Glenn Beck & Thomas Sowell, Housing Boom and Bust

The Housing Boom and Bust

by Walter Williams

Hot off the press is my colleague Dr. Thomas Sowell's 43rd book, "The Housing Boom and Bust." The book is an eye-opener for anyone interested in the truth about the collapse of the housing market that played a major role in our financial market crisis.

The root of the problem lies in Washington. The Community Reinvestment Act of 1977, later given teeth during the Bush and Clinton administrations, forced financial institutions to make risky mortgage loans they otherwise would not have made. President Clinton's Attorney General Janet Reno threatened legal action against lenders whose racial statistics raised her suspicions. Bank loan qualification standards, in general, came under criticism as being too stringent regarding down payments, credit histories, and income. Fannie Mae and Freddie Mac, two government-sponsored enterprises, by lowering their standards for the kinds of mortgage paper they would purchase from banks and other mortgage lenders, gave financial institutions further incentive to make risky loans.

In 2002, the George W. Bush administration urged Congress to enact the American Dream Down Payment Assistance Act, which subsidized down payments of homebuyers whose income was below a certain level. Bush also urged Congress to pass legislation requiring the Federal Housing Administration to make zero-down-payment loans at low-interest rates to low income Americans. Between 2005 and 2007, Fannie Mae and Freddie Mac acquired an estimated trillion-dollar's worth of subprime loans and guaranteed more than $2 trillion worth of mortgages. That, Sowell points out, is larger than the gross domestic product of all but four nations.

There were numerous warnings that went unheeded. In congressional hearings, U.S. Treasury Secretary John Snow said, regarding the risks assumed by Fannie Mae and Freddie Mac, "The concern is, if something unravels, it could cause systemic risk to the whole financial system." Peter J. Wallison, American Enterprise Institute scholar, warned that if Congress did not reign in Fannie Mae and Freddie Mac, "there will be a massive default with huge losses to the taxpayers and systemic effects on the economy."

There were many other warnings of pending collapse but Congress and the White House in their push for politically popular "affordable housing" ignored them. Congressman Barney Frank, who is now chairman of the House Committee on Financial Services, said critics "exaggerate a threat of safety" and "conjure up the possibility of serious financial losses to the Treasury, which I do not see." Chairman Chris Dodd, of the Senate Banking Committee, called Fannie Mae and Freddie Mac "one of the great success stories of all time" and urged "caution" in restricting their activities, out of fear of "doing great damage to what has been one of the great engines of economic success in the last 30 or 40 years."

Sowell provides numerous examples of government actions at both the federal and state levels that created the housing boom and bust and its devastating impact on domestic and foreign financial markets, but here's what I don't get: What can be said about the intelligence of the news media and the American people who buy into to congressionally created lies that our problems were caused by Wall Street greed and Bush administration deregulation? In the words of Barney Frank, "We are in a worldwide crisis now because of excessive deregulation" and "mortgages made and sold in the unregulated sector led to the crisis." The fact of the matter is our financial sector is the most heavily regulated sector in our economy. In the banking and finance industries, regulatory spending between 1980 and 2007 almost tripled, rising from $725 million to $2.07 billion. I challenge anyone to come up with one thing banks can do that's not covered by a regulation.

For the Washington politicians to get away with spinning the financial crisis the way they have suggests that American people are either stupid or ignorant. I hope it's ignorance because "The Housing Boom and Bust" is the cure.

The oil price

Bust and boom

From Economist.com

The price of oil has leapt to nearly $62 a barrel. Another spike may be on the way

RISING oil prices, believes Ali al-Naimi, Saudi Arabia’s oil minister, may soon “take the wheels off an already derailed world economy”. On the face of things, this concern is absurd. The plunge of $115 in the price of oil from its peak last July to its nadir in December was the most precipitous the world has ever seen. Demand for oil is still falling, as the world economy atrophies. Rumours abound of traders hiring tankers to store their excess oil. Rich countries’ stocks cover 62 days’ consumption, the most since 1993 (see chart 1). The average over the past five years has been 52 days’ worth.

Nor are oil firms pumping nearly as much as they could. OPEC has announced three separate rounds of production cuts since September in a bid to steady prices. In all, it has vowed to trim its output by 4.2m barrels a day (b/d). That leaves them with as much as 6m b/d of spare capacity. Despite this growing glut, however, the price of oil has been rising steadily in recent weeks (see chart 2). On Wednesday May 20th it closed above $60 a barrel for the first time in more than six months. That marks an increase of more than 75% since February. The price of futures contracts suggests that energy traders see the price rising higher still in the coming months and years. (During the day on Friday it appeared to be nearing $62 a barrel.)

