Memo To: The Investment Community
From: Jude Wanniski
Re: Is the Stock Market Irrational?
While we are still mulling over the report of the 9-11 Commission and waiting for the Democratic Convention to get started, it is a good time to comment on the “bubble” that some economists see coming in the housing market. We can take as our point of departure a fairly good discussion that appeared in Sunday’s New York Times “The Week in Review” section by Eduardo Porter on “The Perils of Predicting Financial Bubbles. A Times reporter, Porter begins by noting a growing number of economists are now warning that housing prices will soon plunge, “that the surge in home prices over the past few years is pumping up a housing bubble that is doomed to implode, prompting a dramatic decline that could cost the economy trillions of dollars in lost wealth.” One such is Dean Baker, co-director of the liberal Center for Economic Policy Research: "The end result will be a loss of $2 to $3 trillion in housing wealth, and a downturn that is even worse than the fallout from the stock market crash.”
On the other hand, naturally, Porter finds other economists who pooh-pooh the idea of an uncontrolled plunge even as they acknowledge prices have soared here and there “stoked by some of the lowest interest rates in history.” Home prices rose 18% last year in L.A. and 14% in Miami, for example. Not everywhere to that degree, but it is true that when monthly payments that combine principle and interest reflect 5% mortgage money instead of 8%, the same family income can trade up or move from renters to owners and bid for a housing stock that can’t expand as fast as the demand does.
Porter, though, does not stop here but introduces the idea that the debate doesn’t have much to do with housing prices: “It is about fundamentally different views of how markets operate.” He cites Robert Shiller, “the famed Yale economist and bubble-ologist who predicted the end of the dot-com stock boom in his book ‘Irrational Exuberance,’ who thinks there is a housing bubble in the works. “He explains that bubbles are created when the prices of assets are fueled by psychological rather than economic considerations. From apartments in New York to tulips in 17th-century Holland, a bubble is born when people lose sight of the fundamental value of an asset and are willing to pay whatever it takes because they see that prices have risen like crazy and assume they will continue to do so. ‘People get excited about price increases and start behaving differently,’ Mr. Shiller says.”
On the other side, Porter cites Peter Garber, a global strategist at Deutsche Bank, who “believes that psychological explanations like herd behavior are a deus ex machina invoked by economists who do not properly understand the economic underpinnings of the market. Mr. Garber argues that from the Dutch tulip craze to the stock market boom of a few years ago, soaring prices have been justified by economic fundamentals - be it the earning potential of rare tulips or stocks. Some of the arguments backing the tech boom ultimately proved to be flawed, he acknowledges, but the analysis holding stock prices up - that productivity had reached a new level and companies would be able to capture this in higher profits - was reasonable. When stock prices fell, it was because of changes in this underlying business landscape.”
Having made a career at Polyconomics out of figuring out why markets suddenly SOAR as well as suddenly CRASH, I essentially agree with Mr. Garber of Deutsche Bank. I’m the fellow who finally discovered the cause of the Wall Street Crash of 1929, upending the idea that it was the bursting of a bubble caused by a frenzy of speculation. In researching my book, “The Way the World Works,” I discovered the market fell by almost 40% between Labor Day and the last week of October because of the Smoot-Hawley Tariff Act. It had caused Wall Street convulsions in March when it passed the House, but recovered and the market climbed again with news that a clear majority of Senators opposed it, and would kill it when it returned after the August recess.
If you read Chapter VII of my book, investors, you will find I make an airtight case. Nevertheless, here it is 2004 and the Political and Economic Establishment continues to ignore my finding. They PREFER to believe the Crash occurred. It suits their interests to believe the Market is imperfect and that Government must intervene to manage the Market, to prevent irrational Booms and Busts. If I am right about 1929, liberal politicians and their Keynesian supporters, whose careers are dependant on imperfect markets and bigger governments, are threatened. The same is true of conservative Keynesians and Monetarists. If I am right, they are wrong. Oddly enough, the same is true of other Supply Siders. You might think they would cite TWTWW as making the definitive finding on the Crash of 1929, but then their competing theories developed before mine would be wrong. This is the way the world works.
Getting back to the housing market’s lively advance, the financial press still has not caught up with the news about why it has been so lively. First, the monetary deflation that depressed all nominal dollar values as the price of gold fell to $250 in 2001 from $385 in November 1996 had reversed. The nominal dollar values of almost everything reversed as the supply of money exceeded the demand for money. LA real estate up 18%? The price of gold is back up to $390 from $250, practically an identical percentage increase. In addition, the entire housing market got an ENORMOUS gift from the Clinton Administration in 2000 when, with almost no publicity, it tacked a provision into the last tax bill of the year that exempted the first $500,000 from capital gains tax on the sale of a primary home. Polyconomics has been writing about this great windfall for the last three years, arguing it is the equivalent of a $4 trillion tax cut, and that it, not low interest rates, is the PRIMARY reason for the refinancing boom and housing market boom.
There is hardly a financial correspondent in the press corps to whom I have not pointed this out. But it is an inconvenient fact because it cuts entirely against the conventional wisdom. You would think the Clintonites would love the story, but they do not want to be seen as supply-side tax cutters even if it is to their credit. No kidding. As for conservatives Republicans, they do not want it to get out that Clinton and the Democrats actually did something that was a boon to the economy and the people.
As for the dot.com bubble, investors, you will find if you ask that I wrote a long series of client letters in the run-up to the April 14, 2000 “bursting of the dot.com bubble” that explained why the market was behaving as it was. In a few words summarizing those letters, I said the terms of trade had temporarily shifted in favor of the producers of intellectual goods as opposed to physical goods and this imbalance had to be corrected. In other words, people who lived by taking things out of their head were enjoying a great advantage over people who took things out of the earth. This occurred because of the monetary deflation. In addition, I argued incessantly that in the earliest states of a New Economy capital had to flow to a thousand different prospects, because investors could not tell which would survive the Darwinian process of survival of the fittest.
Where does this bring us vis a vis a housing bubble? Forget it, unless Congress decides to repeal the $500,000 capital gains exemption or if the Federal Reserve screws up again and lets the gold price fall back way below $350, which is the optimum price.