could rely forever on home buying and refinancing. But the hope was that by the time the housing boom petered out, it would no longer be needed.

But although the housing boom has lasted longer than anyone could have imagined, the economy would still be in big trouble if it came to an end.


This would be inconsistent with the 2002 article if Krugman believed that recessions were the inevitable result of boom times, and that easy credit would necessarily cause a recession. But he doesn't; he calls that the "hangover theory" and dismisses it.

While we're on the subject of consistency, it appears that everyone here knew that the economy during Bush's Presidency was a mirage, with the housing bubble masking a deep rot and just postponing (if not creating) an inevitable recession. It's really too bad that no one bothered to say anything at the time.

Al T writes:

More evidence the we need to regulate pundits.

Markets are good for some things, but public goods, like public speech, clearly aren't one of them.

Eric H writes:

Is Krugman prophetic, or just another modern liberal statist?

Isn't the Obama administration working to create another bubble in some other sector, say "alternative energy"?

Ben writes:

If you think that quote was bad, read these ones.

German Interview, undated
http://www.pkarchive.org/global/welt.html
“During phases of weak growth there are always those who say that lower interest rates will not help. They overlook the fact that low interest rates act through several channels. For instance, more housing is built, which expands the building sector. You must ask the opposite question: why in the world shouldn't you lower interest rates?”
July 18, 2001
http://www.pkarchive.org/economy/ML071801.html
“KRUGMAN: I think frankly it's got to be -- business investment is not going to be the driving force in this recovery. It has to come from things like housing, things that have not been (UNINTELLIGIBLE).
DOBBS: We see, Paul, housing at near record levels, we see automobile purchases near record levels. The consumer is still very much in this economy. Can he or she -- or I should say he and she, can they bring back this economy?
KRUGMAN: Well, as far as the arithmetic goes, yes, it is possible. Will the Fed cut interest rates enough? Will long-term rates fall enough to get the consumer, get the housing sector there in time? We don't know“
August 8th 2001
http://www.pkarchive.org/economy/ML082201.html
“KRUGMAN: I'm a little depressed. You know, inventories, probably that's over, the inventory slump. But you look at the things that could drive a recovery, business investment, nothing happening. Housing, long-term rates haven't fallen enough to produce a boom there. The trade balance is going to get worst before it gets better because the dollar is still very strong. It's not a happy picture.”
August 14, 2001
http://www.pkarchive.org/column/81401.html
“Consumers, who already have low savings and high debt, probably can't contribute much. But housing, which is highly sensitive to interest rates, could help lead a recovery…. But there has been a peculiar disconnect between Fed policy and the financial variables that affect housing and trade. Housing demand depends on long-term rather than short-term interest rates — and though the Fed has cut short rates from 6.5 to 3.75 percent since the beginning of the year, the 10-year rate is slightly higher than it was on Jan. 1…. Sooner or later, of course, investors will realize that 2001 isn't 1998. When they do, mortgage rates and the dollar will come way down, and the conditions for a recovery led by housing and exports will be in place.
October 7, 2001
http://www.pkarchive.org/economy/ML071801.html
“Post-terror nerves aside, what mainly ails the U.S. economy is too much of a good thing. During the bubble years businesses overspent on capital equipment; the resulting overhang of excess capacity is a drag on investment, and hence a drag on the economy as a whole.
In time this overhang will be worked off. Meanwhile, economic policy should encourage other spending to offset the temporary slump in business investment. Low interest rates, which promote spending on housing and other durable goods, are the main answer. But it seems inevitable that there will also be a fiscal stimulus package“
Dec 28, 2001
http://www.pkarchive.org/column/122801.html
“The good news about the U.S. economy is that it fell into recession, but it didn't fall off a cliff. Most of the credit probably goes to the dogged optimism of American consumers, but the Fed's dramatic interest rate cuts helped keep housing strong even as business investment plunged.”

Billy writes:

From the article, I gathered that Krugman agreed that a major increase in household spending was necessary but wasn't too confident that Greenspan could accomplish this by creating a housing bubble. However, he attributed his doubt not to the reality that the federal reserve can't manipulate the economy as easily as the textbooks tell us, but to the fact that Greenspan's crystal ball had been "murky."

