Garett Jones  

Bubbles: Who to blame?

Debt: The Stickiest Price of A... Feldstein and Rosen on Romney ...

I believe in bubbles.  They turn up in theory, in the lab, in history. We are a bubbly species, prone to waves of enthusiasm that crash upon the shore.

Our financial crisis is often told as a story of a housing bubble that crashed and created financial chaos, bad policy choices, a more polarized politics.  But what kept the bubble growing for so long? 

Vernon Smith, emeritus professor here at GMU, ran experiments that I think give us a good reason to blame the Fed and Fannie and Freddie for a fair amount of the financial crisis--but for some reason, I don't see other economists connecting the dots the way I have. 

Back in the 80's, Smith and his coauthors ran the first bubble experiments: Students (and professional traders!) kept creating asset price bubbles in these experiments. Lab subjects routinely traded these assets at freely-negotiated prices that were far above their objective cash value.  But he found that as subjects played the same game again and again, bubbles became less common--people learned the lesson of The Who: "Won't Get Fooled Again."

One lesson a person could draw at this point: Perhaps lab bubbles don't really tell us about real life.  After all, real life lasts a long time, and people in real life hear stories about bubbles, so maybe normal people are already at the Won't Get Fooled stage.

But a funny thing happened: The bubble literature grew.  A key finding:

When you add liquidity to the market--even with the same set of experienced players--you can reignite bubbles.  Liquidity creates bubbles

Did we see liquidity pushed into the housing market?  Of course we did.  Not just the Federal Reserve's low rates in the mid-2000s (lower than the Taylor Rule recommended); we also saw the massive entry by Fannie and Freddie into the fringes of subprime, the most dangerous portion of the market.

The private sector created the housing bubble in the same sense that college students created bubbles in Smith's experiments: They voluntarily made the trades but Fannie, Freddie, and the Fed created a liquid, bubble-prone environment. 

Humans are a bubbly species: Good government policy should take that into account before creating an agency whose mission is "to provide the mortgage market."

P.S. To those who think Fannie and Freddie had little subprime involvement: The SEC begs to disagree.  Great PDF image from the SEC here

Comments and Sharing

COMMENTS (39 to date)
F. Lynx Pardinus writes:

Is this the economic version of "she was asking for it"?

david writes:

The beginning of the post seems to be missing.

Jim writes:

I'm by no means an expert on government programs aimed at providing financial assistance to college bound students. However in my view it seems that the liquidity created by such programs will result in similar consequences described above. These loans are made at below market rates on an unsecured basis to students, in which the primary repayment source is derived from their expected placement into the job market, which is suspect at best. Given the pace of tuition growth and high unemployment, is higher education the next bubble?

Jason writes:

The Taylor Rule graph uses realized inflation, not expected inflation. The Fed put a paper out which argues that rates were in line with a Taylor Rule when you use measures of expected inflation that were known at the time interest rates were set.

Ken B writes:

I cannot help myself: whom to blame.

Garett Jones writes:

@Ken B: +1. But when I wrote it, it just sounded pedantic, so I went to "Who."

The "Who is" formulation appears modal, I'd love a grammatical explanation for why that's so.

@Jason, True.

But note that Taylor's original Taylor rule used lagged inflation---In my view, that's a real power of the Taylor Rule. It uses facts on the ground, not forecasts.

Normal theory says expected inflation should be in the rule, but since inflation is endogenous to the Fed's behavior, the metaphysics of the issue aren't trivial.....

Using lagged inflation breaks that loop---and weakens our ability to use behavioral biases when deciding on an inflation rate.

In any case, as good Bayesians we should place at least a little weight on the view that the financial crisis vindicates Taylor's lagged inflation version of the Taylor Rule.

David N writes:

I don't think liquidity is a necessary condition for bubbles. I'm sure we can find examples in history where there wasn't a market maker, or where entrepreneurs performed that role after recognizing an opportunity. Then we might say that bubbles create liqudity.