The explanation is simple. Oilmen are worried because they believe that many of the factors behind the record-breaking ascent last year remain in place. Much of the world’s “easy” oil has already been extracted, or is in the hands of nationalist governments that will not allow foreigners to exploit it. That leaves firms to hunt for new reserves in ever more inhospitable and inaccessible places, such as the deep waters off Africa or the frozen oceans of the Arctic. Such fields take a long time and a lot of expensive technology to develop. Worse, new discoveries tend to be smaller than in the past and to run dry faster.

So oil firms must work doubly hard to replace declining fields and to increase output. Yet the oil industry is short of equipment and manpower, thanks to underinvestment in the 1980s and 1990s, when prices were low. As soon as the world economy starts growing again, the theory runs, demand for oil will once again outstrip the industry’s ability to supply it. In other words, the global recession has only interrupted the “supercycle” of which many analysts used to speak, during which the normal boom-and-bust cycle of oil and other commodities would give way to a protracted period of high prices, as ever-growing demand from emerging markets swallowed everything the extractive industries could produce.

Oil bosses, OPEC ministers and anxious bankers all agree on what is needed to prevent this scenario becoming reality: lavish investment in the development of new fields and in exploration. Yet the reverse is happening. The oil industry is cutting its spending, bringing fewer new fields into production and exploring less. The International Energy Agency reckons that overall investment will drop by 15-20% this year.

In theory, this should not be happening. Big Western oil firms (“majors” in the industry jargon) claim that they continue to invest steadily throughout the cycle, irrespective of gyrations in price. Big fields, they argue, can take a decade or more to develop, and may then produce oil or gas for several decades more. The price of oil at the time the investment is approved is irrelevant; the important thing is to make sure projects will be profitable across a range of possible future prices. If anything, given that most oilmen expect prices to rise in the medium term, you would expect them to be increasing their investment, to capitalise on the good times to come. Nonetheless, the extreme volatility of prices over the past year must have made big firms more cautious about future investments.

Then there are the state-owned firms in oil-soaked countries. These companies control the overwhelming majority of the world’s oil. The better managed and funded of them plan to continue investing despite the downturn. Saudi Aramco, the world’s biggest oil producer, recently completed a five-year scheme to expand its production capacity from 10m b/d to 12.5m b/d, at a cost of $70 billion. But in Russia, the world’s second-biggest oil producer, output is falling largely because private capital has been scared off by a series of expropriations, while the state starves the firms it controls of sufficient cash for investment. And most oil-rich states, naturally enough, are happy to see the price rise. Many have become used to bumper revenues in recent years and have struggled to balance their budgets since the price slumped last year.

Falling costs within the industry will offset the impact of falling investment budgets to some extent. BP argues its slight cut in investment does not really represent a reduction, thanks to deflation. Yet many constraints on expansion remain. For one thing, the world still does not have as many experienced petroleum engineers and geologists as it needs, says Iain Manson of Korn/Ferry, a recruiting firm. He expects it to take a decade or more to overcome the shortage. Meanwhile, he says, wages in the oil industry are not falling by nearly as much as other costs.

Worse, there is little sign that governments are willing to grant oil companies easier access to the most promising territory for exploration. Iraq’s plans to sign big new contracts with foreign firms are years behind schedule, as is its new oil law. American sanctions continue to impede investment in Iran. The Nigerian government has been unable to quell the insurgency in the Niger delta, making it difficult for oil firms to operate there. Even in America, despite years of debate, most coastal waters and much of Alaska remain off-limits to drilling.

So when demand begins to revive, a sharp rise in prices is inevitable. That does not mean that a price spike is just around the corner, however. The speed with which it arrives will depend on the strength of the global recovery. For the moment, global consumption of oil continues to fall, despite the slight brightening of the economic outlook. At the recent OPEC powwow Mr al-Naimi, the Saudi oil minister, argued that a low oil price always sowed the seeds of a future price rise, since it led to underinvestment. The only question this time is how quickly the strain will emerge.

The Next Housing Bust

Everyone knows how loose mortgage underwriting led to the go-go days of multitrillion-dollar subprime lending. What isn't well known is that a parallel subprime market has emerged over the past year -- all made possible by the Federal Housing Administration. This also won't end happily for taxpayers or the housing market.