This must have been an embarrassing realization for Krugman considering that he wrote this for Slate back in 1997:

Indeed, if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.
Patrick writes:

Jesse wrote:
"While we're on the subject of consistency, it appears that everyone here knew that the economy during Bush's Presidency was a mirage, with the housing bubble masking a deep rot and just postponing (if not creating) an inevitable recession. It's really too bad that no one bothered to say anything at the time."

Jesse, if you bothered to read John Mauldin's writings you would have realized back as early as 2004-05 that a) the economy was being artificially propped up by Mortgage Equity Withdrawals (MEWs) & that without impact of MEWs the economy was doing poorly, b) housing prices were out of whack using any of a number of analyses to gauge "fair value".

Further, if you read "Manias, Panics and Crashes", predicting a housing bubble post-dotcom bubble was easy. Kindleberger demonstrates repeatedly in that fascinating book that real estate bubbles frequently follow on the heels of bursting of other asset bubbles.

Sorry if you didn't take notice of the evidence, but it was right there in the open. And people were talking about it - just not most people.

Troy Camplin writes:

Anybody who wants a bubble is an idiot. Bubbles, by definition, cannot be prevented from bursting. Further, one does not fix a problem by throwing more of what caused the problem in the first place at it. "You know what this rusty old bike needs? A high humidity, high-oxygen environment!"

In 1994, I received a scholarship from the economics dept. at Western Kentucky University. In granting me the scholarship, Robert Pulsinelli, with whom I had only had Econ 100 (my only economics class) told me he had chosen to give it to me because, "You understand economics better than any of my graduate students." I thought he was being generous. With people like Krugman around, I'm not so sure anymore. Especially since I find myself invited to things like the Liberty Fund colloquium on Hayek nowadays. I have degrees in the humanities, English, and molecular biology, but it's always work in economics that has paid me anything. Maybe I should take the hint.

The Rage writes:

It wasn't the "FED" that created the housing bubble, it was the market that did. Basically you see it begin in the 4th quarter in 2001 as it became the "new" thing. New products in mortgage innovation which came from the 82-00 boom were starting to be employed. The regulators never had a chance to catch up as the Bush Admin told them essentially to cease and desist.

You gotta remember, we had 18 years of a big economic boom in tech and new re-development of the world. It provided for expansive credit BECAUSE of the growth during this period, really hittings its nadir between mid/96-00 in America (03-07 in the rest of the world). Since then, the economy in real terms, has been stagnate.

So, we have a Bush presidency who basically, instead of capitulating and admitting the boom was over, basically urging the market on, helped the market further enjoy themselves by helping the housing bubble, a important piece of the credit bubble. The FED was outright bullied into helping it along from the "strange" 9-11 attacks to Bush's direct financial gurus: The Koch's.

You see, this just shows how wrong the "credit cycle" theorists are. It isn't the credit cycle that is at issue, but the real ability of economies to grow. When that is dulled, you have problems.

1969 was the last nadir and poor decisions by the government and market were seen then as well. Nobody wants to admit the party is over and thus will do anything to keep it going. You could argue 1926 was a similiar nadir.

Troy, we always have bubbles: canal bubbles, railroad bubbles, industrial bubbles, tech bubbles. It is called economic growth.

Green Energy isn't going to create a bubble though it could have big impact on growth down the road(especially if nuclear fusion becomes reality by mid-century).

Krugman sounded scared out of his mind by 2005. You could tell, though he tries to hide it.

So as they say, it is time to ration. The bleakness will last for awhile.

Jeremy, Alabama writes:

Krugman's ideas are not economic management, but what engineers call "provocative maintenance". You don't swallow the spider to catch the fly.

The "reason" comment you highlight is followed by some other good ones, including slams on economists and climatologists. I have always felt that if you want to understand climate, you have to ask a geologist. I feel some dazzling repartee welling up, along the lines of "if you want to understand economics, you ask a hog farmer", but that does not quite get it. Maybe you ask a geologist.

