The Price of Everything (36 page)

And ended:

A REGULARITY THAT
stands out in these spurts of overenthusiastic invention is the exuberance of the institutions providing finance. This can be prompted by newly discovered investment opportunities—like the Internet or the transatlantic slave trade. But it can also be fueled by changes in the rules governing financial institutions. During the housing boom, financial inventions like floating rate and reverse amortization mortgages were instrumental in bringing less solvent buyers into the American housing market, creating a whole new class of financial product—the subprime loan. In the years of the bubble’s rise, the monthly payments needed to buy a $225,000 house with a standard thirty-year, fixed-rate mortgage and a 20 percent down payment were about $1,079 a month. With an interest-only adjustable-rate mortgage, payments would fall to $663. With a negative amortization mortgage, initial monthly payments could fall all the way to $150.

Mortgage banks wanted to lend but weren’t much interested in their borrowers’ ability to pay. They were slicing up the mortgages and gluing them back together into structured products called “Residential Mortgage-Backed Securities”—RMBS in the jargon—that they sold to other financial institutions, who often had no idea of what they contained. By 2007 the mortgage-backed securities market was worth $6.9 trillion, from $3 trillion in 2000. This euphoria had little to do with hard-nosed analysis of the “real” value of homes.

Some eighty years ago the great British economist John Maynard Keynes provided a subtle explanation of how investors can take prices badly astray. In his book
The General Theory of Employment, Interest and Money,
Keynes compared picking stocks to a reverse beauty contest in which investors didn’t have to choose the most beautiful face but the face that was most popular among other investors. “It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes wrote. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” It wouldn’t be smart, Keynes observed, to simply buy shares of the company the investor believed to be a good investment. Regardless of the company’s merits, its stock wouldn’t rise if other investors didn’t share his belief.

In the late 1990s, every investor was a sheep looking for the herd—paying top dollar for dubious Internet stocks in the belief that the next investor along would pay a higher price, regardless of the underlying companies’ profitability. It made little sense for an investor to bet against the flock. When there were enough fools who believed eToys would become the largest toy store in the United States and should be worth eighty dollars per share, it made perfect sense for the most hardheaded dot-com skeptic to buy the shares for fifty dollars even though he or she believed the company was around the corner from bankruptcy.

So it was during the housing bubble. I doubt that at any point in the cycle of euphoria there was a banker who didn’t suspect home prices would eventually stop rising. Still, the dynamics driving investment into the sector depended on prices going up forever. To be able to keep paying the mortgage bill, the financially shaky subprime homeowners needed house prices to keep rising. That way they could either sell and plow the profit into a new property, or refinance at a higher price and pull “equity” from their home to make ends meet. Yet even those who knew that the music would eventually stop couldn’t drop out of this game of financial musical chairs.

In the summer of 2007, as mortgage default rates were rising and the “subprime” mortgage market was starting to falter, the chief executive of Citigroup, Charles Prince, argued that “as long as the music is playing, you got to get up and dance. We’re still dancing.” Months later, Prince was ejected from his post. But he wasn’t wrong. He was referring to a long-acknowledged feature of finance: even if an investor were to correctly call a bubble, it could be expensive to bet against it. If other investors were still carried away by their enthusiasm, the bubble could stay inflated longer than the contrarian investor could remain solvent.

Bubbles leave no end of hardship in their wake: banking crises, recessions, and unemployment spikes, as well as more subtle consequences. One study found that the geographic mobility of people whose houses are underwater—worth less than the value of their mortgages—is about half that of homeowners in better financial condition. University students who graduate during a recession earn less throughout much of their careers. A study of Canadian graduates in the 1980s and 1990s found that those entering the labor market during a recession suffered lower earnings for up to ten years.

Some social scientists have predicted the current crisis could favor extreme right-wing politics in Europe and the United States in coming years, as lower growth leads to hostility toward governments and taxes—spawning movements like the populist Tea Party in the United States. A study of the impact of economic shocks on politics between 1970 and 2002 concluded that a one-percentage-point decline in economic growth leads to a one-percentage-point increase in the share of the vote going to right-wing and nationalist parties.

Still, it’s hard to know what to do about bubbles, even when we know they are going to pop up time and again. The cycle of investment surge and bust can bankrupt many investors but can also do good along the way. Investment booms built upon technological breakthroughs like electricity, railways, or the Internet ultimately revolutionized the world economy—fueling surges of productivity that could—at least temporarily—justify the exuberance.

The long-standing American approach, shared by the chairman of the Federal Reserve, Ben Bernanke, as well as his predecessor, Alan Greenspan, has been that bubbles should be dealt with only after the fact. The Fed should be ready to pick up the pieces after they burst—flooding the economy with cheap money to encourage lending and help debtors avoid bankruptcy as the value of their assets deflates. But the government should do nothing to the bubbles themselves. Their point is that we can’t tell when a bubble is a bubble.

