The Credit Bubble

by Dave Schuler on November 15, 2011

Interesting post over at The Big Picture. See especially the graph of the the increase in housing prices in OECD countries. I think it certainly supports the idea that what we saw was, in fact, a credit bubble rather than a housing bubble:

The chart below reads to me as having regular cycles, oscillating within a range. But something happened in the early 2000s to have that range explode upwards.

It isn’t clear to me how that graph can be explained by changes in the U. S. tax code alone, the actions of the GSEs, or even the two in combination. I’ve put forward my preferred explanation which starts a bit earlier than 2000 but I’m open to suggestions.

I think I do see some demographic influences on that chart. Isn’t it interesting that the losers of World War II did not experience a bubble while the winners did?

Update

The more I think about it the more I wonder whether the world’s policymakers and central banks (and, maybe, borrowers and lenders) responding to the same issues and incentives in the same way in lock step didn’t create the very apparent credit bubble.

{ 31 comments… read them below or add one }

Drew November 15, 2011 at 10:29 am

Two points:

1. As a data reader/interpreter for 35 years, the citation that “something happened in 2000″ is really sloppy. Its reliant on pegging the bubble against a prior peak. Yet every single line except Germany starts upward in the mid to late 90′s. 96- 97 really. I liken this to an analysis of an industrial boiler explosion. “Well, you know, the boiler pressure spiked a couple years ago. But if you look at the temperature and pressure data it started to go up two weeks ago ( and we think the regulator started to fail two weeks ago ) but T&P didn’t surpass the spike we saw two years ago, so it couldn’t be the regulator.” Really?

As a follow on, I think an anlysis of Germany’s credit posture from 1995 – 2005 would be instructive.

2. The piece, because of its references to CRA and Barney Frank, seems to an exculpatory attempt.

Let’s just stipulate for the moment that CRA is off the table. What is a credit bubble? Low financing costs (current interest rates) + lax credit underwriting standards (especially loan to value and history of repayment) + ability of loan originators to offload from their balance sheets the credit risk. Viola.

I don’t know what central bankers and politicians in all those other countries were saying at the time……..I just know what they were saying here in the US. I’ve cited this so many times people are probably sick of it, but evidence is evidence. In Congressional hearings regulators and whistleblowers were excoriated by the Maxine Waters, Barney Franks and Chris Dodd’s of the world. Called incompetant, racists etc etc. “There is no credit/housing problem” acording to them. Its on tape for your own eyes and ears.

Even if you want to take CRA off the table as an element driving the credit bubble because it was a US only regulation, you can’t remove the overall oversight and advocacy driving lax credit by pols like I just mentioned. Its a complete and total head in the sand position.

Again, I think a worthy follow up would be the credit posture of Germany.

PD Shaw November 15, 2011 at 10:31 am

Real Interest Rates Before and After EMU (1/1/99):

Germany 2.5 (1993-98) 1.7 (1999-2004)
Netherlands 2.1 (1993-98) 0.7 (1999-2004)
Belgium 3.1 (1993-98) 1.2 (1999-2004)
France 3.9 (1993-98) 1.4 (1999-2004)
Italy 4.9 (1993-98) 0.8 (1999-2004)
Spain 4.3 (1993-98) 0.0 (1999-2004)
Finland 3.7 (1993-98) 1.6 (1999-2004)
Portugal 4.7 (1993-98) 0.2 (1999-2004)
Ireland 4.5 (1993-98) -0.6 (1999-2004)
Greece 7.4 (1993-98) 1.0 (1999-2004)

Table on Page 29

PD Shaw November 15, 2011 at 10:48 am

I meant to remove Finland from that chart because Finland is not listed in the graph at The Big Picture. Otherwise, I’ve listed the countries in order of the relative change in real interests rates that might be attributable to the European Monetary Union. With Germany experiencing the least change and the PIIGS the most, but all the members experienced not insignificant reductions.

Icepick November 15, 2011 at 11:00 am

I couldn’t believe it in 2003 when the Fed did NOT start raising interest rates. I was aware of how that was going to impact pension plan valuations. (Low interest rates create a bad funding environment for pension funds because it means you can expect lower rates of return on prior investments, and thus a need for more direct contributions to the plan going forward. Ideally a pension plan’s trust fund can sustain itself through investments and does not need ongoing contributions.)