Boonton writes:

Will someone care to explain how low short term interest rates can create a housing bubble?

Think about it. If the Fed has interest rates 'too low' the market will fear inflation. Long term bonds will fall in price and the yield curve will get steeper. How can a housing bubble arise if mortgage rates are going up?

If the rate cuts are not 'too low' then you're essentially saying the economy is in a recession and needs monetary stimulus. That means a housing bubble can't be created on purpose but may happen in a healthy economy. Sure you can prevent bubbles, just keep the economy in a recession. There were few bubbles between 1930 and 1940.

2. "Anybody who wants a bubble is an idiot. Bubbles, by definition, cannot be prevented from bursting. Further, one does not fix a problem by throwing more of what caused the problem in the first place at it. "You know what this rusty old bike needs? A high humidity, high-oxygen environment!""


Yea well we don't really know that. A while ago there was a NYT story about people who suddenly had fatal tumors but when they were checked a few weeks later they were totally clean. The hypothesis is that people may get tumors all the time that disappear without ever being picked up in medical exams. Bubbles may deflate all the time peacefully but we don't recognize them as such because they are causing so little commotion. So:

a. I haven't seen anyone here show how Greenspan 'created' a housing bubble. Let me suggest that even back in 2001 many people sensed a housing bubble was happening but attributing it to Greenspan was a fallacy. I think Greenspan could have stopped the bubble by wrecking the economy...but that's hardly the same as saying he could call on into existence. Further evidence, interest rates and monetary stimulus are lower and greater today than they ever were in 2001. Where's the housing bubble now?

b. It isn't clear that bubbles are the problem. I suspect bubbles are a normal but random feature of the economy. They might often be small and beneficial or even large and beneficial (the dot-com bubble spurred a lot of investment in IT infrastructure, tested out several new business models and even found a few good ones (Amazon.com etc.)). I would put forth a counter argument that the bubble isn't as much of a problem as the bursting of the bubble. If the bursting is what causes the problem then you do indeed apply 'more of the what caused' it as the solution.

JS writes:

If the Fed didn't create the housing bubble, or at least strongly influence it, what would it take for the Fed to actually create a housing bubble, assuming Krugman is right and that it is possible for the Fed to do.

SydB writes:

I just read that opinion by Krugman and don't find him arguing for a housing bubble. He's saying that's what Greenspan is going to do, will have to do. And Krugman was right.

Where does Krugman say that's what we should do?

While all the commenters above pile on Krugman, what Krugman seems to be saying is that Greenspan is much too cheerful and the only way he will continue his cheer is by creating a housing bubble.

I will summarize Krugman's opinion: (1) the underlying economy has problems; (2) Greenspan is positive thus ignoring the underlying problems; (3) the only way Greenspan can remain euphoric is by creating a housing bubble.

Krugman's focus is on the underlying conditions, not arguing for a housing bubble.

Am I wrong?

SydB writes:

"I haven't seen anyone here show how Greenspan 'created' a housing bubble."

(1) Negative real interest rates.

(2) Cheerleading variable rate loans shortly before interest rates started going up.

(3) Ignoring levers available to him to tighten up sloppy lending practices.

Boonton writes:

If the Fed didn't create the housing bubble, or at least strongly influence it, what would it take for the Fed to actually create a housing bubble, assuming Krugman is right and that it is possible for the Fed to do.

I would say it can't. Suppose the Fed printed money and directly started to buy houses with it. Maybe that would cause a housing bubble...then again it might cause an equal number of people to sell housing short to mop up the Fed's printing press making the intended housing bubble into your run of the mill general inflation.

A bubble essentially needs the market to act irrationally. The problem with this is that it's not quite as easy as just saying 'please act irrationally now'. If you don't have that, you won't get a bubble. Bubbles, therefore, need money sloshing around in the economy so an economy in a recession (i.e. 1930) is not going to generate bubbles but that doesn't mean bubbles can be created at will.

