Chinese Predatory Lenders

This article in the New York Times examines how Chinese savings fueled the US bubble. In accord with Bernanke's Global Savings Glut theory it argues that excessive savings in the rest of the world is the source of our deficits and there is nothing we could have done about it, except pressure China to revalue the reminbi.

The essential parallel is with subprime lending. The Chinese were the predatory lenders and Americans were the ill-informed borrowers. It is a hard story to maintain. The fact that China saved excessively and lent to the US did not mean that we had to use these flows to finance a housing bubble. We could just as easily have used it for investment not consumption, or for building roads in the US instead of in Iraq. The fault for what we did with Chinese savings lies with us. If we had used low-cost finance effectively we would be better off now. The fact that we used it poorly is just a reflection of how short-sided our leaders were and how foolish investors were to believe that a bubble can go on forever.

Bubbles

Virginia Postrel has an article in the Atlantic on experimental results concerning bubbles. Even though the participants in the experiments can easily determine the fundamental value of the assets they are trading bubbles and crashes still appear. What seems to happen is that traders are not sure if others realize that there is a bubble and try to profit before the crash.

Although she does not mention it, these results are not surprising given the work by Abreu and Brunnermaier on bubbles and crashes. In their work

The resilience of the bubble stems from the inability of arbitrageurs to temporarily coordinate their selling strategies. This synchronization problem together with the individual incentive to time the market results in the persistence of bubbles over a substantial period.

The key point is then is that even if I know a stock is overvalued I may still participate in the bubble if I do not realize that you are similarly aware of it. After all, if I short the stock and am by myself I may lose big time, while if I ride for a while I may profit till enough short sellers are ready to attack. So the sequence of learning is essential.

It is just this phenomenon that the experimenters seem to be pointing at. But Brunnermaier has already shown that similar phenomena were at play in previous bubbles, looking at the trading strategies of informed traders.

But there is another problem regarding bubbles that is worth discussing. That is the bias in the benefits. Think of the housing bubble. While it is taking place who is losing? Certainly those priced out of the markets, but who else? Everybody else is gaining, whether they are construction workers, bankers, financiers, governments dependent on tax payments...Now what happens if the bubble bursts? Everybody who was riding the bubble now suffers.

Suppose that the bubble was burst by the actions of a concerned policymaker. Would this policymaker be applauded? Seems unlikely. Everyone who suffers would blame the messenger. Certainly, everybody hates short sellers -- the only difference being the latter try to profit from their information. But still, if a bubble collapses it is hard to believe that the policymaker would be anything but blamed.

If this is correct, then there is a bias in favor of bubbles. Cheering on the asset price increases the politicians can say how we have a new economy. The old rules do not apply, and look at the prosperity we have brought. The gloomy official who tries to prick the bubble will be pilloried.

Gravity and Real Estate Prices

This article in today's NYTimes gets to the heart of one key aspect of the housing crisis. Here is the key quote:

But behind the political pyrotechnics is a simple truth: Executives at IndyMac, like many people on both Wall Street and Main Street, apparently never dreamed that home prices might fall. To the contrary, IndyMac made many loans on terms that implicitly assumed prices would keep rising.

This presumption forgets the truism that what goes up must come down. This is at least true when the prices of assets rise faster than rents. Apparently, many lenders forgot this, despite the fact that at least in recent years we have some good data. Robert Shiller produced this graphic, for example, in his book Irrational Exuberance, and the graph was published in the New York Times in 2005.
It is pretty apparent that real housing prices fluctuated between 100 and 125, aside from the Great Depression, for about 100 years. The recent period clearly looks like a bubble. Looking at this graph would you believe that prices never come down?

This is more apparent still when we look at house prices compared with rents. Shiller provides this in a recent working paper (gated).



Housing prices clearly grew faster than rents since 2000, and this is the hallmark of a bubble. But bubbles eventually burst. If financial institutions lend while ignoring this basic fact they can burst too.