Last year banks issued $180 billion of new mortgages insured by the FHA, which means they carry a 100% taxpayer guarantee. Many of these have the same characteristics as subprime loans: low downpayment requirements, high-risk borrowers, and in many cases shady mortgage originators. FHA now insures nearly one of every three new mortgages, up from 2% in 2006.

The financial results so far are not as dire as those created by the subprime frenzy of 2004-2007, but taxpayer losses are mounting on its $562 billion portfolio. According to Mortgage Bankers Association data, more than one in eight FHA loans is now delinquent -- nearly triple the rate on conventional, nonsubprime loan portfolios. Another 7.5% of recent FHA loans are in "serious delinquency," which means at least three months overdue.

The FHA is almost certainly going to need a taxpayer bailout in the months ahead. The only debate is how much it will cost. By law FHA must carry a 2% reserve (or a 50 to 1 leverage rate), and it is now 3% and falling. Some experts see bailout costs from $50 billion to $100 billion or more, depending on how long the recession lasts.

How did this happen? The FHA was created during the Depression to help moderate-income and first time homebuyers obtain a mortgage. However, as subprime lending took off, banks fled from the FHA and its business fell by almost 80%. Under the Bush Administration, the FHA then began a bizarre initiative to "regain its market share." And beginning in 2007, the Bush FHA, Congress, the homebuilders and Realtors teamed up to expand the agency's role.

The bill that passed last summer more than doubled the maximum loan amount that FHA can insure -- to $719,000 from $362,500 in high-priced markets. Congress evidently believes that a moderate-income buyer can afford a $700,000 house. This increase in the loan amount was supposed to boost the housing market as subprime crashed and demand for homes plummeted. But FHA's expansion has hardly arrested the housing market decline. The higher FHA loan ceiling was also supposed to be temporary, but this year Congress made it permanent.

Even more foolish has been the campaign to lower FHA downpayment requirements. When FHA opened in the 1930s, the downpayment minimum was 20%; it fell to 10% in the 1960s, and then 3% in 1978. Last year the Senate wisely insisted on raising the downpayment to 3.5%, but that is still far too low to reduce delinquencies in a falling market.

Because FHA also allows borrowers to finance closing costs and other fees as part of the mortgage, the purchaser's equity can be very close to zero. With even a small drop in prices, many homeowners soon have mortgages larger than their home's value -- which is one reason FHA's defaults are rising. Every study shows that by far the best way to reduce defaults and foreclosures is to increase downpayments. Banks know this and have returned to a 10% minimum downpayment on their non-FHA loans.

In a rational world, Congress and the White House would tighten FHA underwriting standards, in particular by eliminating the 100% guarantee. That guarantee means banks and mortgage lenders have no skin in the game; lenders collect the 2% to 3% origination fees on as many FHA loans as they can push out the door regardless of whether the borrower has a likelihood of repaying the mortgage. The Washington Post reported in March a near-tripling in the past year in the number of loans in which a borrower failed to make more than a single payment. One Florida bank, Great Country Mortgage of Coral Gables, had a 64% default rate on its FHA properties.

The Veterans Affairs housing program has a default rate about half that of FHA loans, mainly because the VA provides only a 50% maximum guarantee. If banks won't take half the risk of nonpayment, this is a market test that the loan shouldn't be made.

These reforms have long been blocked by the powerful housing lobby -- Realtors, homebuilders and mortgage bankers, backed by their friends in Congress. They claim FHA makes money for taxpayers through the premiums it collects from homebuyers. But keep in mind these are the same folks who said taxpayers weren't at risk with Fannie Mae and Freddie Mac.

A major lesson of Fan and Fred and the subprime fiasco is that no one benefits when we push families into homes they can't afford. Yet that's what Congress is doing once again as it relentlessly expands FHA lending with minimal oversight or taxpayer safeguards.

Local-government finances

Bust in the boonies

As central-government finances buckle, local coffers take the strain too

BRITAIN’S cupboard is looking pretty bare. After a binge of bail-outs, lifelines and fiscal stimuli, public borrowing is soaring. And if things look bad in Westminster, pain will be felt in town halls around the country. Councils get an average of three-quarters of their money from central-government grants, rising to 90% in poor areas. So “as national finances go, so go local finances,” reckons Adam Marshall of the Centre for Cities, a think-tank. For the past ten years that has been a good deal: grants went up by 39% in real terms in the decade from 1997, though more work came with it. Now, as belts tighten in London, town-hall tums must be sucked in too.