I think Krugman's column recognized a new bubble forming but, like many, incorrectly attributed its creation to Greenspan's supposedly mystical powers.

Max writes:

@Jeremy:

True, I view climate models with the same distain and the same expectation of a good and robust result as financial models: A lot of distain and no results. And financial tools had a lot more time to get tuned against a lot of data that was more reliable than any temperature record!

Having designed control systems for many engineering application, I have to say ground-work is essential and often has the people that do understand the whole system better than some statistician who only has the data and some approximate equations at hand. This is why engineers in the field find and solve problems that never occured to the simulation specialists in the first run and why simulation specialists always have to consider real field-experiments to adjust or validate their models. Both are things that the climate science field does not do as far as I am aware and which is impossible for the financial field. That's why I think that most of these models fall apart if one variable (or believed constant) suddenly changes in a way that was not anticipated because they never could do field-tests...

Troy Camplin writes:

Bubbles do not equal growth. That shows an ignorance of both the nature of bubbles and the nature of growth. Bubbles are created by government interference. In this case, with the housing bubble, it was the fed creating artificially low interest rates to encourage risky loans. We get bubbles form bad information; we good healthy growth from good information. Government creates bad information. To say a bubble is growth is to equate cancer with growth. Yes, cancer grows, but it will eventually create an unhealthy organism, if not kill it. Healthy growth is not cancer, and it is not a bubble. Again, anyone who supports the creation of a bubble is a idiot. And Krugman is the king of the idiots.

Ike writes:

It is dishonest to clip a quote from the article, which argues as a whole that the Bush and Greenspan policy is to create another bubble, to continue "irrational exuberance", and say that Krugman argues we "need" another bubble. Read the entire article.

Your post is something you should have been glad not to say.

Dubya's Double Dip?

By PAUL KRUGMAN
If the story of the current U.S. economy were made into a movie, it would look something like ''55 Days at Peking.'' A ragtag group of ordinary people -- America's consumers -- is besieged by a rampaging horde, the forces of recession. To everyone's surprise, they have held their ground.

But they can't hold out forever. Will the rescue force -- resurgent business investment -- get there in time?

The screenplay for that kind of movie always ratchets up the tension. The besieged citadel fends off assault after assault, but again and again rescue is delayed. And so it has played out in practice. Consumers kept spending as the Internet bubble collapsed; they kept spending despite terrorist attacks. Taking advantage of low interest rates, they refinanced their houses and took the proceeds to the shopping malls.

But predictions of an imminent recovery in business investment keep turning out to be premature. Most businesses are in no hurry to go on another spending spree. And those that might have started to invest again have been deterred by sliding stock prices, widening bond spreads and revelations about corporate scandal.

Will the rescuers arrive in the nick of time? Not necessarily. This movie may not be ''55 Days at Peking'' after all. It may be ''A Bridge Too Far.''

A few months ago the vast majority of business economists mocked concerns about a ''double dip,'' a second leg to the downturn. But there were a few dogged iconoclasts out there, most notably Stephen Roach at Morgan Stanley. As I've repeatedly said in this column, the arguments of the double-dippers made a lot of sense. And their story now looks more plausible than ever.

The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

Judging by Mr. Greenspan's remarkably cheerful recent testimony, he still thinks he can pull that off. But the Fed chairman's crystal ball has been cloudy lately; remember how he urged Congress to cut taxes to head off the risk of excessive budget surpluses? And a sober look at recent data is not encouraging.

On the surface, the sharp drop in the economy's growth, from 5 percent in the first quarter to 1 percent in the second, is disheartening. Under the surface, it's quite a lot worse. Even in the first quarter, investment and consumer spending were sluggish; most of the growth came as businesses stopped running down their inventories. In the second quarter, inventories were the whole story: final demand actually fell. And lately straws in the wind that often give advance warning of changes in official statistics, like mall traffic, have been blowing the wrong way.

Despite the bad news, most commentators, like Mr. Greenspan, remain optimistic. Should you be reassured?