Fannie and Freddie are certainly not blameless with respect to the housing bubble, but they didn't keep interest rates low for a decade. They didn't bribe appraisers. They didn't rate securities. They didn't lever banks' balance sheets 80:1. They didn't buy jumbo mortgages or international mortgages in what was a global phenomenon.

Ken B writes:

@Garrett: I confess, I is to blame.


I'm not sure what you are asking about the grammar, but the subject is always in the nominative and you can't be asking about that. Or are you asking about 'who is' vs 'who could be', subjunctive mood, and that kind of thing? I am one of I think 17 people alive who lament the lack of a clear subjunctive in English. If you mean that there is certainly blame to be affixed and you seek only a target, then 'is' is what you want (this corresponds to 'whom to blame'); if you mean to imply that blame is only a lively possibility then 'could be', or the like is better.

It depends on what the meaning of the conjugated first person form of 'to be' is .... :)

soonerliberty writes:

"Who" is a perfectly acceptable substitute for "whom" when using objects in the modern English language. The accusative and dative "whoms" are falling out in everyday speech.

Whom is to blame is incorrect, b/c it's nominative.
Who or whom to blame are both correct, b/c it's not clear if it's nominative or accusative. Without the to be verb it's hard to say.

Steven Kopits writes:

A couple of years ago, a client asked us to forecast the orders for the number of offshore drilling rigs. Now, ordinarily we are asked to forecast the demand for goods and services, including rigs. But in this case, we were asked to forecast orders.

The two are materially different. Forecasting supply and demand is an exercise in fundamental analysis. Forecasting orders, by contrast, is a matter of anticipating behavior. One could forecast the demand for, say, housing in Ireland in 2005 and conclude that it was a heck of a lot less than the orders for housing there. But if you were a construction company there, you would want to know orders, not demand.

In any event, our client's request forced us to think about the drivers of orders. The data suggested that rig orders proceeded in a boom-bust fashion. Rig owners would order rigs when utilization was high and rising and dayrates were strong. This would seem to make sense, except that rigs take four years to deliver.

So in Year 1 of the cycle, utilization and dayrates would rise, and rig owners would order rigs. In Year 2, utillization and dayrates would rise more, because, of course, none of the rigs ordered in Year 1 had yet arrived. So more orders, although fundamental analysis here was already suggesting that an overbuild cycle was possible.

Same thing in Year 3, with fundamental analysis suggesting that overbuild was highly likely. And on to Year 4. Now newbuilds were beginning to hit the market and dayrates and utilization were beginning to collapse. Orders all but cease, and drillers face hard times.

So, boom-bust in this model is the result of owners beginning orders too late and ordering too long. This begs the question of why.

There are two possible explanations. The first posits that owners react defensively to maintain market share. If their competitor orders a rig, then they feel obliged as well. An alternate view suggests that owners, people who actually have to commit capital, will wait for tangible validation of an inflection point to change behavior. They need "visibility" to act, which in practice means a lead time of 6-12 months. That's as much information as decision-makers are actually willing to use in the timing of capital decisions.

This makes some sense for a people evolved in a temperate climate with predictable seasons but unpredictable weather. You plan your planting and harvesting one year out.

If this is so, then there is a market failure in anticipation. As a practical matter, decision-makers fail to take into account data beyond the visible horizon and wait for emotional validation before making a decision. For assets with greater than one year build cycles--and this would include real estate and major capital items like vessels or factories--it means that decision-makers are myopic and react too late, leading to classic boom and bust cycles.

No doubt excess liquidity can lead to an increase in demand for assets, goods and services. But the bubble itself is driven by the lag between the manifestation of demand (ie, orders) and the delivery of the asset some years later. There was no bubble for haircutting services in 2007; there was a bubble for residential housing. The reason for the bubble was the lag from order to delivery.

See more here:

Ken B writes:

@soonerliberty: Oh I don't deny that in casual speech the distinction is fading into disuetude faster than the 10th amendment. But there is an implict subject in 'Who(m) to blame' and it's not who(m)ever is being blamed. So the pronoun is definitely an object in that sentence.