Constraints are closing in from four directions. Government grants are agreed in three-year tranches, and the current tranche has just entered its second year. But these settlements, designed to help councils plan for the long term, are gentlemen’s agreements, not legally binding, and rumours now buzz that the cash-strapped Treasury is contemplating cutting next year’s grant. Even if it holds off, no one thinks the next three-year deal will be generous: money needs to be saved somewhere, and boring-sounding council grants may be easier prey than health, education and other popular public services.

Secondly, councils, like most folk, aren’t making much on their investments anymore. The Bank of England’s base rate of interest tumbled to 0.5% in March from 5.5% at the beginning of 2008. “We became used to the benefit of that interest,” says Joanna Killian, chief executive of Essex County Council, which has some £300m ($440m) invested in the markets on a typical day. Some councils may have lost not only interest but deposits too, after parking savings in the Icelandic banks that sank in October last year. More than £793m was deposited by 105 councils, of which the worst exposed was Kent, with £48.9m of it. Councils acted without due regard to the risks involved, and a small number were negligent, according to a report last month by the Audit Commission, a spending watchdog (which itself made deposits of £10m in two Icelandic banks).

Other forms of income have dried up too. Revenues from council tax, a property levy and the only tax that councils directly set themselves, are down since more people are unemployed and thus qualify for means-tested exemptions. This tax cannot be raised much for remaining payers because the central government has said it will cap increases at 5%. A slowdown in homebuilding means that predictions of higher future tax receipts will not be met. And the stalled property market has also cut income from the charges that councils make when they grant planning permission. EC Harris, a building consultancy, calculates that councils made around £9 billion from planning permissions in the year to March 2008. In the subsequent year they will have made only £2 billion-3 billion, Harris reckons.

The take-up of paid-for consumer services has fallen too. Fewer people are going to public pools, or doing up their kitchens (councils can earn an easy fee by picking up an old fridge). Ms Killian says parking receipts in Brentwood, a town in her empire, are down by as much as a quarter as people stay at home or take the bus.

Finally, councils expect to spend more on other, free services. Hard-up parents may transfer their children from private to state schools, and more of those who were there already are applying for free school meals, according to the Local Government Association (LGA), which represents town halls. Demand for social housing is likely to rise. And elderly people whose savings income has dropped are turning to the state. “Some people who wouldn’t ever have thought about taking a local-authority service need us now,” Ms Killian says.

The consequence—and a silver lining

Already, councils are trimming their costs. The LGA reckons 10,000 council jobs have been shed since September. A survey by the Times in February predicted 40,000 could go in 2009. Education budgets (the biggest expense) are ring-fenced, leaving councils to cut transport, social services, housing, rubbish collection and fun things such as sports facilities and libraries.

So prepare for a dirtier, glummer Britain. But the belt-tightening has some upsides. It may lead to better procurement (see article). Small authorities could save money by sharing call centres or other back-office functions, suggests James Hulme of the New Local Government Network, a think-tank. And council chiefs report two pluses: lower inflation has made it easier to negotiate contracts, and the quality of job applicants has soared as bright people flee the private sector.

The crisis may also force more realistic thinking about pensions. Unlike many in central government, whose pensions will be paid by tomorrow’s taxpayers, council workers are members of actual pension funds, which are now nowhere near big enough to meet their obligations. The Icelandic experience may foster more sensible stewardship of these funds; but generous final-salary pensions, almost extinct in the private sector, may also be ditched.

The crisis may have a lesson for Whitehall too: that councils need more power if they are to make bigger savings. Their central funding, much of which comes earmarked for particular projects, leaves them “fighting the recession with one hand behind their backs”, Mr Marshall argues. A big city such as Birmingham, where £7.5 billion of public money is spent each year by various central-government agencies, could recover more quickly if the council were allowed to divert resources into, say, youth unemployment, he suggests.

Councils have proved good at spending their money in the past. Though newspapers focus on their handsomely paid chief executives (16 of whom earn more than the prime minister), the Audit Commission has praised them for repeated efficiency savings. In fact, the Communities Department, which sets these targets, could perhaps take a leaf from their book: an internal review of Whitehall procurement policies, leaked this week, put the department second from the bottom.

