06 September 2009

Dr. Krugman Makes My Heart Go Pit-Pat

Paul Krugman does it again. His story in today's Times Magazine brings joy to my heart. Finally, a full-blown bullshit whistle against the Right Wingnut economists. But with all due respect, he does miss out on one point. And it's a very important point, why the behaviour of all those sub-prime and Alt-A home buyers was purely rational. It is the explanation of where the bubble came from. The bubble came from an increasingly unequal income distribution.

Here is the story.

The story begins with a basic question: why would a bus driver in Stockton, CA buy a $400,000 house? That was the assertion made on one of the talking head shows in the last few days. I'll take it as apocryphal that a bus driver could only afford a $100,000 (say) house at the market rate for 30 years fixed, and would only take on the $400,000 house if he were Totally Nuts. Said bus driver is rational for a number of reasons.

First, house buyers are not buying a house at a price they can afford. They are buying a house at the monthly payment they can afford. This basic distinction has been missed by all commentators I have so far heard. It is a fact which I recognized when I was a graduate student in economics in the early 1970's. At that time, interest rates were high, home prices were driven low to meet the constraint of monthly income/payment. And those who bought then made out like bandits as interest rates declined, and housing prices rose in concert.

The asking price of housing at a point in place and time is not determined by the bus drivers. It is determined by banks and builders acting in concert, even if they neither realize it or will admit it. Rationally, banks and builders would only produce $100,000 houses if the income data (yes, they have such) says that's what can be afforded. That they chose instead to produce $400,000 houses was not because the data told them to do so, but because they chose to ignore the data.

It is a fact that house prices and interest rates are inversely correlated, and the fulcrum is median income. From median income comes median house payment. From median house payment comes the division between bank and builder. The interest rate does the division. That interest rate is not necessarily the one you read in the newspaper. As the Alt-A growing fiasco makes clear, the actual interest rate is partly in the hands of the home buyer. That is not a good thing. With median incomes stagnant, to within a gnat's eyelash, during the Bush years (I and II) ameliorated only a bit during the Clinton interregnum, the only way for bankers and builders to inflate house prices was to fiddle the interest rate down. And the only way for the middle class to maintain their standard of living was to live off the rising equity from their houses courtesy of the fiddle house prices. Without the perceived need to maintain consumption, and thus burn off increasing equity, this crash wouldn't be as bad as it will be. Had home owners not burned off the equity then, it would be available now to maintain consumption. But that is not to be, and is another story.

Why contemporary economists and pundits can't connect those dots is beyond me. For most, who are employed directly or indirectly by the finance industry, it is in their income generating self interest to remain ignorant. Why Krugman remains ignorant, I can't figure.

Second, back to our bus driver. He is shown a calculation by a real estate agent, which fits his maximum monthly payment into the $400,000 home. So far as he is concerned, it's a house he can afford. The agent just proved it to him. So he signs. Even if he's sophisticated enough to realize that he won't be able to afford it once/if the monthly resets, it's still a rational decision. In 2005, 2006 that is. And that's the key to understanding that the house buyers up to 2006, approximately, were acting rationally.

And here's why. Let's assume that our bus driver is a complete imbecile, but does know how to read and do simple arithmetic. He reads that house prices have been increasing. He knows that in a year or two he will have accumulated $100,000 (say) of equity in the house due to inflation in house prices. At that point, he knows he can sell the $500,000 house, take out $80,000 (say) net proceeds, which amounts to a tidy downpayment on a $300,000 house. Said $300,000 house, with tidy downpayment, could be financed with a conventional 30 year fixed with a monthly payment he can afford.

Why not just buy the $300,000 house now? Because he doesn't have the tidy downpayment that the real estate industry expects. In his current situation, he has to game the real estate industry's gaming of him (and his ilk). As has been pointed out, but not by Krugman in the current essay, the demand for home mortgages was not driven by home buyers, but by the banks, hedge funds, and other investors. Recall that Greenspan had forced down interest rates, and declared that they would remain down.

How to get greater returns, at low risk, for these holders of large amounts of money? This was the patient zero of securitization "innovation". It was the demand for these tranched instruments that caused the residential real estate industry to lure home buyers into their net. In order to get all that money, they needed ever more house buyers. But with median income stagnant, thanks to the Bushes and the Republican Congress, they had to fiddle the interest rate down in order to fiddle house prices up. The game was started by, and run by, the financial "innovators" not by the bus driver in Stockton. Don't blame the cat's paws.

So, in sum, the housing bubble was a purely rational reaction by home buyers squeezed out of income by the freshwaterists (you need to read the article). For those who bought early in the pyramid building and didn't burn the equity, it was an intelligent decision.

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