Bear in mind that business forecasters are under enormous pressure to be cheerleaders: ''I must confess to being amazed at the venom my double dip call still elicits,'' Mr. Roach wrote yesterday at cbsmarketwatch.com. We should never forget that Wall Street basically represents the sell side.

Bear in mind also that government officials have a stake in accentuating the positive. The administration needs a recovery because, with deficits exploding, the only way it can justify that tax cut is by pretending that it was just what the economy needed. Mr. Greenspan needs one to avoid awkward questions about his own role in creating the stock market bubble.

But wishful thinking aside, I just don't understand the grounds for optimism. Who, exactly, is about to start spending a lot more? At this point it's a lot easier to tell a story about how the recovery will stall than about how it will speed up. And while I like movies with happy endings as much as the next guy, a movie isn't realistic unless the story line makes sense.

Josh Hill writes:

SydB, I agree 100%. Nowhere do I see Krugman advocating a housing bubble, as opposed to saying that Greenspan will have to do this to do what he -- Greenspan -- wants. In fact, his remark is fairly sardonic, a subtlety that seems to have passed over the head of Mr. Kling.

Those who aren't convinced should read the entire article, rather than the (intentionally?) out-of-context quote. Krugman goes on to say, "The administration needs a recovery because, with deficits exploding, the only way it can justify that tax cut is by pretending that it was just what the economy needed. Mr. Greenspan needs one to avoid awkward questions about his own role in creating the stock market bubble." Hardly the words of a cheerleader.

In actuality, Krugman was one of the few to warn against the housing bubble. Repeatedly. Those of us who read (and dare I say understood) his columns were anything but surprised when the bubble burst. And I guess that bothers some people.

Boonton writes:

Troy, you've provided no arugment or evidence to back up your assertions either that bubbles are government creations, that the housing bubble was due to low short term rates or that bubbles are always unhealthy in a roboust economy.

jsh writes:

"Nowhere do I see Krugman advocating a housing bubble"

This is from 2006:

http://krugman.blogs.nytimes.com/2006/10/30/credit-where-credit-is-due/?pagemode=print

Neeraj Mehra, Amritsar, India: Mr. Greenspan has done a disservice to the nation by creating the housing boom. As a layman-observer, that’s the lingering thought I’ve had. Your article reaffirms it.

The question I have is this: Did he do the right thing — acting morally by engineering a housing boom, more as a bridge loan, until something else showed up at the horizon to shore up the economy — because he didn’t have a choice, or did he undertake a path of mere political expediency? And, that’s a question that’s nagging me for a while.

Would appreciate it if you could shed some light.

Paul Krugman: As Paul McCulley of PIMCO remarked when the tech boom crashed, Greenspan needed to create a housing bubble to replace the technology bubble. So within limits he may have done the right thing. But by late 2004 he should have seen the danger signs and warned against what was happening; such a warning could have taken the place of rising interest rates. He didn’t, and he left a terrible mess for Ben Bernanke.

SydB writes:

Based upon further quotes from those above, it's clear to me that Krugman was stating his belief that Greenspan was creating the conditions for another bubble, Krugman had concerns about it--what's on the other side of the housing bubble?--and that once the housing bubble took off Greenspan should have tightened up lending.

Krugman was right on the money with this one. I'm not sure what the point of Kling's post was. I think he has a duty in this blog to clarify his point for us. It's very easy in the blogging sphere to sling political mud. Is that what Mr Kling was trying to do? Was he agreeing with Krugman? Or what? His objective is totally confusing to me. It seems to me he was trying to gain political points with a limited quote, having not read the context showing Krugman's overall understanding of the issue.

Boonton writes:

jsh,

First, your quote is Krugman speaking retrospectively. Did he advocate a housing bubble or say in retrospect that a bit of a bubble in 2001 was a good idea but by 2004 it should have been surpressed? Your quote is from 2006 looking backwards so that doesn't really address the question of what, if anything, Krugman was advocating in 2001.

More importantly, though, the question should be addressed. What should have been done in 2001? No monetary or fiscal stimulus even though it appeared the economy was in a recession from the combo of 9/11, the tech bubble bursting and other things? Raised interest rates to ensure the deep recession arrived in 2001 rather than 2008?

