Bernanke - should he stay or should he go

[alfred russel]

Who won the argument?

Lets revisit the argument. DGuller maintained that stock valuations were too high, home prices were too high, and investment banking was out of control and due for a correction. I disagreed on all points. Who would you give the edge to?

[Admiral Yi]

Lets revisit the argument. DGuller maintained that stock valuations were too high, home prices were too high, and investment banking was out of control and due for a correction. I disagreed on all points. Who would you give the edge to?

You thought home prices were *not* too high?

[alfred russel]

Lets revisit the argument. DGuller maintained that stock valuations were too high, home prices were too high, and investment banking was out of control and due for a correction. I disagreed on all points. Who would you give the edge to?

You thought home prices were *not* too high?

I didn't think there would be a meltdown.

[citizen k]

Lets revisit the argument. DGuller maintained that stock valuations were too high, home prices were too high, and investment banking was out of control and due for a correction. I disagreed on all points. Who would you give the edge to?

You thought home prices were *not* too high?

I didn't think there would be a meltdown.

I thought it would unwind slowly and not crash.

[Sheilbh]

The fact that most decision makers didn't predict this kind of argues that it was in fact difficult to predict...

I think this is true, but I also think there was an element of groupthink as DGuller says.  Ultimately decision makers have to be elected.  How do you get elected telling people their houses are over-valued and that they need to spend and borrow less?  I think Jimmy Carter tried it once.

[Razgovory]

Generally I usually agree with Dguller or JR on economic stuff cause I don't like to think on my own.  So I'm like right by proxy!

[Alatriste]

There must be other candidates who could be expected to do a better job than Bernanke as Federal Reserve Chairman.

Most underwhelming way to end an article ever. 'There must be' is not exactly the same as 'There are'... and I must point that the piece very definitely fails to mention any name. If there are truely qualified candidates that saw what Bernanke -and so many others- didn't see, Lachman should have mentioned some of them. Without those names his article looks like a rant

And I have to add that there is a serious problem with people in high places telling the economic naked truth. Namely, self-fulfilling prophecies.  If Bernanke had told the world that there were inmense credit and housing bubbles, that stock valuations were too high, home prices were too high, and investment banking was out of control and due for a correction (all of which was patently true as we see now) and started to take appropiate measures, he would have caused a panic and a crisis, very probably lesser but a crisis,  and he would be blamed for it. "Damned if you do, damned if you don't".

[alfred russel]

Lets revisit the argument. DGuller maintained that stock valuations were too high, home prices were too high, and investment banking was out of control and due for a correction. I disagreed on all points. Who would you give the edge to?

You thought home prices were *not* too high?

To revisit this, I argued at times that housing was not a good investment, but with DGuller that it was about to melt down.

Here is a thought experiment, that to keep things simple is going to involve a lot of assumptions:

The expected nominal return on the stock market is 10% (after tax).
The expected risk premium between stocks and housing is equal.
Your property taxes and property insurance will be offset by the home interest deduction.
The long term expected return on a home is inflation, which is 3%.
Home repairs run at $2,000 a year.
Closing costs are negligible.
Your rent is $1,500 a month.

Your landlord offers to sell you the home at the current market value of $450k. You can get an interest only loan at a 6% interest rate with 10% down. You have the funds for the downpayment invested in stocks. You will not need the money anytime soon and are not planning to move. Is this a good deal?

[DGuller]

To revisit this, I argued at times that housing was not a good investment, but with DGuller that it was about to melt down.

Here is a thought experiment, that to keep things simple is going to involve a lot of assumptions:

The expected nominal return on the stock market is 10% (after tax).
The expected risk premium between stocks and housing is equal.
Your property taxes and property insurance will be offset by the home interest deduction.
The long term expected return on a home is inflation, which is 3%.
Home repairs run at $2,000 a year.
Closing costs are negligible.
Your rent is $1,500 a month.

Your landlord offers to sell you the home at the current market value of $450k. You can get an interest only loan at a 6% interest rate with 10% down. You have the funds for the downpayment invested in stocks. You will not need the money anytime soon and are not planning to move. Is this a good deal?