The Real Estate Bust Is Far From Over

Mises Daily by Doug French

For those thinking that the real-estate bust is all over with — think again. The residential market has hit the ditch and continues to sink lower, but now the commercial property market is rolling over and will take many lenders down the drain with it. America's small and regional bankers are pointing their fingers at the big banks, claiming the big money center banks "have tarred and feathered us," City National Bank chief executive Bill McQuillan told the Wall Street Journal during the Independent Community Bankers of America convention in Phoenix. But banks — large and small — all over the country are loaded with commercial real-estate loans, and that collateral is heading south according to a Deutsche Bank report.

The folks at Deutsche Bank see price declines of 35 to 45 percent and maybe more in commercial property, due to the large number of loans coming due between now and 2012 that will not be able to be refinanced. Not only are loan delinquency rates up and rents down, but the go-go years of aggressive loan underwriting are gone. The interest-only, high low-to-value loans that drove capitalization (cap) rates to the five-percent range are history. Property buyers who are required to put more money down will offer significantly less for the same net operating income to achieve the required return on investment. Thus, cap rates for properties in Las Vegas, for instance, are closing in on 9 percent according to a local appraiser and may be on their way to 10 percent.

But bankers are in a state of denial, according to real-estate pro Andy Miller, who spoke at Doug Casey's Crisis & Investment Summit in Las Vegas recently. Miller's been in the business for 30 years and hasn't seen a property financing market this tight. But the current note holders are saying "don't worry, be happy." Miller told the capacity Casey crowd that bankers show him the door when he rains on their parade.

Despite being inexperienced and clueless, at least bank workout officers understand what's going on, according to Miller, however the rose-colored-glasses-wearing bank senior managements are counting on real-estate values to turn around by year's end. It's the same sort of denial Miller saw during the S&L debacle. Eventually there was capitulation, but it took years. A Vegas appraiser who lived through the 1980s Texas property meltdown echoes Miller's view, remembering that it took property owners in Texas back then years before they figured out that their property values weren't coming back any time soon.

The conventional wisdom is that people losing their homes will rent an apartment so apartments are a safe place for real-estate investment dollars. Miller's view is just the opposite, thousands of empty houses compete with apartments and a gigantic multifamily implosion is coming. The numbers in Deutsche Bank's report confirm that the apartment implosion is already underway. The total current delinquency rate for apartment loans is 3.53 percent, much higher than the last peak in delinquency of 2.35 percent back in October of 2005. And the past-due rate on new apartment loans are especially bad at over 5 percent. Tennessee, Georgia, and Florida top the multifamily most-delinquent list.

But no area of commercial property will be spared the bloodbath. Hotels are imploding according to Miller and cap rates for retail properties have jumped 250–300 basis points in a year, while office cap rates have increased 200 basis points. These cap-rate increases translate to property value decreases of a quarter to a third, and the market is just starting to deteriorate. This property meltdown will "make the 1980s look like a picnic," Miller says.

There will be tens of billions of dollars in losses in the Las Vegas condo market, Miller told the Casey faithful while pointing at the nearby Las Vegas Strip. But Sin City won't be alone. The United States had 14 months' worth of condo inventory at the end of last year and the 93,000 units scheduled to be finished this year will increase inventory 28 percent. A good share of those units — 12,000 — will come online in job-bleeding New York and northern New Jersey, reports the Wall Street Journal, while the Windy City will have an additional 5,500 units for sale and Miami will add nearly 3,500.

The condo crash is making life miserable for Donald Trump, who has projects in many of the once-hot-and-now-not markets. He's fighting with his lenders in Chicago, has only closed sales on a quarter of his finished units in Las Vegas, and buyers in two projects in Miami bearing the Trump name aren't showing up to close escrow.

But, The Donald is keeping the sunny side up. As for his Vegas tower, "We are doing very nicely considering that Las Vegas is in a massive depression," Trump told the Wall Street Journal.

The Housing Bubble was hardly the first in human history.

On the housing front, there was a nearly 10-month supply of unsold homes on the market at the end of February while the Case-Shiller home-price index plummeted a record 19 percent in January, causing David Blitzer of S&P's index committee to say, "There's no daylight that I can see in this report."

But national homebuilder Pulte Homes must see daylight in their crystal ball. The company announced it will buy competing builder Centex.

"We believe this is the right combination at the right time in the business cycle," Centex Chairman and Chief Executive Officer Timothy Eller, said in a statement. "By acting decisively now, we're creating unrivaled firepower to capitalize on the opportunities in home building that are now becoming visible on the horizon."

Lenders aren't the only ones in denial.

