Asset Price Deflation

George Soros on the financial crisi:

The Financial Crisis: George Soros: I think it was, but it would have required recognition that the system, as it currently operates, is built on false premises. Unfortunately, we have an idea of market fundamentalism, which is now the dominant ideology, holding that markets are self-correcting; and this is false because it's generally the intervention of the authorities that saves the markets when they get into trouble. Since 1980, we have had about five or six crises: the international banking crisis in 1982, the bankruptcy of Continental Illinois in 1984, and the failure of Long-Term Capital Management in 1998, to name only three.

Each time, it's the authorities that bail out the market, or organize companies to do so. So the regulators have precedents they should be aware of. But somehow this idea that markets tend to equilibrium and that deviations are random has gained acceptance and all of these fancy instruments for investment have been built on them.... The large potential risks of such investments are not being acknowledged....

The authorities, the regulators--the Federal Reserve and the Treasury--really failed to see what was happening. One Fed governor, Edward Gramlich, warned of a coming crisis in subprime mortgages in a speech published in 2004 and a book published in 2007, among other statements. So a number of people could see it coming. And somehow, the authorities didn't want to see it coming. So it came as a surprise.... [Y]ou have a whole establishment involved. The economics profession has developed theories of "random walks" and "rational expectations" that are supposed to account for market movements. That's what you learn in college. Now, when you come into the market, you tend to forget it because you realize that that's not how the markets work. But nevertheless, it's in some way the basis of your thinking....

[T]he situation is definitely much worse than is currently recognized. You have had a general disruption of the financial markets, much more pervasive than any we have had so far. And on top of it, you have the housing crisis, which is likely to get a lot worse than currently anticipated because markets do overshoot.... I'm sure that it will be necessary to arrest the decline [in housing] because the decline, I think, will be much faster and much deeper than currently anticipated.... [F]oreclosures are going to add to the supply of housing a very large number of properties.... There are about six million subprime mortgages outstanding, 40 percent of which will likely go into default in the next two years.... Problems with... adjustable-rate mortgages are going to be of about the same magnitude as with subprime mortgages. So you'll have maybe five million more defaults facing you over the next several years....

[Y]ou need to reduce the number of foreclosures. You need to keep as many people as possible in their houses so that they don't come onto the market. You need to arrest the decline in house prices, but you also need to prevent human suffering and social disruption because it's going to be very, very severe....

[Rescue] is their [the Federal Reserve's] job, whether unhealthy or not... to save the system when it is in danger. However, because that is their job, it ought to be their job also to prevent asset bubbles from developing. And that task has not been recognized. Greenspan once spoke about the "irrational exuberance" of the market.... [I]t's generally accepted that the Fed tries to control core inflation, but not asset prices. I think that control of asset prices has to be an objective in order to prevent asset bubbles because they are so frequent.... You have to recognize that just controlling money doesn't control credit.... [Y]ou have to take into account the willingness to lend. And if it's too great—if borrowers can obtain large loans on the basis of inadequate security--you really have to introduce margin requirements for such borrowing and try to discourage it....

[W]e are close to a tipping point [for the dollar] where, in my view, the willingness of banks and countries to hold dollars is definitely impaired. But there is no suitable alternative so central banks are diversifying into other currencies; but there is a general flight from these currencies. So the countries with big surpluses—Abu Dhabi, China, Norway, and Saudi Arabia, for example—have all set up sovereign wealth funds, state-owned investment funds held by central banks that aim to diversify their assets from monetary assets to real assets. That's one of the major developments currently and those sovereign wealth funds are growing. They're already equal in size to all of the hedge funds in the world combined. Of course, they don't use their capital as intensively as hedge funds, but they are going to grow to about five times the size of hedge funds in the next twenty years.

I must say, these days when I read my backlist I feel like a genius--for example, back in 1998 I tried to convince the Brookings Panel that:

Why We Should Fear Deflation: Economies may well have more to fear than declines in broad goods-and-services price indices alone. If securities and real estate holdings have been pledged as collateral for debt contracts, then large-scale asset price declines also trigger the confusion of macroeconomic events with entrepreneurial failure that makes deflation feared.

Is the United States today potentially vulnerable to large-scale asset price declines in this way? In real estate no [this was written in 1999]. In the stock market yes [ditto]. Perhaps fundamental patterns of equity valuation have truly changed, as investors have recognized that the equity premium over the past century was much too large--in which case stock prices have reached a permanent and high plateau. But it seems more likely that there are substantial risks of stock market declines on the order of fifty percent back to Campbell-Shiller fundamentals...

http://www.jstor.org/stable/pdfplus/2534666.pdf

Comments

[Emma Anne]

Soros certainly has a completely different view of things than most. If there were any possibility that the feds would act to prevent the same sorts of problems from cropping up again, I would be much more inclined to support a bailout. But since that won't happen, I'm afraid it would just add to the moral hazard.