This, to critics, sounds as crazy as a bout of euphoric investment in single-family homes. Why not lean against a bubble by gradually raising interest rates and cutting the flow of money into the new investment before things get out of hand? Allowing it to grow will ensure that the fallout from its implosion will be that much more painful. Yet while this seems clear-cut after the collapse of the housing bubble has sent us careening to the edge of another Great Depression, it’s not quite as easy to figure out beforehand what to prick and when to prick it.

Economists still debate whether Greenspan was wrong to have kept interest rates low to boost employment as the United States emerged from recession from 2001 to 2003. Raising interest rates would have taken the air out of the incipient housing bubble, but it would have also slowed the economy, lengthening the recession and boosting unemployment. Had housing growth stalled, lots of construction-sector jobs—which provided a livelihood for many workers—wouldn’t have existed. “Whenever in the future the US finds itself in a situation like 2003, should it try to keep the economy near full employment even at some risk of a developing bubble?” wondered the economic historian J. Bradford Delong. “I am genuinely unsure as to which side I come down on in this debate.”

Beyond the immediate impact on aggregate employment, what would happen with innovation if every time investors swooped upon a new technology the emergent bubbles were preemptively pricked? Big jumps in asset prices can lead to misallocated investments that squander productive resources. Bubbles generate enormous economic volatility as they inflate and burst. The damage is always most acute among the most vulnerable, who lose their jobs, lose their houses, and lose control over their lives. But speculation can also increase investment in risky ventures, which often yields benefits to society. The Internet is no bad thing to have.

In 1922 James Edward Meeker, the economist of the New York Stock Exchange, wrote: “Of all the peoples in history the American people can least afford to condemn speculation in those broad sweeping strokes so beloved of the professional reformer. The discovery of America was made possible by a loan based on the collateral of Queen Isabella’s crown jewels, and at interest, beside which even the call rates of 1919-1920 look coy and bashful. Financing an unknown foreigner to sail the unknown deep in three cockleshell boats in the hope of discovering a mythical Zipangu cannot, by the wildest exercise of language be called a ‘conservative investment.’” What’s more, whatever we do to prevent financial turmoil, we must acknowledge an important limitation: we are unlikely to stamp out bubbles and crashes entirely.

Financial crises spawned by investment surges, credit booms, and asset bubbles appear to be a standard feature of the landscape of capitalism. Economists Carmen Reinhart and Kenneth Rogoff found that of the world’s sixty-six major economies—including developed nations and the largest developing countries—only Portugal, Austria, the Netherlands, and Belgium had avoided a banking crisis between 1945 and 2007. By the end of 2008 no country was unscathed.

Every time investors become enthusiastic about some new investment proposition, they assure us that this time will be different. During the dot-com bubble the surge of productivity enabled by information technology allowed us to believe that the historical moment was unique. During the housing boom, we were sure that high-tech financial engineering would protect us from financial risks, spreading them among investors who knew how to handle them. Each time the Pollyannas were wrong.

Interestingly, there are economists—prominent ones—who believe bubbles don’t exist. Indeed, during the past four decades the prevailing view among many if not most economists was that prices could never be wrong. The insight that prices set in a free exchange between willing buyers and sellers can allocate resources to where they would be most profitably used somehow transformed into a blind belief in the infallibility of markets. According to this model of reality, processes that took prices way above their reasonable, true value, luring people into big mistakes, could not possibly exist.

The seeds of this ideology were laid in nineteenth-century Vienna before settling in the middle of the twentieth at the University of Chicago, perhaps the most influential school of economics of the last thirty years. It held that the free market was the only legitimate way to organize society because it started with individuals’ free will. Markets would organize the world impeccably by assigning relative values to goods, services, and individual courses of action. Humans being rational—meaning that they had a consistent set of preferences and beliefs about how their choices would improve their well-being—their decisions had to be the right ones. Government intervention, imposing the will of the state upon the people it ruled, was in this view necessarily inefficient and wrong.

To be sure, the so-called rational actor model has been enormously powerful in understanding people’s choices. Its simple core idea, that we set out to maximize our well-being, provides a convincing immediate explanation of people’s behavior. And it meshes with our understanding of the evolutionary processes shaping the development of species: if each decision we make leads to a set of probable outcomes with different odds of genetic survival, natural selection would shape preferences in such a way as to maximize biological fitness. But our faith in this theory went much too far. In the 1970s, the rational actor model was extended into the theory of “rational expectations.” This adapted the belief in humanity’s rationality to the fact that we cannot predict the future and thus must make decisions based only on what we expect the consequences of our actions will be, fitting the probable outcomes of our choices to our set of preferences. For instance, it posits that we plan our lives by coolly estimating our likely future income paths, adjusting our savings accordingly in order to smooth our consumption through our entire lifetimes—consuming less during our peak earning years in order to be able to consume more in retirement.