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GUEST: Dean Baker, Co-Director of Center of Economic and Policy Report, author of the report, “Midsummer Meltdown: Prospects for the Stock and Housing Markets”

Last Friday, the Federal Reserve Bank issued a statement saying that it would seek to “facilitate the orderly functioning of financial markets.” Wall Street followed the statement and cash infusions from the bank with a volatile day of activity capping another week of instability. Global markets followed suit and dipped as they were unnerved by the U.S. credit crisis. One of the main reasons cited for the crisis is the continued defaults in the mortgage market. Though the volatility of the market caught some analysts by surprise, a new report from the Center for Economic and Policy Research argues otherwise. The report, “Midsummer Meltdown: Prospects for the Stock and Housing Markets,” analyzes instability on the grounds that market fundamentals were ignored in both policy circles and the media. Instability in the housing market has lead to a record oversupply of unsold homes and vacant ownership and rental units. The report concludes that correcting this problem alone could lead the U.S. economy into a severe recession.

Download the report here: www.cepr.net/documents/publications/meltdown_2007_08.pdf

For more information, visit www.cepr.net.

Rough Transcript

Sonali Kolhatkar: My guest this morning is Dean Baker. He is Co-Director at the Center for Economic and Policy Research and he is also author of the report. Welcome to Uprising, Dean.

Dean Baker: Thanks for having me on.

Sonali: Thanks very much for joining us today. First, what do you mean when you say that market fundamentals were ignored in policy circles in the media?

Dean: Well, this has happened both with the Stock Market in the 90’s and then the housing market at present. You know, the fundamentals aren’t that hard to determine in the stock market. Basically, it’s corporate profits – the ratios of stock prices to corporate profits and those had gone through the roof in the late 90’s so it should have been apparent to people that there was a bubble. I know, retrospectively, everyone says they knew that but the fact was at the time, if they did, they weren’t saying that or acting that way. So, you know, that was the fundamental of the stock market. In the more recent period, the fundamental housing market was simply, you know – how are house prices moving relative to other prices? And, I’ve looked at government data going back to the early 50’s and you find that house prices have just increased at pretty much the same rate as other prices. The house prices basically move at the same rate as the overall rate of inflation, which is the national average. Now, Robert Schiller’s an economist at Yale University, constructed his own series where he went back to the 1890’s and he finds for 100 years, 1890’s, mid-90’s, into 19th century, mid-19th and 20th century, house prices just keep pace with inflation. Suddenly, in the late 90’s and on thru the current decade, house prices start to rise and, in fact, increase by 70%, after you adjust for inflation. There’s no precedence whatsoever and no one had any explanation for it either. I debated, I think, just about everyone on this topic and no one had anything to pass the laugh test and, you know, that’s the basic fundamentals. You see this increase in prices that is, really, lacks any explanation, so, you know, I began to say we had a housing bubble and, you know, bubbles, by their nature, they can’t persist so, you know, at some point, they collapse and it looks like we’re starting to see that now.

Sonali: So, you’re basically saying that some of these very fundamental statistics that really should have been obvious to economists in the media were ignored. If so, what were they paying attention to to convince them that there wasn’t a crisis looming?

Dean: Well, they like happy talk. And this happened, you know, you go back to the 90’s where they had all these people who kept saying no matter how high the NASDAQ went that it would just keep going higher, you know, the DOW – 36,000. I mean, basically, total nonsense. I mean, if you just picked someone who is an alcoholic and babbling, they would have had more sensible things to say but these people were on the Lehrer News Hour, they were on NPR, they were in the NYTimes and the Washington Post and the same thing happened with the housing market. So, you know, we did a quick Nexus search – the most widely cited figure on the housing market in the media was David Lereah, who was the Chief Economist from the National Assoc. of Realtors, and the author of the book, Why the Housing Boom Will Not Bust and How You Can Profit From It. You know, so this is who they had on – people who were basically pushing people to buy homes, who had a direct material stake in getting people to buy homes and those who might have been more objective, who had stood back and might have made the points I made – there were other economists, not a lot – but, other economists saying the same thing, we were rarely heard from.

Sonali: Now, Dean, let’s talk more about the housing issue. As anybody who has tried to buy a home in recent years realizes, housing prices have gone up ridiculously and apparently, since 1995, they’ve risen by more than 70% and that’s after you adjust for inflation. So, this is basically, a clear indication as you have said, of one of those fundamentals that should have been paid attention to regarding the housing bubble. What now, if there are so many unsold homes, so much, sort of, vacant, even rental units, what can happen and how would it affect the market if the rate of construction continued at its current rate?