Why? Because housing might have become a bubble. But how would one have known this in 2001? We know from observation that bubbles happen in all types of goods from housing to tulips to dot-com companies with implausible business plans. What in 2001 would have told me that low interest rates would result in a housing bubble rather than, say, a housing recovery coupled with recovery in a few other sectors of the economy like business investment?

The answer is nothing so the question has to probe a bit deeper. Was the problem with the housing bubble that it got started in the first place or was it the refusal to recognize it crossing the line from a rational recovery to an irrational bubble? If it was the second then Krugman was quite right to simply report what was going on in 2001, not raise the red flags and so on. Krugman's point, IMO, is valid.

Suppose in 2004 Greenspan was talking up the dangers of a housing bubble. What if he told people to beware of adjustable rate mortgages and exotic new types of loans that could leave you with unmanageable payments instead of hyping 'innovation' in the lending sector and telling consumers to get adjustable rate mortgages because they are 'cheaper' (something an economist as smart as him really has no excuse for, they are cheaper because you are taking on interest rate risk rather than the lender). The bubble might have paused a bit and wimpered out without a crash.

Barring that, though, there is another question of whether the Fed should be in the business of 'deflating bubbles'. I would say no it shouldn't. It should let the market pop its own bubbles and use its powers to keep the damage from the popping contained.

Josh Hill writes:

?

"Within limits," "*may* have done the right thing," and then "should have seen the danger signs." Seems to me an observation and a statement that Krugman isn't sure whether Greenspan was right in his initial decision rather than an endorsement, followed by criticism of Greenspan's failure to apply the brakes when "irrational exuberance" got to the point where it endangered the economy. Which seems to me a reasonable take . . .

Josh Hil writes:

In this context, I think it's worth reading what Krugman wrote in 2005:

Remember the stock market bubble? With everything that's happened since 2000, it feels like ancient history. But a few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses.

I've never fully accepted that view. But looking at the housing market, I'm starting to reconsider.

In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. "There is room," he wrote, "for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing."

As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst.

Now the question is what can replace the housing bubble.

Nobody thought the economy could rely forever on home buying and refinancing. But the hope was that by the time the housing boom petered out, it would no longer be needed.

But although the housing boom has lasted longer than anyone could have imagined, the economy would still be in big trouble if it came to an end. That is, if the hectic pace of home construction were to cool, and consumers were to stop borrowing against their houses, the economy would slow down sharply. If housing prices actually started falling, we'd be looking at a very nasty scene, in which both construction and consumer spending would plunge, pushing the economy right back into recession.

That's why it's so ominous to see signs that America's housing market, like the stock market at the end of the last decade, is approaching the final, feverish stages of a speculative bubble.

Some analysts still insist that housing prices aren't out of line. But someone will always come up with reasons why seemingly absurd asset prices make sense. Remember "Dow 36,000"? Robert Shiller, who argued against such rationalizations and correctly called the stock bubble in his book "Irrational Exuberance," has added an ominous analysis of the housing market to the new edition, and says the housing bubble "may be the biggest bubble in U.S. history."

In parts of the country there's a speculative fever among people who shouldn't be speculators that seems all too familiar from past bubbles - the shoeshine boys with stock tips in the 1920's, the beer-and-pizza joints showing CNBC, not ESPN, on their TV sets in the 1990's.

Even Alan Greenspan now admits that we have "characteristics of bubbles" in the housing market, but only "in certain areas." And it's true that the craziest scenes are concentrated in a few regions, like coastal Florida and California.

But these aren't tiny regions; they're big and wealthy, so that the national housing market as a whole looks pretty bubbly. Many home purchases are speculative; the National Association of Realtors estimates that 23 percent of the homes sold last year were bought for investment, not to live in. More than 30 percent of new mortgages are interest only, a sign that people are stretching to their financial limits.

The important point to remember is that the bursting of the stock market bubble hurt lots of people - not just those who bought stocks near their peak. By the summer of 2003, private-sector employment was three million below its 2001 peak. And the job losses would have been much worse if the stock bubble hadn't been quickly replaced with a housing bubble.