Austrians Can Explain the Boom and the Bust

by Robert P. Murphy

In a recent debate, prominent Keynesian professor and blogger Brad DeLong claimed that the Austrian explanation of the business cycle "does not work as an intellectual enterprise."[1]

DeLong quotes Paul Krugman who, back in December, apparently dealt the Austrian diagnosis a crushing defeat on both theoretical and empirical grounds.

In the present article, I will set the record straight. Krugman's theoretical criticism of (what he dismissively calls) the "hangover theory" of recessions is silly, and his empirical test is also a poor one. Once we set up a more appropriate test, the "hangover" theory — i.e., the Mises-Hayek explanation — passes with flying colors.

Krugman's Two-Pronged Critique of the "Hangover Theory"

On his popular New York Times blog, back in December, Krugman lamented the idiocy of his colleagues. He can't believe that John Cochrane would say something this (allegedly) foolish:

"We should have a recession," Cochrane said in November, speaking to students and investors in a conference room that looks out on Lake Michigan. "People who spend their lives pounding nails in Nevada need something else to do."

In response to such (apparent) nonsense, Krugman offers first a theoretical objection:

The basic idea is that a recession, even a depression, is somehow a necessary thing, part of the process of "adapting the structure of production." We have to get those people who were pounding nails in Nevada into other places and occupation, which is why unemployment has to be high in the housing bubble states for a while.

The trouble with this theory, as I pointed out way back when, is twofold:

1. It doesn't explain why there isn't mass unemployment when bubbles are growing as well as shrinking — why didn't we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

Before dealing with Krugman's second (and empirical) objection, let's handle this theoretical objection.

You can't understand Austrian business-cycle theory (ABCT) unless you first understand the Austrian view of the capital structure of the economy. In this article, I showed how Krugman was simply incapable of grasping ABCT because he lacks a rich enough model of capital. For those newcomers who are unfamiliar with ABCT, I strongly encourage you to read the fuller discussion in the hyperlinked article.

For our purposes here, a brief recapitulation of the argument: In a market economy, prices really serve a function; they are not mere appendages of exploitative power relations, but instead market prices signal real, underlying scarcity and help everyone in the economy adjust his plans in light of reality. The interest rates on various loans also mean something; they are not arbitrary.

In particular, the market interest rate coordinates the "intertemporal" (i.e., across-time) activities of investors, businesses, and consumers. If consumers become more future oriented and want to reduce consumption in the near term in order to provide more for later years, what happens in the free market is that the increased savings push down interest rates, which then signal entrepreneurs to borrow more and invest in longer projects. Thus resources (such as labor, oil, steel, and machine time) get redirected away from present goods, like TVs and sports cars, and the freed-up resources flow into capital or investment goods like tractors and cargo ships.

Now when the Federal Reserve artificially reduces interest rates below their free-market level, it sends a false message to entrepreneurs. Firms begin expanding as if consumers have increased their savings, but in fact consumers have reduced their savings (due to the lower interest rates). Businesses that churn out durable goods, such as furnaces, cargo ships, and, yes, houses will find business booming, because these sectors respond positively to low interest rates.

On the other hand, other sectors don't need to contract, because (unlike the scenario of genuine savings) nobody is cutting back on consumption. This is precisely why the Fed-induced boom is unsustainable — real resources have not been released from consumer sectors in order to fuel the expansion of the capital sectors. Because modern economies are so complex, the charade can continue for a few years, with entrepreneurs cutting corners and "consuming capital" (i.e., postponing necessary replacement and maintenance on equipment) while both investment and consumer goods keep flowing out of the pipeline at increased rates. But the music eventually stops, since (after all) the Fed's printing of green pieces of paper doesn't really make a country wealthier. When the Fed "cuts interest rates" it isn't really creating more capital for businesses to borrow; it is instead distorting the signal that the market interest rate was trying to convey.

So, in this context, Krugman the Nobel laureate is confused. When the Fed starts dumping wads of newly printed cash into particular sectors of the economy, why does this foster a period of prosperity — however illusory and fleeting it may be? Why instead doesn't the money drop cause millions of people to get laid off?

I admit I feel sheepish even phrasing the question that way, but go reread Krugman's blog post; that's what he's asking. The answer, of course, is that businesses armed with newly printed Fed dollars must bid away workers from their original niches in the structure of production. Obviously, this process doesn't lead to mass unemployment. The workers voluntarily quit their original jobs because the inflated money supply has allowed a few firms to offer them higher salaries. The Fed's injection of new money has not yet distorted the whole economy, and so there is no reason for other businesses to suddenly find themselves in trouble and lay off workers at the beginning of the artificial boom.

