OK after browsing through his archives circa 2005, I must retract my earlier criticism of Paul Krugman. For sure, Krugman did identify the housing bubble before many other analysts (including me), and so he’s not bluffing when he says nowadays that he called it. Also, people who comment at his site should be a little more nuanced instead of saying things like, “None of you Keynesian wizards saw this coming, so why should we listen to you now? Only Peter Schiff and the Austrians predicted the crash.”
Last apology: I also was suspicious in the previous post that Krugman didn’t point to any of his own articles (for proof that he had called the bubble), but instead linked to a 2005 article which in turn referred to Krugman’s 2001 articles–when those articles came 95% close to recommending that Greenspan create a housing bubble!! In retrospect, I think Krugman probably did that to show, “Hey, I know I was calling this back in 2005, and here are people attacking me for saying so–therefore I clearly was making loud noises about the bubble!” (Also, it’s possible there is a typo in that article critical of Krugman; I could never find his article that they were talking about.)
OK now that the apologies are out of the way, let’s go through and see the difference between Krugman’s identification of the bubble, versus a Peter Schiff or a Mark Thornton (from 2004). Here’s Krugman from May 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.
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.
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.
Not to beat a dead horse, but let’s go back to August 2002 closer to when the guy from Pimco first made the comment about Greenspan replacing the Nasdaq bubble with a housing bubble. Here’s what Krugman said at the time:
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.
So yes, Krugman did identify that there was a housing bubble in progress in 2005, but it was akin to a doctor thinking a cancer patient was reacting very severely to aggressive chemotherapy. The Fed-induced housing bubble wasn’t poison, as far as Krugman was concerned, just medicine that was having unfortunate negative consequences. His recommendation wasn’t for the government to stop tinkering and fueling new booms, but rather to search for something else to inflate.