Dean: Well, there seems no way out of this except for house prices to continue to fall. House prices, in many areas of the country, are now falling. In places like D.C., they fell about 6% over the last year; San Diego, about the same amount; they’re down a little bit less in Boston. So, in many areas of the country, they are now falling and I don’t see any way out of this story except for them to continue to fall and, likely, a lot more because the inventory of unsold homes is more than 50% higher than it’s ever been in the past, the number of vacant ownership units is about double its previous peak. So, it’s very hard to see how you correct this vast inventory unless you get a large, large drop in prices. Now, you also continue to see cutbacks in the housing sector itself. So, housing construction’s down about 20% from its peak but it’s probably going to fall, you know, a fair bit further – I’d say it would fall another 20% or so. So, we’re going to see a very, very big hit to the housing sector itself. A big one we’ve already seen. But, then on top of that, as house prices fall, this is, you know, a huge portion of people’s wealth. I estimate the amount of housing bubble wealth – the difference between house, the value of housing wealth as it is today, and where it would be if house prices just followed their long term trend, at 8 trillion dollars, which comes to $110,000 for every home owner in the country. So, much if not all that, is likely to disappear in the next few years and that’s going to be a very, very big hit to the economy and a very, very big hit to a lot of people’s personal finances.

Sonali: What effect are defaults on mortgages having on the housing bubble itself?

Dean: Well, this is part of the story of why you see the meltdowns in the stock market because the debt. What happens these days is you get a mortgage in a bank, they typically sell that in the secondary market. They pass that off, it gets formed into pools, and those bonds are sold all over the world. Now, it turns out that you have people, you know, investors in France, in Germany, other countries, that were holding this debt. Now they’re finding that it’s actually not good debt, you know, so that’s created the problems in the financial markets both in the United States and around the world. But, in terms of the housing market, the direct impact there is that as soon as those defaults start to rise, investors get a very, very different attitude towards lending in the housing market. So, what was going on a year, 2 years, 3 years ago, were investors just throwing money into this market because they assumed it was very, very safe and they didn’t realize it wasn’t. Now, they suddenly go the other way and they realize that, no, there’s actually a big risk and they’re likely to be very tight with making money available. So, in addition to having huge oversupply of housing, a lot of people that would have been able to buy a home a year ago are going to find they have a much more difficult time getting a mortgage now so the demand side is going to be crimped as well.

Sonali: I’m speaking with Dean Baker. He is the Co-Director of the Center for Economic and Policy Research and has authored a new report called, Midsummer Meltdown: Prospects for the Stock and Housing Markets. Let’s talk about the cash infusions by the Federal Reserve Bank. What is your opinion of this means of trying to stabilize the markets and what sort of long-term effect can it have, if any?

Dean: Well, there are two points here: one, as a long-term prospect, I don’t see it having that much impact because the basic story is you have a lot of mortgage debt that is going to go bad and there’s nothing the Fed can really do about that. People owe, you know, $300,000 on homes that today are worth $250,000. A lot of those mortgages are going to default because it doesn’t, you know, it doesn’t make a lot of sense, unless you really love the home to pay a $300,000 mortgage on a $250,000 home and, in some cases, the discrepancies are even greater so you probably have places, you know, like San Diego where you’ve had a big fall in prices or Florida, where people might owe $400,000 or $500,000 on a home that may be only worth half that much. So, you’re going to see a lot of defaults. There’s not a lot the Fed can do about that. Now, as a short-term matter, if they can sort of, kind of, keep things afloat, one thing that I worry very much about is that you might have, you know, more sophisticated actors dumping this debt on less sophisticated actors. So, you have, you know, Ben Bernanke, the Chair of the Federal Reserve Board, saying everything’s fine. I mean, he’s not necessarily encouraging people to go out and buy mortgage-backed securities but, nonetheless, a lot of people might take it that way. So, what you might have is some of the high-flying hedge funds and the other big actors dumping those mortgage-backed securities that are now worth at least a lot less, if not actually worthless, worth a lot less than they were, say, a month or two ago, dump them on, you know, more naïve investors, put them into mutual funds, maybe even some individuals will end up with them and then they’ll go bad 6 months, a year or two years down the road. So, what the Fed, in fact, would be doing is giving these people some breathing room, giving them the opportunity to dump their bad assets on those who don’t know better.

