When do Bubbles Burst? Or how do we know that we have hit the ceiling?

There has been a wide talk about the determinants of the financial crisis as well as our ability to forecast it. Many neoclassical economists argue that we could not have predicted anything; yet some of their colleagues did (with varying degrees of success). Keynesians, (or more likely Minskyans) such as Steve Keen are said to have predicted the credit crunch and the crash that followed. Austrian economists have also had their share of predicting as well, again with various degrees of success.

This paper by Dirk Bezemer, presents a list of people who have "anticipated" the financial crisis, as early as 2005 (page 9 of the said paper). Notable names include Robert Shiller (2006), Nouriel Roubini (2005 and 2006) and Steve Keen (2006). Some of the common reasons of analysts/economists behind their predictions are:

1. “a concern with financial assets as distinct from real-sector assets,
2. with the credit flows that finance both forms of wealth,
3. with the debt growth accompanying growth in financial wealth, and
4. with the accounting relation between the financial and real economy.”

Yet, the reasons behind their estimations do not seem so clear. For example have a look at the following graph, obtained by Keen's blog:

With no intention of being disrespectful to neither of the economists/analysts whose views were proven to be much better (to be exact here would be to use infinitely better) than their colleagues, I cannot help ask the following: why should it happen in 2008 and not earlier?

Have a look at reason 3. Debt growth accompanying growth in financial wealth. How can we know that a ceiling has been reached? We can know when we are exceeding the "normal" levels but why not in 2001 when the debt-to-GDP ration was higher than the one in the Great Depression of the 1930's? (the careful reader will see that at the initiation of the Great Depression the debt-to-GDP ratio was less than 175% of GDP, approximately the same as in 1995-1996)

The next graph indicates the level of home owners in the red line (i.e. the percentage of people who choose to buy a house instead of renting one) and the percentage of sub-prime loans compared to overall loans in the US economy.

Home ownership began its decrease in 2004; yet, sub-prime loans boomed during that period. One really has to wonder who the bankers were lending to. Less people willing to buy a house in addition to more sub-prime loans... This might just be the answer, yet why didn't the break happen earlier?

Prices in the US cannot point to the answer as they are not the ones causing the crunch, but the ones receiving it. The Case-Shiller index, however, may state otherwise:

Here, it appears that the index peaked in 2006, dropped lightly until 2007 and started a free-fall in 2007. Could we have known that 2006 was the peak year of the index, ex ante? I have no definite answer to that question. Surely, some people believed that then. And history proved them right. Yet, a prediction on its own is not enough. We have to understand the rationale behind these forecasts. Why wasn't the peak of the debt-to-GDP ratio in 2004 or 2005? Foreclosures were also increased after 2007. But not before it.

Correlations, co-movements or links are easy to find ex post. We know what happened, thus we can find what we are looking for. Yet, we are subject to what is called as Survivorship Bias. We concentrate on the people or things that "survived" some process and inadvertently overlooking those that didn't because of their lack of visibility. 

In other words, we can see more clearly looking back. Keen is right that most macroeconomic models do not account for the four factors mentioned above. Yet, even if they did could they have predicted when we would reach a ceiling? Not really. We are still unaware of many issues which help in lengthening a bubble's life. These are our known unknowns. Each case is somewhat unique in its determinants and evolution, not to mention length. We could have suspected that we were experiencing one when prices exploded for a large period of time. Nevertheless, we could not know when it would burst.

Could we have know whether we were experiencing a bubble as early as 2006? Probably yes. Could we have known when it would burst? Probably not.

To quote Keynes: "Markets can remain irrational much longer than you can remain solvent"

Spain: Bad Solutions to a Known Problem

It looks like some countries have started paying the price of austerity in people. I am of course talking about Spain where at least 10 people have committed suicide due to their lack of paying their loans and the subsequent bank and court decision for their eviction. Now, after 10 fellow humans have left this world, Mariano Rajoy's government has decided to put up a moratorium on evictions for the next 2 years. As this excellent article from Mike Shedlock states, the policy is expected to blow up spectacularly.

An old man evicted in Santiago de Compostela, Spain. Source: Wikimedia Commons

The reason is simple: suppose that you are paying your mortgage loan regularly and you have never missed a payment although you are financially struggling. Now if a law comes up which says that they cannot kick you out of your house even if you do not pay your mortgage, for the next 2 years, what is your motive to repay as you did? I would agree that most people would continue to pay their loans regularly because people have a high sense of values, and also know that when the 2 years end then they will face a much greater loan amount than before. Nevertheless, as Mike states, it is obvious that some people will take the option of not repaying, thus making the bank take a turn for the worse. 

What has always amazed me in the world of politics and economics, is the lack of imagination from its practitioners. In the words of John Maynard Keynes they "are usually the slaves of some defunct economist". Yet, as most of them would hate to admit, they have neither the knowledge nor the imagination to produce solutions which would work in practice rather than in theory. Politicians lack understanding of basic economic truths. Economists lack understanding of world functioning. And unfortunately the combination provides us with solutions that are neither well applicable nor produce the right results. (You may ask the IMF for details on this. It has vast experience from the Greek experiment)

As usual, I wouldn't like to criticize without proposing something else. (you may imagine how I feel when I hear politicians argue about policies without actually proposing an alternative) What Spain should have done, is separate class of borrowers. What do I mean by that? For example the first class would be the persons who are unemployed for more than 6 months. The second class would be those who are unemployed for less than 6 months. The third would be those who are earning minimum wage, or due to other circumstances are facing troubles even though their earning power is larger (e.g. have many children, provide support to elders, etc), and the 4th class would be comprised by those who have "regular" jobs and can pay their mortgage.

To continue, it is more than obvious that the first and second class would need more support than the 3rd and 4th ones. However, the moratorium should not be aimed at people ceasing mortgage payments. First of all, a mortgage restructure, allowing for more installments with a lower amount, should take place. In simple words, if a mortgage has 20 years left and has a monthly installment of 400 euros, a restructuring would allow it to go for 30-40 years with an installment of approximately 200 euros. Now, this is more likely to work for the second group than the first. In that case, the moratorium could take place, although in a different notion: the bank would be allowed to sell the house/apartment, nevertheless, the tenant would be allowed to remain there for as long as it takes for the bank to find a seller. After the sale is completed, the bank will have to return an amount of money to the original tenant, who due to unemployment could not repay his/her mortgage. The amount, which would have an upper limit, will be directed at paying the rent on the tenants new house/apartment and will be deposited directly each month to the house/apartment owner's account. This would allow the unemployed to have a place to live, and it would prevent them for abusing the money if given in a lump sum. To avoid having to do this for everyone, it should be stated that this would occur only after a person has reached 6 or more months of unemployment.

Obviously, since this is just a proposal, groups of people may be more in practice, although I do believe that 4 classes would be a good number as well. This was not very hard to come up with. It is a policy which assists people in need and does not allow them to abuse the policy for their own purposes. Now, if I can come up with something like this, why don't they try to do it as well and not endanger neither banks nor people?