It seems clear in retrospect that the folks at the Fed did not believe the US could sustain its historic GDP growth rates without the use of performance enhancing interest rates. Thus the sustained cheap credit from that direction. One wonders if they realized they were creating a credit bubble but thought they could contain it, or if they knew the bubble was there and just hoped it would resolve itself, or if they really thought it would be different this time. Perhaps they were (and are) just deperate.

Incidentally, we often hear pols talking about the demographic problem of too many Boomers retiring & the adverse effect on SS MC et al, but have any of them ever suggested the boom years post-WWII were at least partly due to positive demographics?* You can read it on some places on the internet (here, of course), but have any of our elected officials ever acknowledged this? I’m wondering if any of them have that level of curiosity or if they’re too busy with managing their portfolios to care about anything else.

* If you answer is that you heard Daniel Patrick Moynihan discussing this back in 1989, I don’t care. He’s dead and buried – what about the current batch?

Drew November 15, 2011 at 11:32 am

Thanks, PD. I’m not a good enough international economist to fully understand the nuances of the various rate declines. But it certainly looks like some of the current weak sisters like Greece and Italy experienced much larger rate declines, probably to finance their public largesse. But its not clear to me that Germany was a credit hawk on rates. That brings me back to my essential point on housing: underwriting standards.

Steve Verdon November 15, 2011 at 11:52 am

Japan did indeed have a real estate bubble (or a credit bubble that showed up in the real estate market) it was just earlier than what the rest of the world (except Germany) has recently gone through. so I don’t think the “losers of WWII” is anything other than a coincidence. Especially when you keep in mind that Germany has always been rather “conservative” in regards to economic policy.

Were the Australians compelled to follow the CRA? Did Barney Frank influence the Belgians? Were the US GSEs effecting policy in the UK?

What these countries can’t have similar programs? Why is it hard to believe that different countries all settled on similar policies. They do all meet after all, the top policy makers/politicians all these GNumber summits. And in game theory people often end up settling on similar strategies in equilibrium. So different countries all look at promoting home ownership as a road to prosperity. Big banks here and in Europe both think it is a great idea because it is a way for them to make lots of money too.

No, different countries absolutely MUST pursue different strategies. It is a law of the universe right?

Dave Schuler November 15, 2011 at 11:57 am

As a data reader/interpreter for 35 years, the citation that “something happened in 2000″ is really sloppy. Its reliant on pegging the bubble against a prior peak. Yet every single line except Germany starts upward in the mid to late 90’s. 96- 97 really

I would add that compounding can make a process that has been ongoing for quite some time suddenly become troublesome but the problem didn’t begin when it became troublesome but long before.

Dave Schuler November 15, 2011 at 12:02 pm

Steve V:

I think it’s more than a coincidence. In Japan’s case in particular there was no post-war baby boom and, consequently, no demographically-based transition in the economy. I think the same is true of Germany although to a lesser extent.

Steve Verdon November 15, 2011 at 12:05 pm

But Japan had its bubble anyways. And your contention is that the housing bubble was a product of the Baby Boom? Okay, how so?

Steve Verdon November 15, 2011 at 12:06 pm

Oh and while we are talking demographics while Japan may not have had a baby boom, they do have the problem of an aging population…kind of like us.

Steve Verdon November 15, 2011 at 12:09 pm

And wasn’t Italy a loser in WWII? Why are they in the middle? I don’t know Dave, I’m just not seeing it, you need to provide more for this to be a tasty sandwich. Right now it is just two pieces of bread….provide a bit of meat, some mustard and a few other garnishments and you might have something, right now its rather bland.

Dave Schuler November 15, 2011 at 12:15 pm

First, IIRC Japan didn’t have a residential real estate bubble but a commercial one. Big difference.

I don’t think that the Baby Boom caused the housing bubble but I do think it caused us to rely more on residential housing construction than we otherwise might have. It also provided the illusion that housing prices always go up, something I think is quite evident from the graph I mentioned at the beginning of the post which to my eye follows demographic patterns.

I think that the credit bubble had multiple causes including Chinese trade policy and the mechanisms they used to peg the yuan to the dollar, declining tolerance for risk, demographics (which may be related to a declining tolerance for risk), bad policies coming home to roost. It’s sure interesting that so many but not all OECD countries had big run-ups in housing prices, though. I don’t think that the CRA is completely irrelevant but it can’t be dispository, either.