It's like "It's me." Even I say say that on the phone all the time, except with one friend whom (sic) I like to irk.

But we're getting off the subject to no object.

q writes:

there are a lot of liquidity suppliers to the housing market, not just the government! why did you name the government suppliers of liquidity and not countrywide?

KnowPD writes:

Who to blame or who to thank? It depends on perspective I guess. Bubbles create winners and losers. People who profit from bubbles have incentives to disguise this fact - the social desirability bias. Bankers made a lot of money but it's the government's fault. Should we blame the profiteers for the irrationality of others?

If "the bubble literature grew," how do we know that isn't a bubble? Maybe economists are investing too much of their time...

Ken B writes:

Shouldn't we ask Bryan about the housing bubble? He lives in one.

I actually DO want to hear from all three bloggers here on bubbles, or more particularly on the EMH. For laymen like me it's hard to keep up. The EMH looks like a good first approximation to me, and I read Random Walk, but reading Mandelbrot a few years ago convinced me it's got problems. What's the current status, and what do you guys think? I gather Garett's a skeptic on EMH ...

pyroseed13 writes:

Poster "q" above raises a good point. The Fed is only one of many suppliers of liquidity in financial markets. I think the plunging of interest rates prior crisis had more to do with capital inflows from East Asian economies than Fed policy.

Jason writes:


Here is the key question to ask yourself: If inflation had been low enough that a Taylor Rule matched the rates the Fed used, would the housing bubble have been impossible?

The key thing to recognize is that the level of rates compared to a Taylor rule is not whats important for whether rates contribute to rising housing prices. Its the level of rates that matters. Low rates can start the process of a bubble that gets carried forward by bubble psychology. This can happen whether rates are higher, lower or equal to those suggested by a Taylor rule.

This is because the Taylor rule approach to stabilization doesn't even take housing into account in theory. The Taylor Rule is designed to stabilize output and inflation around a target. If the Taylor Rule included a measure of asset prices and rates moved along with stock or housing prices, then we could have an argument about whether the rates were too low relative to the Taylor rule and whether that caused a bubble. Until we do, we can only talk about low rates, not low rates relative to a benchmark that has nothing directly to do with housing.

Lee Waaks writes:

Discussions of marginal tax rates: how to feed the state without getting your hand bitten off.

why did you name the government suppliers of liquidity and not countrywide?

Countrywide was coerced into it by HUD, through its 'voluntary' Best Practices Initiative. When Henry Cisneros took over he had a little talk with then Mortgage Banker's Assn. head Angelo Mozillo to the effect that, 'Those are nice little lending operations you guys a shame if anything happened to them.'

Steve writes:

I guess the fact that Fannie/Freddie followed the private lenders into the subprime market rather than led them there is conveniently forgotten. Also sorry but $360 billion of subprime exposure does not explain the trillions lost in shadow banking.

Steve Sailer writes:

Dear Garett:

Good to see you aboard. If anybody can replace Arnold, it's you.

Steve Sailer writes:

My model of the Housing Bubble is this:

At any point in time, some lenders will have excessively optimistic expectations about borrowers' ability to pay back and some will have excessively pessimistic expectations. But, it's not obvious who will turn out to be right.

In the middle of the 20th Century, the government pushed to make it easier overall for people to get mortgages, while maintaing controls on the most optimistic lenders by requiring down payments and the like. This proved quite successful for the mainstream population, so by the late 1960s, government attention turned increasingly toward increasing lending to minorities. Lenders who were pessimistic about minorities were increasingly subjected to various kinds of quotas, as well as demonization as racists.

For example, in 1994, Clinton's HUD secretary Henry Cisneros threatened non-bank mortgage lenders like Countrywide with having the CRA paperwork provisions extended to them unless they agreed to boost lending to minorities. Angelo Mozilo of Countrywide signed a deal with Cisneros. During the long, strong real estate market of the 1990s, Mozilo became more optimistic about minority lending, especially the fast-growing Hispanic market, and appointed Cisneros to Countrywide's board.