In contrast, once the bubble has popped, many firms realize they are embarked on unsustainable projects. They need to lay off their workers. Unemployment goes up, and only as workers reluctantly accept lower wages can they be reintegrated into the economy. On average, workers are earning less during the bust period than at the height of the boom. This is because the salaries and wages of the boom period were exaggerations of the true "fundamentals" of worker productivity, and also because the fundamentals themselves have been hurt due to the waste of capital during the boom period.

In short, workers on average are not as economically productive during the recession because the whole structure of production has been thrown out of whack by the Fed's injections of funny money. It is much harder for workers to switch jobs and take a pay cut versus quitting a job in order to take a better one that pays more.

That's the simple explanation for why the Fed-induced boom sees low unemployment, while the necessary bust experiences high unemployment.

The Housing Bubble Has Nothing to Do With Job Losses?!

After his theoretical objection, Krugman turns to the data to raise a second objection to the "hangover theory":

2. It doesn't explain why recessions reduce [employment] across the board, not just in industries that were bloated by a bubble.

One striking fact, which I’ve already written about, is that the current slump is affecting some non-housing-bubble states as or more severely as the epicenters of the bubble. Here’s a convenient table from the BLS, ranking states by the rise in unemployment over the past year. Unemployment is up everywhere. And while the centers of the bubble, Florida and California, are high in the rankings, so are Georgia, Alabama, and the Carolinas.

This is rather surprising, isn't it? Forget the Austrian theory; Krugman is here saying that the bursting of the housing bubble doesn't help explain the onset of the recession! But don't worry, Krugman's analysis is flawed; you're not going crazy.

First, note that the BLS table Krugman links to looks at the over-the-year change in unemployment (by state) from December 2007 to December 2008. Now, is that really a good measure of whether the bursting of the housing bubble has anything to do with the recession? After all, the bubble had well burst by December 2007. So if the "hangover theorists" are right, you would expect the connection between unemployment jumps and housing-price collapses to be weaker the farther along you get from the bursting of the bubble.

In response to an email from a grad-school friend, I decided to check on the relation during a time frame that more tightly captures the bursting of the housing bubble. The OFHEO has quarterly data on home prices by state; I picked the top of the bubble as the second quarter in 2006.

Then I picked the other variable to be the change in unemployment (in terms of absolute point changes, not percentages of percentages) from June 2006 to December 2008, which is available (though not in a very convenient form) from the BLS.

Armed with this data, I ranked the states according to these two criteria, and looked at the worst 10 in both rankings. In other words, I looked at the list of the 10 states that had seen the biggest percentage decline in home prices since the 2nd quarter of 2006, and I also looked at the list of the 10 states that had seen the biggest jump in the unemployment rate from June 2006 to December 2008. The 7th through 10th slots on the two lists didn't match up, but check out the worst 6 slots in both lists:

Ranking of States By Point Increase in Unemployment Rate, June 2006 – December 2008

1. Rhode Island (+4.9)
2. Florida (+4.8)
3. Nevada (+4.8)
4. California (+4.4)
5. North Carolina (+3.9)
6. Michigan (+3.8)

Ranking of States By Percentage Drop in OFHEO Housing Price Index, 2Q 2006 – 4Q 2008

1. California, -27%
2. Nevada, -26%
3. Florida, -22%
4. Arizona, -16%
5. Rhode Island, -11%
6. Michigan, -11%

Note that North Carolina and Arizona are the only ones that don't match. That seems like a very strong correlation. (Depending on how we frame the problem, the chances of this matching occurring randomly are anywhere from 1 in 8,400 to about 1 in 350,000.)

Conclusion

Brad DeLong and Paul Krugman continue to mock the Austrian explanation for the business cycle, but their ridicule is based on their own deficient model of the economy's capital structure. Moreover, Krugman's quick empirical points turn out, upon closer inspection, to support the Austrian position. Unfortunately, because DeLong and Krugman have so fundamentally misdiagnosed the problem, their "solutions" are a recipe for further disaster.

Synchronized Boom, Synchronized Bust

Bad U.S. monetary policy had global consequences.

MARC FABER

The world has gone from the greatest synchronized global economic boom in history to the first synchronized global bust since the Great Depression. How we got here is not a cautionary tale of free markets gone wild. Rather, it's the story of what can happen when governments ignore market signals and central bankers believe in endless booms.

