Becker on the Pundits that Cried "Wolf!"

I have two issues with Professor Becker’s argument

1. Probabilistically speaking, if an economic crisis does not come to pass that doesn’t mean it wasn’t extremely likely that one was going to occur.

2. The probability of a financial crisis is not independent from predictions. Policy makers may precautionary steps in the face of dire predictions that cause the crisis to be averted, or market participants may subtly alter their behavior which prevents underlying imbalances from increasing.

As with Global warming our policy and personal decisions should be focused on reducing the likelihood and magnitude of major adverse events.

In terms of the worst economic crises of the world, they have revolved around macro issues: great inflation and great deflation.

Both the Great Depression and to a lesser extent the “Lost Decade” of Japan were born in deflation (despite lots of other things going on like the business cycle and asset bubble bursts).

The big lessons are: don’t deflate during a time of economic turmoil, and otherwise stick to high growth policies.

Perhaps before the economics profession can distinguish true prophets of doom from false ones, it needs to learn how to distinguish bubbles from legitimate sector growth. I can’t believe that is impossible. For example, I called the housing bubble five years ago, and I can prove that: I convinced my wife that we should sell our house, move into an apartment, and wait to buy again after the slump!

I was quite wrong, actually, about how far the bubble could expand before it popped. (I thought housing prices would slump after a rise in mortgage interest rates, which I thought would eventuate a while back. It didn’t.) My wife became very unhappy with me as prices continued to soar– I had not predicted that lenders would decrease credit standards as prices rose to keep moneyless borrowers in the bidding.

I’m still marveling at the way the bubble ended: it stopped growing when there was literally no way to debase credit standards further– at the end lenders were giving people with no verifiable income the whole price of the house or condo, 100% LTV (or more with DPA), secured by property which the lender knew was “optimistically” appraised, at sub-market “teaser” interest rates (for a year or two), and then allowing borrowers to increase their loan balances after funding (negative amortization due to low minimum payments). Wow!

My wife and I missed out on a lot of potential gain. However, events have proved my basic analysis correct: when nearly all “buyers” count on rapid appreciation to pay off their loans because they can never pay them from their incomes, you’re in a bubble. The stark divergence of purchase prices and rental value confirmed the analysis. Reading remarks from economics PhD’s suggesting that housing prices were reasonable filled me with wonder; it still does. It takes truly remarkable mathematical acumen to see how people can afford houses or condos priced at huge multiples of their incomes.

Anyway, I don’t think identifying a bubble is so very difficult– though predicting just when one will pop appears hard. Obviously, if it were easy, bubbles might not occur since everyone would know when to sell out and almost by definition a bubble will collapse when any significant number of participants try to sell out.

The dot-com bubble and the housing bubble both ended when credit ran out as opposed to collapsing when too many people tried to take their profits and run. If we don’t take any other lesson from these recent bubbles, we should note that too-easy credit facilitates bubbles. Perhaps it even causes them.

I think if I wanted to be a successful prophet of doom I would watch for a sector with very easy credit and predict disaster for it.