The government and cultural pressure to lend more to minorities was slowly ratcheted up, but restrictions, such as down payment requirements, were still applied to keep optimistic get-rich-quick lenders from blowing things up too badly.

Then, in the summer of 2002, George W. Bush announced an initiative to dramatically boost mortgage lending to minorities. In particular, at his White House Conference on Increasing Minority Homeownership on 9/15/02, he denounced down payment requirements as the leading impediment to racial equality in home ownership. As part of this drive, he also called for a largely symbolic bill to create a small fund for the government to pay the down payments of some borrowers, which passed in 2004.

These actions were seen by the optimists in the lending industry as the government's assurance they wouldn't get in trouble for zero-down payment and other risky mortgages. Angelo Mozilo of Countrywide, for example, announced in February 2003, while quoting Bush's 2002 speech, that Countrywide would pour $600 billion into minority and lower-income mortgages. Later, when Fannie agreed to buy Countrywide's dubious mortgages, Mozilo announced in January 2005 that Countrywide would lend in one trillion dollars in minority and lower-income mortgages by 2010, with Cisneros named to help out oversee this lending, which signaled to Bush Administration regulators that much was going to Latinos.

Mozilo talking Fannie into buying up Countrywide's trashier loans, which happened either late in 2004 or very early in 2005 didn't start the liquidity bubble, which had taken off using mostly private money in 2004. But, Fannie and Freddie's firehoses of liquidity probably kept the bubble going an extra year or two, disastrously worsening it.

So, the long-running War on Racist Redlining ended up, like most things that go on a long time, going too far, giving overly optimistic and overly short-term oriented lenders the excuse they needed to facilitate an immense Housing Bubble centered in four states with large Hispanic immigrant populations: California, Arizona, Nevada, and Florida, especially in working class exurbs.

This account strikes me as the most moderate and balanced view of what happened in the mortgage business, but it's universally unpopular. Republicans don't like blaming Bush. Democrats refuse to think about the roles of race and immigration. Libertarians don't like the idea that government regulations favoring down payments were a good idea. Pro-business groups don't like the idea that businesses messed up. And so forth.

But, isn't it likely that something as epochally awful as the Housing Bubble had multiple causes?

Joe Calhoun writes:

Is this news? Really? Excess liquidity can create bubbles? Who woulda thunk it?

Ken P writes:

@F. Lynx Pardinus, So if government policy required women to walk down dark alleys at night alone, such a policy would not be a factor contributing to unfavorable outcomes?

Ken P writes:

From 1980 to 2000, the Fannie/Freddie share of mortgages went from 5% to 45%. See Guaranteed to Fail White Paper on St Louis Fed Site

I consider that to be a major amount of liquidity, especially when accompanied with a drop in quality requirements.

As for interest rates, if they were allowed to float naturally investors would know when to cutback on long term projects because rates would go up as people slowed their savings (causing rates to rise) for such delayed purchases.

Shayne Cook writes:

Back in my parent's day (I'm 58), people bought homes for their intrinsic value - the characteristic a home has of keeping the rain off of one's head. This was, more or less, why Dutch folks bought tulip bulbs in the 1500's - for the intrinsic beauty of tulips during the summer.

But something happened on the way to the 2000s housing bubble (and previous local housing bubbles). Everyone started focusing on, and emphasizing/maximizing, exclusively the (potential) investment value of a home.

1.) The Federal Government grants 100% deduction of mortgage interest costs - on first and second homes - ostensibly to encourage home ownership - and enhance investment value.
(Of course, that deduction is maximized when the buyer puts no money down on the home[s] being purchased.)

2.) The State and Local Governments strongly endorse home price (investment value) increases. Both property tax revenue increases AND the appearance of a strong local economy is created - to support the housing price increases.
(Homes and home prices are inherently a local, not national phenomena.)