So what happens if the housing bubble bursts? It will be the same thing all over again, unless the Fed can find something to take its place. And it's hard to imagine what that might be. After all, the Fed's ability to manage the economy mainly comes from its ability to create booms and busts in the housing market. If housing enters a post-bubble slump, what's left?

Mr. Roach believes that the Fed's apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he's wrong. But the Fed does seem to be running out of bubbles.

http://www.pkarchive.org/column/052705.html

Patrick writes:

boontoon writes:
"Barring that, though, there is another question of whether the Fed should be in the business of 'deflating bubbles'. I would say no it shouldn't. It should let the market pop its own bubbles and use its powers to keep the damage from the popping contained."

Ok, if you want to go with this line of reasoning, then the Fed has to actually let the bubble pop. The Fed can't continue to pump air into the balloon and further expand it.

SydB writes:

Patrick wrote: "Ok, if you want to go with this line of reasoning, then the Fed has to actually let the bubble pop. The Fed can't continue to pump air into the balloon and further expand it."

Exactly. It's a difficult question. What is a money supply? What is inflation? Is inflation a basket of goods? A particular good or service (e.g. housing or oil)? It's not defined at all.

I may be mistaken, but I think Krugman's point was that Greenspan thought he could solve the problem of the crash and its effect on the overall economy through money supply alone, which would quite possibly lead to a housing bubble.

Boonton writes:

Ok, if you want to go with this line of reasoning, then the Fed has to actually let the bubble pop. The Fed can't continue to pump air into the balloon and further expand it.

The error is assuming the bubble is a creature of the Fed or the gov't rather than a feature of the market itself.

Where is this bubble today? Interest rates are super low still, stimulus is in full gear. If bubbles have to be popped by the Fed, well they never took the pin out from the 'In case of Bubble, break glass'!

Yet the bubble popped more or less on its own. Seen from this light, the low rates of 2001 were a sensible response to the tech bubble's pop. The low rates of 2008/9 were likewise a good response to the housing bubble's pop.

This makes perfect sense from monetary theory. When a bubble pops, people get scared and want more liquidity. If more liquidity is not provided, the economy crashes into a deflationary spiral. Is the fear here that there might be another bubble in ten years? If so, then so what? If inflation is not a problem let the money supply grow as needed. There weren't any bubbles between 1930 and 1940. Was that a better policy?

Jerome writes:

Sorry, I'm new here. But as much as I despise political hack Paul Krugman, it seems to me that in 2001 he saw very clearly the recession-recovery device of a run-up in housing prices, construction, and the related credit market tool of real estate financing. Not rocket science, maybe, but he was certainly correct in that.

I have no idea what he meant by declaring that the Greenspan Fed "needs" a housing bubble - was he advocating a policy of low rates to induce the price run-up? Or was he lamenting the excessive use of market manipulation by the Fed to keep our economic bubble from bursting?

In 2005, he seems to regret the coming burst, fearing, as many of us did, the effect on the entire economy as prices fell. I see no recommendation from him at that point, and thus I conclude as always that he is a minor-leaguer and a partisan hack, and that Princeton only sullies their otherwise sterling reputation by associating with him.

But that doesn't change the fact that his 2001 and 2005 comments both are dead-center-correct. When you're right, you're right.

Josh Hill writes:

Jerome,

Don't know why you call Krugman a hack. He's first and foremost a Nobel Prize-winning economist, and having read his columns, it's easy to see why -- he's almost always right and not infrequently prescient. Not to mention that he's willing to express uncertainty when he doesn't know, as he did here, something that political hacks of whatever stripe are usually unwilling to do.

M. Report writes:

So the best Con Artists work for the Fed;
This is News ? :)

Seems to me that Heinlein's Cautionary Comment
says it all:
Government attempts to stimulate the economy
always act as positive feedback, causing the
system to oscillate out of control.

Magic Dog writes:

What's all the carping about? Krugman made a great call. He has every reason to feel good about it.

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