Following the March 2000 Nasdaq bust, the Federal Reserve began to slash the fed-funds rate from 6.5% in January 2001 to 1.75% by year-end and then to 1% in 2003. (This despite the fact that officially the U.S. economy had begun to recover in November 2001). Almost three years into the economic expansion, the Fed began to increase the fed-funds rate in baby steps beginning June 2004 from 1% to 5.25% in August 2006.

But because interest rates during this time continuously lagged behind nominal GDP growth as well as cost of living increases, the Fed never truly implemented tight monetary policies. Indeed, total credit increased in the U.S. from an annual growth rate of 7% in the June 2004 quarter to over 16% in early 2007. It grew five-times faster than nominal GDP between 2001 and 2007.

The complete mispricing of money, combined with a cornucopia of financial innovations, led to the housing boom and allowed buyers to purchase homes with no down payments and homeowners to refinance their existing mortgages. A consumption boom followed, which was not accompanied by equal industrial production and capital spending increases. Consequently the U.S. trade and current-account deficit expanded -- the latter from 2% of GDP in 1998 to 7% in 2006, thus feeding the world with approximately $800 billion in excess liquidity that year.

When American consumption began to boom on the back of the housing bubble, the explosion of imports into the U.S. were largely provided by China and other Asian countries. Rising exports from China led to that country's strong domestic industrial production, income and consumption gains, as well as very high capital spending as capacities needed to be expanded in order to meet the export demand. An economic boom in China drove the demand for oil and other commodities up. Rapidly accumulating wealth allowed the resource producers in the Middle East, Latin America and elsewhere to go on a shopping binge for luxury goods and capital goods from Europe and Japan.

As a consequence of this expansionary cycle, the world experienced between 2001 and 2007 the greatest synchronized economic boom in the history of capitalism. Past booms -- of the 19th century under colonial economies, or after World War II when 40% of the world's population remained under communism, socialism, or was otherwise isolated -- were not nearly as global as this one.

Another unique feature of this synchronized boom was that nearly all asset prices skyrocketed around the world -- real estate, equities, commodities, art, even bonds. Meanwhile, the Fed continued to claim that it was impossible to identify any asset bubbles.

The cracks first appeared in the U.S. in 2006, when home prices became unaffordable and began to decline. The overleveraged housing sector brought about the first failures in the subprime market.

Sadly, the entire U.S. financial system, for which the Fed is largely responsible, turned out to be terribly overleveraged and badly in need of capital infusions. Investors grew apprehensive and risk averse, while financial institutions tightened lending standards. In other words, while the Fed cut the fed-funds rate to zero after September 2007, it had no impact -- except temporarily on oil, which soared between September 2007 and July 2008 from $75 per barrel to $150 (another Fed induced bubble) -- because the private sector tightened monetary conditions.

In 2008, a collapse in all asset prices led to lower U.S. consumption, which caused plunging exports, lower industrial production, and less capital spending in China. This led to a collapse in commodity prices and in the demand for luxury goods and capital goods from Europe and Japan. The virtuous up-cycle turned into a vicious down-cycle with an intensity not witnessed since before World War II.

Sadly, government policy responses -- not only in the U.S. -- are plainly wrong. It is not that the free market failed. The mistake was constant interventions in the free market by the Fed and the U.S. Treasury that addressed symptoms and postponed problems instead of solving them.

The bad policy started with the bailout of Mexico following the Tequila crisis in 1994. This prolonged the Asian bubble of the 1990s, because investors became convinced there was no risk in growing current-account deficits and continued to finance Asia's emerging economies until the bubble burst with the start of the Asian crisis in 1997-98.

Then came the ill-advised bailout of Long-Term Capital Management in 1998, which encouraged the financial sector to leverage up even more. This was followed by the ultra-expansionary monetary polices following the Nasdaq bubble in 2000, which led to rapid and unsustainable credit growth.

So what now? Unfortunately, Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner were, as Fed officials, among the chief architects of easy money and are therefore largely responsible for the credit bubble that got us here. Worse, their commitment to meddling in markets has only intensified with the adoption of near-zero interest rates and massive bank bailouts.

The best policy response would be to do nothing and let the free market correct the excesses brought about by unforgivable policy errors. Further interventions through ill-conceived bailouts and bulging fiscal deficits are bound to prolong the agony and lead to another slump -- possibly an inflationary depression with dire social consequences.

Mr. Faber is managing director of Marc Faber Ltd. and editor of "The Gloom, Boom & Doom Report."