3.) The entire real estate agency and sales industry strongly endorses home price (investment value) increases. A 6% commission on a $500,000 home is greater than the 6% commission on a $100,000 home.

4.) The entire financial industry strongly endorses home price (investment value) increases. They are in the business of moving money from lenders to borrowers and earn their fees from providing that service. Besides which, as others here have noted, the Federal Government strongly endorses - and requires - those flows of money from lenders to borrowers.

5.) Even the folks who are not directly participating in this investment scheme (previous homeowners who neither buy nor sell during the resultant bubble), endorse the housing price increases. Those price increases create the myth that their investment is enhanced. This, of course, completely irrespective of whether the local economy is actually capable of supporting said price increases.

With all that, what could possibly go wrong?

I suspect the Dutch of the 1600s, during the Tulip craze, didn't have a Federal Reserve, or a Fannie and Freddie, or a bad old Wall Street to blame. Instead, I suspect they merely got carried away with thoughts of maximized investment value of tulips, rather than just buying tulips for their intrinsic value.

I wonder if their Dutch Government of the day strongly encouraged that perspective - as the U.S. Government of our day does?

David N writes:

@Steve Sailer -- Your view may be unpopular because it doesn't explain why the housing bubble spread to places like the UK, Spain, and Korea, among other reasons.

@Shayne Cook -- mortgage interest has always been deductible since 1913.

Shayne Cook writes:

@David N:

You are quite correct. Except on second homes - that is more recent, when the investment perspective emphasis was enhanced.

Oh, and I forgot to mention the post-1913 $250,000 capital gains exclusion afforded to home investment gains.

Build bigger and more, Buy bigger, and more! And lever up to, and beyond, the max!

It is, after all, an investment, not a home.

Shayne Cook writes:

@David N:

I also forgot to mention the more recent Home Equity Line of Credit (HELOC) miracle of modern (Federal Government endorsed - also tax deductible) housing finance.

With that little miracle, folks can spend ALL of the optimistically valued future investment returns on their homes today! For anything - a new car, pretty clothes, or even a month-long cowboy drunk.

It seems, however, that those optimistically valued future investment returns failed to materialize. So much so in fact, that lots of folks have even lost the homes and the related intrinsic value of owning a home.

It's kind of a bummer when an investment doesn't work out.

Floccina writes:

To me the main point is not the bubbles. For example I have no problem with the 2000 stock market bubble. The problem is that the monetary system is such that bursting credit bubbles lead to unemployment and that is because the monetary system has a bad feed back problems. IMHO we should fix the monetary system an let the bubbles run.

Steve Sailer wrote;

In particular, at his White House Conference on Increasing Minority Homeownership on 9/15/02, he denounced down payment requirements as the leading impediment to racial equality in home ownership.

The denigration of down payments began a lot earlier than that. It came from the Boston Fed in the early 90s, in their pamphlet Closing the Gap.

Ted Day and Stan Liebowitz presciently criticized the idea back in 1998 in Economic Inquiry.

Steve wrote;

I guess the fact that Fannie/Freddie followed the private lenders into the subprime market rather than led them there is conveniently forgotten.

Not forgotten, because it isn't true. The FMs got into subprime thanks to a piece of legislation known as The GSE Act of 1992.

That's long before 'Wall Street' got involved. It took the favorable treatment of AAA rated MBS through the Basel Accords to entice banks onto the bandwagon.

Shayne Cook writes:


The Federal Reserve just announced they are beginning a policy of purchasing agency-backed MBS, at a rate of $40 Billion per month for the foreseeable future. That makes it unanimous - homes are just investments.

And it's now the bound duty of both the Federal Government (through borrowing) and the Federal Reserve (through printing) to insure those optimistic investment returns!

I guess we'll have a chance to test Dr. Jone's assertion that liquidity causes bubbles (again).

Steve Sailer writes:

"The denigration of down payments began a lot earlier than that. It came from the Boston Fed in the early 90s, in their pamphlet Closing the Gap."

