The Housing Bubble Villains Deny Responsibility

The central bankers of the world gathered last weekend for their annual meeting at Jackson Hole, Wyoming. This was an opportunity to talk about the major issues confronting the world economy, as well as an opportunity to spend some time in a very beautiful vacation spot.

When they met in Jackson Hole in 2005, the meetings were devoted to an Alan Greenspan retrospective, honoring his 18-year tenure as Federal Reserve Board chairman, which was due to end the following January. A number of papers were presented analyzing his record at the Fed, including one that raised the question of whether Mr. Greenspan was the greatest central banker of all time.

The elite Jackson Hole crew did not debate whether Greenspan was the greatest central banker of all time this year. The world is now facing the most serious financial crisis since the Great Depression. At least, that is the assessment of Alan Greenspan. With house prices plunging, unemployment and inflation rates rising and banks failures mounting, Greenspan has a pretty good argument.

How did we get here? The centerpiece in this story is the United States allowed an $8 trillion housing bubble to grow unchecked. Between 1996 and 2006, house prices rose by more than 70 percent, after adjusting for inflation. In the previous century, from 1896 to 1996, house prices had just kept even with the overall rate of inflation.

When there is suddenly a sharp divergence from a long-term trend like this, it is reasonable to look for an explanation. Was there some fundamental factor on either the supply or demand side that was suddenly causing house prices to skyrocket?

A quick investigation revealed no obvious suspects. On the supply side, there were no major new constraints that were impeding construction. In fact, housing starts were at near record levels over the years 2002 to 2006, so there was no reason to believe any developments on the supply side could explain skyrocketing house prices.

The demand side also didn't feature any obvious culprits. The rate of population growth and household formation had slowed sharply. If demographics could explain a sharp rise in house prices, then we should have seen the surge in the 70s and 80s. That was when the huge baby boom cohort was first forming their own households. In the current decade, the baby boomers are preparing for retirement.

There also was no plausible income story. Income grew at a healthy but not extraordinary rate in the years from 1996 to 2000, but income growth has been very weak throughout the current decade.

Finally, if the run-up in house prices could be explained by the fundamentals of the housing market, then we should expect to see a comparable increase in rents. But there was no unusual run-up in rents. They did slightly outpace inflation in the late 90s, but they actually were falling behind inflation by the early years of this decade.

If the run-up in house prices could not be explained by the fundamentals, then it was a bubble, which would burst. This was easy to see for anyone who cared to look, but Greenspan and his sycophants could not be bothered. Greenspan insisted everything was fine - there was no housing bubble - and virtually the whole economics profession, including his fellow central bankers, acted an enablers touting Mr. Greenspan's wisdom.

While the exact timing and path of the housing market's collapse and the resulting turmoil in financial markets could not be predicted, the basic course of this tsunami was entirely foreseeable. The collapse of the bubble will destroy in the neighborhood of $8 trillion of housing wealth. Most of these losses will be absorbed by homeowners ($8 trillion comes to $110,000 per homeowner), but if just ten percent of the loss ends up on bank financial sheets, the losses will be $800 billion.

That is enough to put many banks under. Losses of this magnitude were virtually certain to sink Fannie Mae and Freddie Mac, the two huge government-sponsored enterprises that created the secondary mortgage market in the United States. The current financial crisis was, therefore, an inevitable follow-on to the collapse of the housing bubble and will almost certainly amplify its negative impact on the US economy.

This all seemed painfully obvious from even a quick look at the housing data back in 2005 when the central bankers were honoring Alan Greenspan. In fact, it should have been obvious at least three years sooner.

But the Jackson Hole economists were convinced everything was just fine. Now, they are all saying no one could have foreseen the current crisis. And they say no one, at least among the Jackson Hole crowd, saw any problems coming.

The really tragic part of this story is there are no consequences. The same group of economists that led the economy into this catastrophe still has its hands on the wheel. Holding them accountable for their disastrous performance is simply not on the agenda.

Central bankers are not like dishwashers and custodians. They don't get fired when they mess up on the job. They don't even get a pay cut.

So, lets all hope the Jackson Hole crew had a good time at their summer retreat. We've paid a big price for it.