Other things that Japan and Germany have in common: exports comprise an out-sized portion of the economy. IMO that’s at least partially attributable to the war but I suppose opinion can differ.

Dave Schuler November 15, 2011 at 12:21 pm

The population pyramid for Italy is quite different that that of Germany or Japan. Cultural differences?

Steve Verdon November 15, 2011 at 12:37 pm

First, IIRC Japan didn’t have a residential real estate bubble but a commercial one. Big difference.

That is not what you are Ritholtz are implying in your OP and his post. You are pointing to a credit bubble with the real estate aspect being of secondary or even uninteresting importance….but now a commercial vs. residential bubble is an important distinction? This too needs further explanation, IMO.

And as an FYI, this paper says that Japan did have a baby boom.

link

Population growth is falling rapidly throughout Asia; Japan is in the vanguard. In its case, there was a baby boom in the late 1940s, followed by a baby bust. As a result, Japan’s working age population is now in decline, and from 2007 total population will begin falling. China, Korea, Taiwan and Thailand now also have birthrates below replacement level, and fertility in Indonesia and Vietnam is approaching the critical threshold of 2.1 children per woman (Gubhaju and Moriki-Durand, 2003; Eberstadt, 2004). All will, like Japan, soon face an aging population with a labor force that will no longer be expanding. It is important to think about the implications of this transition.

I don’t think that the Baby Boom caused the housing bubble but I do think it caused us to rely more on residential housing construction than we otherwise might have. It also provided the illusion that housing prices always go up, something I think is quite evident from the graph I mentioned at the beginning of the post which to my eye follows demographic patterns.

I think this is too easy an explanation. Look at the graph, housing prices go up then they go down. In a bubble people seem to rely too much on the recent past vs. a longer view of history or they come up with ways to justify how “this time its different”. That is what is primarily at work behind bubbles, IMO. Not growing demand.

I don’t think that the CRA is completely irrelevant but it can’t be dispository, either.

Ritholtz has used a logical fallacy. Does Europe have the CRA, Barney Frank, and U.S. GSEs at work there? No, then it couldn’t have been those things. But does Europe have their counter parts? Was there something like the CRA? Ritholtz doesn’t tell us that. Does Europe have entities like Fannie and Freddie? I don’t know and Ritholtz probably doesn’t either. So we don’t know if perhaps OECD countries all selected the same bad strategies or not. Maybe they didn’t but noting that Barney Frank is a Congressman here and not a politician in Europe is an amazingly stupid argument. It is like saying, Tim McVeigh is dead so we can never have another Oklahoma City style bombing ever again.

Steve Verdon November 15, 2011 at 12:43 pm

The population pyramid for Italy is quite different that that of Germany or Japan. Cultural differences?

Oh…cultural differences, but look there we are right next to Italy. And why are we so far from the UK? I would think we have quite a bit in common with the UK culturally speaking.

And Germany also appears to have had a Baby Boom, it just started later than other Western countries.

cfpete November 15, 2011 at 12:58 pm

In re to Germany, you have to take reunification into account.

michael reynolds November 15, 2011 at 1:08 pm

Wouldn’t the baby booms be a function of how many dead and how much damage done in WW2? Italy was relatively intact and lost a little over 1% of its population. Japan and Germany lost in the vicinity of four times as many people (as a percentage of 1939 population) and were severely damaged. Hard to get boom going when all the young men are dead and you’re eating rats.

Dave Schuler November 15, 2011 at 1:39 pm

Offhand I’d guess that absolute quantities account for something. What was the total volume of the Japanese commercial real estate bubble? The U. S. residential bubble? Which was more likely to have worldwide spillover effects?

Still, I’m less proposing an explanation than looking for one. What’s the difference between Japan and Germany on the one hand and the rest of the OECD on the other? More exports, fewer commodity exports, less consumption, more savings. What else?

Drew November 15, 2011 at 2:02 pm

“I would add that compounding can make a process that has been ongoing for quite some time suddenly become troublesome but the problem didn’t begin when it became troublesome but long before.”

I think this is a valid observation, but I’m at a loss to identify an earlier catalyst. I suppose one could site stagnating middle class income, a phenomenon I’ve cited today over at OTB – and am getting pummeled by the usual idiots who now infest that site – which clearly became a factor in the early 70′s. That is, people began borrowing to sustain lifestyle.