Right, it had been going on a long time, but it took a Republican President going all in to kick it into overdrive.

Charlie writes:

The experiment and the Fannie and Freddie article are talking about two different definitions of liquidity. Liquidity in finance is being able to go to the market to buy or sell without moving the price. In the experiment, they actually halve the number of shares available. They made the market less liquid (in the way we talk about it in finance).

What the experiments mean by liquidity is just adding cash to the environment compared to the number of shares. That isn't what Fannie and Freddie do. If you think the bubble was in house prices, then you'd be looking for increased dollars flowing into the home buyer market (more home buyers with more money) compared to the stock of housing. If you think the bubble was in mortgage back securities prices, then you'd probably be critical of securitization that made it possible for a lot of new money (like pension funds) to buy mortgage debt.

caltrek writes:

It all boils down to the effort to increase lending to Hispanics and other minorities?

Five me a break. This is blaming the victim at its most refined. An outfit called ACORN was camplaining about predaroty load practices before the bubble burst. Congress liked their efforts so much that they passed an unconstitutional bill of attainder to prohibit any further funding of that agency.

Now, its the big lenders who are being portrayed as the victims. Why?

Because they can't tell the difference between a lender who will be able to make payment on their mortgages versus one that will not be able to keep up?

Do not equate being in a minority with being unable to meet your mortgage obligations. Those are two different and only partially overlapping sets of people.

caltrek writes:

Rats, darn proofreading skill deficiency. I meant "Give me a break", not "Five me a break", and "predatory", not "predaroty".

Please carry on.

Justin H writes:

One of the best exposes showing that the fed really did keep rates too low too long is this, by George Selgin:

caltrek writes:

@ Justin H,

From your link: "the Fed should have begun raising the federal funds target, not in mid 2004, but towards the end of 2001, when it was still well above 1 percent.[1] Doing so, Taylor claims, "would have avoided much of the housing boom"—about a third of it, to judge by Taylor's own simulations."

It also cites "regulatory causes independent of Fed policy, such as have been very well described by Stan Liebowitz".

In then following the link to Liebowitz we see the old conservtive cliche that falsely blame regulatroy policies to encourage loans to minorities. At least the article acknowledges that decisions made by lending institutions involved making loans to people who could not afford to pay those loans back. That the Fed some how allowed enough liquidity in the system for those loans to be made is beside the point. Lenders failed to exercise due diligence in establishing and implementing their lending criteria. That is where the true blame lies.

Liebowitz is wrong in the regulatory changes that he cites. He ignores the repeal of Glass Steagal in the late nineties. This straight forward thirty two page depression era act had established barriers between commercial and investment banking. This allowed consolidation and the formation of much larger banks. It also eliminated the separation between those entrusted with caring for ordinary depositors' money in commercial banks from investment banks which had organized the sale of bonds and equities.
When the repeal of Glass-Steagall came about, the investment bank mentality came out on top. The motivation for high returns pushed banks to go for high leverage and high risk taking. Such institutions also operated with the assumption that if things got too out of hand, the federal government would step in and bail out the lending sector. They understood that their institutions had become too big to fail as a result of all of the consolidation.

Real estate loans were packaged together to securitize investment instruments. Loans that had been given to borrowers many of whom simply could not afford to pay their loans back. These toxic assets spread like a cancer throughout the banking industry. The money plowed into the real estate industry created a giant bubble in real estate prices, aggravating the problem that the assets relied upon simply had no material basis of support of their prices. The bubble finally popped, and as many had supposed, the federal government was forced to step in to avoid a catastrophic collapse. As it was, a recession hit at the same time that the government was forced to borrow just to avoid a depression.

So much of what happened can be traced back to the repeal of that 32 page legislation known as Glass-Steagall. So, does the right in this country support re-instatement of Glass-Steagall?


Do they even acknowledge this history?


Instead they scape goat the Community Reinvestment Act of 1977. An act passed thirty years before the collapse. An act that had nothing to do with the problem.

Comments for this entry have been closed
Return to top