Meltdown Myths

The Antiplanner is a microeconomist, and understanding the meltdown and various bailout proposals is a job for a macroeconomist, so I don’t claim to be completely on top of the situation. However, many of the things I read about the meltdown are clearly wrong. So today I hope to eliminate at least a few of the myths.

1. The problem is too many houses.

Economist Tyler Cowan, who is usually right on, misses the mark when he suggests (with tongue only slightly in cheek) that one solution is for the government to “buy or confiscate empty homes in those areas and destroy them. That will raise the price of the remaining homes” and end the mortgage crisis.

Paradoxically, the reason why home prices are declining in so much of the U.S. is not because there are too many houses, but too few. Cowan’s idea might work in Detroit, but in California it is exactly the wrong prescription. To understand this, we have to look at basic supply and demand.

Imagine the supply curve for housing is horizontal (which economists would call “elastic”). No matter how large the demand for housing, that demand can be accommodated and the price stays the same. This is, basically, the situation in Houston: land is virtually unlimited, there is plenty of labor to build homes, and construction materials cost the same nationwide even if there is an increased demand in Houston. Of course, even Houston’s supply curve isn’t perfectly elastic, but large increases in demand result in small changes in price.

Now imagine that the supply curve is very steep (which economists would call “inelastic”). This means small changes in demand result in large changes in price. This is the situation in California, where urban-growth boundaries have driven up the cost of land and made it very difficult for homebuilders to meet the demand.

In the inelastic case, a small increase in demand caused by, say, a loosening of the credit market results in a large increase in price. But then, a small decrease in demand caused by, say, fears of a recession results in a large decrease in price. In other words, land-use restrictions have made housing prices more volatile.

Add to this a planning process that is so onerous that it can take years to get a permit to subdivide and build new homes. This means that, when prices are going up, homebuilders scramble to get permits but, by the time they get them, prices are going down again. In contrast, homebuilders in Houston can respond to changes in demand by almost immediately putting more homes on the market.

As economists Edward Glaeser, Joseph Gyourko, and Albert Saiz observe in a recent paper, “places with more elastic housing supply have fewer and shorter bubbles, with smaller price increases.” So the problem isn’t too many homes; the problem is an inelastic housing supply, and housing restrictions are a major source of that inelasticity.

2. Fundamentally strong? Ha!

People laughed at John McCain for saying that the economy is fundamentally strong. Surprisingly, however, he was right. Unemployment is fairly low, it is still remarkably easy to get loans, and we’ve pretty much shrugged off the effects of high gas prices.

The meltdown is not a failure of fundamentals, it is a crisis of confidence. If you haven’t heard the confidence argument yet, it comes down to this: our entire economy is based on a near-universal faith that pieces of paper with no intrinsic value other than black printing on one side and green on the other are worth something. Once that faith disappears, we are back to tending goats and bartering for survival.

Last week, a money-market fund announced that it had lost a lot of money on the Lehman bankruptcy, and so it was reducing the value of its shares to slightly below the traditional dollar-per-share value of money-market funds. This nearly led to a run on money markets — not so much by individual depositors but by institutions such as pension funds and insurance companies.
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As Megan McArdle explains, even though the funds are solidly backed by safe assets, “no one could dump a billion dollars worth of securities on the market without seeing the price of those securities plummet.” So the runs would lead to shortfalls, which in turn would lead to more runs and more failures.

The government stopped the runs by offering to insure money markets the way it insures other bank deposits. But this led Paulson to worry that other parts of our financial system were vulnerable to a loss of confidence, and he proposed his $700 billion bailout to shore up that confidence.

Some people, by the way, think we should return to a gold standard. But that just means putting your faith in a bright, shiny metal instead of a piece of paper. I understand the difference and frankly prefer the paper.

3. What do you expect in a country that has lost most of its manufacturing jobs?

The shakeout of the financial industry has led to a revival of the tired old myth that the only “real” jobs are manufacturing jobs, and everything else is just a derivative of those jobs. So, when we “lose” manufacturing jobs to other countries, we are losing the only real part of our economy.

The reality is that all jobs (with the possible exception of the Antiplanner’s) are just as real as any other, and any job sector can form the core of an economy. If manufacturing jobs were so important, then consider this: in 1929, manufacturing accounted for a third of the nation’s jobs, while today it is just 10 percent. Yet manufacturing did not save us from the Great Depression.

Today, it is common to say that the U.S. depends on the “service industry.” But that is a vague term too easily associated with flipping burgers and making beds. In reality, the U.S. depends on a “value added” industry. Large numbers of Americans make their money by figuring out ways to help other individuals and businesses do their work more effectively. It is one thing to manufacture, say, a hard drive; it is something else to find ways to combine that hard drive with other software and hardware and turn it into an iPod. That is the value added that makes the hard drive worth something in the first place.

4. Just let the people who can’t pay their mortgages lose their homes.

Sadly, although housing started the crisis, the crisis isn’t about housing anymore. Although politicians talk about saving people from foreclosures, such a bailout wouldn’t address the fundamental problems (not to mention would give people incentives to not pay their mortgages). The real problems today are with things like credit default swaps and other complex financial instruments. While the total expected losses from foreclosures is something less than $300 billion, the losses from credit default swaps could be $1.4 trillion.

5. The proposed bailout is welfare for the rich.

When the government bailed out AIG, company executives lost their jobs and investors lost most of their equity. It certainly wasn’t a bailout for the rich; to a much greater degree it was a bailout for people who had AIG insurance policies.

Similarly, Paulson’s $700 billion bailout proposal is not supposed to be a bailout for the rich. I suspect that Paulson intended to extract the same sorts of concessions from companies that would be bailed out with this money. However, as has been widely reported, his proposal contained no safeguards or oversight that would insure that this would happen. Such a lack of checks and balances is an invitation to abuse.

As an alternative, Connecticut Senator Chris Dodd has proposed that companies being bailed out have to give up equity, their executives have to accept pay limits, and other steps that would guarantee that the “guilty are punished.” But, as Eric Posner points out, Dodd’s plan actually gives more power to the Treasury than Paulson is asking for. (Dodd says that Congressional leaders have now reached a “fundamental agreement” about the bailout and expects legislation soon.)

Is a bailout bill, under any terms, really necessary? Will it (like previous responses to bubbles) create more problems than it solves? Should the federal government regulate credit default swaps?

Unfortunately, I probably won’t have an opinion about these larger questions until it is too late. But if a bailout bill is passed that is based on a myth like one of the above, the results will probably not be great for our economic future.