Sonali: Now, Dean, what is, how do Ben Bernanke’s actions, how do his actions compare to those of the previous Chair of the Federal Reserve, Alan Greenspan, and how much culpability does Greenspan bear in what we’re seeing today?

Dean: Well, I think the big part of the story is letting the bubble get out of hand to begin with. They’re the ones sitting there. You know, the Chairs of the Federal Reserve Board is the entity that’s really sitting there that’s supposed to preserve order in financial markets and they really blew it. I mean, this isn’t a little thing, you know, they’re absolutely obsessed with inflation. They read the numbers down to the, you know, second and third decimal that, you know, inflation might rise by, you know, one tenth of a percentage point. But, here it is, you know, with Greenspan – he let a ten trillion dollar stock bubble grow and just said, oh, I’m not going to worry about that – we’ll just deal with it when it bursts. And then, he and Bernanke allow an eight trillion dollar housing bubble to grow and, you know, again, the attitude is we’ll deal with it when it bursts. And, you know, frankly, it’s not that easy to deal with. And, you know, the only reason they were able to get out of the recession caused by the stock crash was by pushing the housing bubble. I always liken this to an alcoholic who, you know, deals with one hangover by starting on the next one. It’s not a good way to run the economy.

Sonali: Is there any hope, particularly, for lenders, that the government might start or government-sponsored enterprises might start buying mortgages to support the housing market?

Dean: That could happen and I really hope it doesn’t. Again, it’s the same sort of thing because they dump off their debt on someone else. And, that very well could be the someone else that, if they could get Freddie Mac and Fannie Mae are the two government-sponsored enterprises that basically created the secondary market in home mortgages, if they can get them to step in the market and buy up, you know, hundreds of billions of dollars of debt, that will give, you know, the hedge funds and the other big actors an opportunity to dump a lot of it. So, you know, that may happen. There are people who want to see that happen. I think it will be a big political fight. Again, I would say I certainly hope it doesn’t happen. You know, as a general rule, I think that Fannie Mae and Freddie Mac have played a very useful role in the economy and I wouldn’t necessarily be opposed to expanding their role in the housing market but not now. That doesn’t make sense to just tell the big dealers that they can just dump it off on the government.

Sonali: So, Dean, are you saying that a severe recession is unavoidable?

Dean: Well, I think we’re going to have problems. Whether we could, you know, our ability to get out of a recession will depend on the effectiveness of government policy. I don’t think we’re doomed to a severe recession but I think if we have bad policy we certainly can get one. If you look at the case of Japan, after their housing and stock bubble burst at the end of the 80’s, they basically had 13, 14 years of, if not actually a recession, very, very weak economic growth. So, if you do things wrong and I would say they did just about everything wrong in Japan, we could end up in that situation.

Sonali: So, what can be done right? Particularly, not just at a government level, but particularly on an individual level, do you have any advice to dispense to those who are either current homeowners or who are looking to be homeowners?

Dean: Well, you know, in terms of homeowners, I mean, the better advice would have been a while ago, I mean, if you’re looking to buy a place now, I would strongly urge someone to wait. And, you know, in terms of market timing, you know, I’m not a big advocate of, you know, running out and selling and buying. On the other hand, if you’re thinking of something and moving out of a home, you know, you’re probably better off to do it now than try it, you know, 6 months from now. I’d say that much. But, you know, it would have been wise for people to have been cautious. If you weren’t, you know, there’s not much you can do at this point. In terms of the government, you know, when we hit bottom, you know, the key will be to, on the one hand, for the Federal Reserve Board to have a stimulatory policy, have low-interest rates, give the economy room to grow again. And, on the fiscal side, we should have a stimulatory policy which could mean tax cuts targeted towards, you know, more moderate, low-end people and also try and have spending to address some of the needs we have because that would be a good time to do it, you know, extend health-care, rebuild our infrastructure, try and tackle global-warming. There’s lots of things on that list that we could spend money on and, you know, if we’re in a bad slump, we shouldn’t be shy about doing it.

Sonali: Well, Dean Baker, I want to thank you very much for joining us today. And, where can listeners get a hold of your report?

Dean: It’s at our website: cepr.net

Sonali: cepr.net And again, the title of the report is Midsummer Meltdown: Prospects for the Stock and Housing Markets. Dean, thanks so much for joining us.

Dean: Sure, thanks a lot for having me on.

Sonali: Dean Baker is Co-Director for the Center for Economic and Policy Research. Again, that’s online at cepr.net and he authored the report that we’ve just been discussing.

Special Thanks to Julie Svendsen for transcribing this interview