I still have to ask. Why did we only get a debacle in a single time financed asset: housing. And not cars, fridge’s, payday loans, student loans etc. All time financed, so they had an income stream; they’ve all been securitized and syndicated. Many asset classes.

So what does that have to say about the usual BS about “all Bush’s dereg fault,” “the aughts,” “Wall Street greed” etc etc. It doesn’t fit the simple minded leftist narrative, people. It just simply doesn’t fit.

We need a more sophisticated view. Better: housing was an asset class fostered by public policy. I continue to hold my basic position.

sam November 15, 2011 at 2:10 pm

Here’s an interesting article ( New York Times, December 25, 2005): Take It From Japan: Bubbles Hurt.

I find this astonishing:

JAPAN suffered one of the biggest property market collapses in modern history. At the market’s peak in 1991, all the land in Japan, a country the size of California, was worth about $18 trillion, or almost four times the value of all property in the United States at the time.

That was some bubble.

Ben Wolf November 15, 2011 at 3:41 pm

“Yet every single line except Germany starts upward in the mid to late 90’s. 96- 97 really.”

Something very identifiable happened in the mid-late 90′s: the U.S. government shrank its deficits and then ran surpluses, forcing the private sector to move into deficits and start using credit to make up for the loss. Those surpluses were ground zero of the credit bubble which burst in 2008.

Icepick November 15, 2011 at 3:49 pm

Hard to get boom going when all the young men are dead and you’re eating rats.

Technically the eating rats might be more important than the dead young men. Just about any male can provide viable sperm after puberty, and can do so for as many women as the man’s stamina will allow. Women have a much shorter time-frame in which to have children. So the limiting factors will be the number of women of child-bearing age (and younger) that are lost, and the economic viability of having children.

In short, the prolonged struggle against Germany, particularly the air war (go read accounts from pilots about what we did during WWII over Germany) coupled with the nasty ground war, especially in the Soviet zone of operation, would have made a difference. Not to mention the Germans killing off a certain amount of their own population, and a divided nation after the war no doubt didn’t help.

Japan’s WWII demographic problem would have been exacerbated by the fight-until-everyone-is-dead philosophy – not many captive troops coming home after the war, and the island nature of most of the campaign meant the troops had no way to retreat.

Icepick November 15, 2011 at 3:55 pm

IIRC Japan had very high tax rates that impacted property transactions. I swear I remember it being something like 50% of all money collected from a sale of property would be taxed by the government. This meant only people that had a lot of excess money would be interested in buying or selling. That or commercial interests who had access to more money. Thus a commercial property bubble, and not a residential one. My number is probably off, but I remember reading analysis to this effect back in the 1980s.

Anyone else remember how the Japanese CRE bubble bubbled over into the US? Remember how the Japanese and their American partner took a bath on the Empire State Building? Funny stuff! If only I could lose money like The Donald I could be a billionaire too….

Drew November 15, 2011 at 4:52 pm

“Something very identifiable happened in the mid-late 90’s: the U.S. government shrank its deficits and then ran surpluses, forcing the private sector to move into deficits and start using credit to make up for the loss. Those surpluses were ground zero of the credit bubble which burst in 2008.”

OK.

Which components of the private sector were forced into debt, and by what electromotive force of public austerity?

steve November 15, 2011 at 5:44 pm

“I still have to ask. Why did we only get a debacle in a single time financed asset: housing. And not cars, fridge’s, payday loans, student loans etc. All time financed, so they had an income stream; they’ve all been securitized and syndicated. Many asset classes.”

A house is the biggest purchase most people will ever make. It is the single biggest source of wealth for most people. Thus, it has been the source of many other banking/financial crises. It makes a lot of sense.

It is a large enough market that loan originators can make a fortune (Planet Money had very good stuff on this) selling liars loans. It is a large enough market to make securitization work well. They could be rolled into groups and declared AAA. They became interchangeable with Treasuries to hold as collateral for short term loans. Then, all you needed was a derivatives market that was not listed anywhere and overconfidence about the ability to hedge. (AIG still does not make any sense to me. They were so central to this scam. How could they possibly have sold their “insurance” for so little?)

Everything I listed above is easy to set up any place you have banks. Government policy largely needs to be limited to not regulating and keeping interest rates low.