[anne]

Emma Anne, I know you are right; but your complaint needs to be attended to in financial market design emphasizing transparency and oversight which have been increaingly neglected. Rescue now is another matter and we have little choicel; Japan should have taught us we have little choice now.

I will think this through again, now.

[Jonathan King]

George Soros says:
> You need to arrest the decline in house prices

Um, why? Seriously, we are renting in suburban DC because you would need to earn the average income of a resident of Potomac to just about anything at all in the county. Does Soros really want houses to be only affordable to people with top 10% incomes?

[Neal]

There will be no arresting the house price declines--the old rule of thumb of house price not exceeding 3 times household annual income still is applicable. And, prudence would dictate that the house price should not be more than 3 times the primary bread-winner's income due to that vagaries of health, job security, child-rearing and other life issues that may interfere with the other partner helping with the mortgage payment.

Unless there is massive wage inflation, houses values will fall.

I'm not sure what the government could do to keep prices up--become the buyer of last resort--guaranteeing a "permanent and high plateau" of price? Issue a subsidy check every year, like to tobacco or corn farmers? It would be delicious irony after all of the hootin' and hollerin' about "welfare queens" and "welfare Cadillacs" to end up with "welfare McMansions" populated with "drown the government in the bathtub" suburbanites. It would have to be a perpetual subsidy, because there is no way a new home-buyer could enter the inflated market without help.

[Neal]

(quote)

NEW YORK, April 22 (Reuters) - Falling U.S. home prices and a lack of available credit may result in foreclosures on 6.5 million loans by the end of 2012, according to a Credit Suisse research report...could put 12.7 percent of all residential borrowers out of their homes...Nearly a third of subprime borrowers owed more than their home was worth at the end of last year, and that figure will double to 63 percent in 2009, they said.

(end quote)

Keep people in their homes---how?

Option 1: Enforce write-downs of principal amounts: punish investors and banks, reward people who overbought or overborrowed. Passively punish prudent home borrowers who will continue to pay their mortgages as agreed. Dollar negative.

Option 2: Provide checks to struggling borrowers: reward investors and banks that should have known better. Support overbuying and overborrowing. Punish prudent home borrowers with added governmental borrowing and debt. Very dollar negative.

[VennData]

Even if you're willing to stay in the castle, you're an honest, upright person etc... how can we rationally justify "keeping you in your house" without realizing it's really "keeping you in your house at the current financing."

The happy truth is that there's too much house supply (remember too much fiber optic? That's being rapidly diminished as well... eventually the eleven months housing inventory will be absorbed too.)

The policy should be: you were paying a mortgage and now you can't, so rent one of the empty foreclosures down the street.

It's the Wall Street Journal opinion page that wants to bulldoze all that extra inventory. Why not use the mortgage payment/rent arbitrage to the advantage of the regular folk. Get the banks to rent to them at that 40% haircut rate.

No one's going to buy those houses (for a few annum anyway.) It was all spec money (That's where lots of that HELOC dough went too.) Banks need to set up rental arms. Barney Frank and the White house can certainly agree on a way to expedite that.

[Tuco]

Do we really want housing prices stabilizing at a level where people can afford to make mortgage payments and nothing else? How's this going to make for a robust economy?

[anne]

Soros has been right, very right, on the unfolding mortgage-housing market for a long time, and I find no reason to argue with him just now. My sense has been that this period must be treated with much the same concern for deflation that DeLong and Krugman urged in 2001, even though the issue is selected asset price deflation and obviously not general deflation.

[astrid]

The fed will take the easy way out and just inflate themselves out of this situation, with only superficial efforts at reining in the financial institutions that cause this bubble (and numerous bubbles before this). Nominal value will dip slightly but real value will drop like a stone, so new home buyers and banks won't be permanently f_cked and be tempted into bankruptcy. Anyone counting on their house for their retirement will be, and deservedly so. Rinse, repeat.

In two decades' time, we'll be hording petrodollars or Canadian $ and the US $ will have the same level of credibility as all other Banana Republican currencies. And deservedly so.

[Brett Dunbar]

The sustainable level of house prices is related to interest rates, if rates are low then you can borrow more for a given monthly repayment. The shift from typically being able to borrow three times salary to being able to borrow five times salary is a product of a sustained reduction in interest rates.

[jamzo]

" You have to recognize that just controlling money doesn't control credit.... [Y]ou have to take into account the willingness to lend"

does anyone believe greenspan was unaware of the effect of his low interest rates on credit?

[Neal]

It's true--0% interest means that a 60K income would be able to afford a $500K house--but what type of economy is that? Who would the lender be?