It's a marginally good deal with those assumptions, judging just from first year analysis.  However, how good this deal is depends critically on the assumed house appreciation rate.  A little movement here or there changes the math substantially.

[Razgovory]

Also I agree with Dguller cause he laughs at my jokes.

[alfred russel]

It's a marginally good deal with those assumptions, judging just from first year analysis.  However, how good this deal is depends critically on the assumed house appreciation rate.  A little movement here or there changes the math substantially.

Which is 3% with inflation.

If you looked at a historical metric such as a comparison to rents, the price looks overvalued with the price 25x the rent. What is driving the relatively high valuation is the historically low interest rate and the high degree of leverage (just 10% down). There is no guarantee that both will continue to be available, but both show little evidence of going away soon.

[DGuller]

Which is 3% with inflation.

Yes, that's the assumption.  However, the results change drastically based on the changes in that assumption.  Assume 0% or 1% appreciation, and suddenly buying the house turns out to be a disastrous move.

If you looked at a historical metric such as a comparison to rents, the price looks overvalued with the price 25x the rent. What is driving the relatively high valuation is the historically low interest rate and the high degree of leverage (just 10% down). There is no guarantee that both will continue to be available, but both show little evidence of going away soon.

I do agree that price to rent ratios are a bad metric in some ways, as it ignores the role of interest rate in setting the price of housing.  In other ways, though, it's a good measure of instability in the housing market.  The lower the interest rate, the more unstable and speculative things get after house prices compensate.  That's because as interest rate goes down, the income from homeownership shifts from providing you shelter to price appreciation.  Price to rent statistic does capture that.

[alfred russel]

Which is 3% with inflation.

Yes, that's the assumption.  However, the results change drastically based on the changes in that assumption.  Assume 0% or 1% appreciation, and suddenly buying the house turns out to be a disastrous move.

If you are assuming 0% or 1% appreciation, that is negative price appreciation in real terms and I think is an overly conservative expected return. Obviously that is going to be painful if realized, but it would still be less painful than if you didn't buy the house and there were significant stock market declines (the presumed alternative investment). At least in terms of the assumptions I laid out for return rates: 3% for housing and 10% (after tax) for stocks, I don't think many people would adjust the expected returns so that they are less favorable to housing (maybe some of the other assumptions are vunerable, but I tried to be fair).

This ultimately comes down to a discussion of risk premium. Real estate is considered less volatile than stocks in the long term, but then the real estate we are discussing is not diversified (concentrated in your own home) and highly leveraged. Perhaps unfairly I equated those offsetting factors and said the risk premiums were equal. Unfairly because a 20% decline in stocks means that you lose 20%, while in a 10-1 leverage scenario with housing you would lose 200%. On the other hand, what we are going through indicates that losses are roughly capped for many people at 100%, with people walking away from their homes (in theory with the banks taking on that extra risk, though in fact much of it seems to be the government). 

I do agree that price to rent ratios are a bad metric in some ways, as it ignores the role of interest rate in setting the price of housing.  In other ways, though, it's a good measure of instability in the housing market.  The lower the interest rate, the more unstable and speculative things get after house prices compensate.  That's because as interest rate goes down, the income from homeownership shifts from providing you shelter to price appreciation.  Price to rent statistic does capture that.

I have an instinctive aversion to anything approaching a PE ratio, but I agree you have a point about putting too much stock in low interest rate figures (theoretically you could impute large price changes from 1% interest rate changes). I still think you need to take into account interest rate changes when comparing periods. Anything equating the 1970s price to rent to today is nonsense, for example.

[DGuller]

As an aside, what led me to believe that housing was over-inflated and poised for a crash was the human factor, not any particular analytical calculation.  I sensed tremendous irrational exuberance when it came to the wisdom of buying a house, as many people were absolutely sure that it was an investment that can't fail, and yet would react very defensively when whatever passed for their logic was challenged.  When you have such widespread irrational exuberance, you know that it is priced in, and that it's very fragile.

[Legbiter]

I do think it's nice to have someone with a little bit of foresight in position of running the economy.

Yeah, the Fed needs to appoint a full-time astrologer.