Steve

Steve Verdon November 16, 2011 at 1:14 pm

Something very identifiable happened in the mid-late 90’s: the U.S. government shrank its deficits and then ran surpluses, forcing the private sector to move into deficits and start using credit to make up for the loss. Those surpluses were ground zero of the credit bubble which burst in 2008.

I don’t get this. So the Government stops borrowing and so…the private sector absolutely must borrow? I don’t see the mechanism here. Why does the private sector have to ramp up borrowing if the government borrows less? Is the implication that the government is spending less so the private sector has to borrow to “pick up the slack”? I find that rather unconvincing as well. Suppose the government reduces the rate of spending growth for the military…does this mean private firms are going to start spending on defense items? Is McDonalds going to start maintaining a fleet of APCs? Is a private company going to spend money on freeways? I’m just not seeing how this argument works.

Steve Verdon November 16, 2011 at 1:26 pm

A house is the biggest purchase most people will ever make. It is the single biggest source of wealth for most people. Thus, it has been the source of many other banking/financial crises. It makes a lot of sense.

Quite right. Edward Leamer has pointed out that real estate has been a primary factor in just about every recession post WWII.

It is a large enough market that loan originators can make a fortune (Planet Money had very good stuff on this) selling liars loans. It is a large enough market to make securitization work well. They could be rolled into groups and declared AAA. They became interchangeable with Treasuries to hold as collateral for short term loans. Then, all you needed was a derivatives market that was not listed anywhere and overconfidence about the ability to hedge. (AIG still does not make any sense to me. They were so central to this scam. How could they possibly have sold their “insurance” for so little?)

I think part of the problem is that people failed to understand correlations when developing derivatives. A bit shocking given all the “quants” working in that field. But if my house declines in value, then it is almost surely the case that my neighbors houses have also declined in value. In other words, you can’t treat housing prices as iid (independent identically distributed) processes. Or more simply when one asks, “What are the chances my house price will decline.” It very much depends on the price of the houses around you. Housing prices tend to move together. So it can be more like dominoes than say trees falling in a forest. In the latter a tree could fall and leave all the other trees unscathed. With dominoes if one falls, the rest follow along.

I know that is a pretty basic concept and it would be shocking that people overlooked this, but hey those things happen.

Overall the issue with derivatives isn’t inherently bad, IMO. I know lots of people seem to be implying that, but they really are nothing other than an insurance vehicle. The difference between derivatives and other forms of insurance is that the latter are highly regulated while the former is not. Also, there is no central exchange or exchanges for derivatives. These two things make it very hard to evaluate derivatives and their inherent risk. And since it is like placing bets, if you bet wrong (AIG) you can lose big. Ideally, if you bet on a broad number of derivatives and you correctly understand the risk, my guess is you should end up in a break even situation. Kind of like placing lots of bets in a fair game or roulette game. The law of large numbers will ensure that you end up neither ahead nor behind, but pretty much even. The problem is that derivatives are not like roulette where the underlying probabilities are pretty well understood. With derivatives there is going to be a considerable amount of subjective probabilities…i.e. what is your personal belief that a given event will obtain.

Drew November 16, 2011 at 2:25 pm

steve -

Your comment makes sense if you are not fact driven, and have the obvious predisposition you have, and simply want to truncate the analysis.

However, a simple search on topics like “asset backed securities” or “securitization” would show that assets such as credit cards, car loans and the others I cited are huge and active markets.

Sorry to dissappoint you. My query stands.

steve November 16, 2011 at 3:17 pm

“assets such as credit cards, car loans and the others I cited are huge and active markets.”

The car loan market is as large as the mortgage market? Will go look it up. AFAIK, car loans have not been accepted as a AAA alternative to Treasuries.

“Your comment makes sense if you are not fact driven”

I think that I have looked at the numbers for just about everything I cited. Which one are you disputing?

Steve

steve November 16, 2011 at 7:01 pm

Total credit card debt runs about $800 billion. There are 246 million cars in the US, down from 250 million. Say $20,000 per car and you have a $500 billion market. The mortgage market is about $10 trillion.

Steve

Steve Verdon November 17, 2011 at 5:02 pm

There are 246 million cars in the US, down from 250 million. Say $20,000 per car and you have a $500 billion market. The mortgage market is about $10 trillion.

Uhhmmmm no. I think you need to rethink what a market is. The total value of all mortgages might be $10 trillion, but that is a different thing altogether, IMO.

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