Nobel economist speaks at USF

02/13/09 Sean Kinane
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Vernon Smith is a professor of economics and law at Chapman University School of Law in Orange, Calif. This morning at the University of South Florida, Smith outlined the economic and sociological reasons for the collapse of the housing bubble, which led to the current global financial meltdown.

Smith showed data from the Dow Jones index and house prices since the 1970s to establish that there has been a pattern of bubbles and collapses in the housing market. In the current and largest of those bursting bubbles, Smith says, the collapse first happened in homes but then spread to banks, stocks and the broader economy.

“And this decline, I would argue, blindsided the financial system, the stock market, the economy, even the Federal Reserve system, because they didn’t really catch on to what was going on until August 2007 and all of a sudden they realized, ‘oh my god, look what’s happening in the banking and financial system.’ And they moved, you know, to create lots of liquidity and everything and that liquidity just died in puddles.”

In 2002, Smith along with fellow economist Daniel Kahneman was awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. It was established and funded by the Bank of Sweden and is often called the Nobel Prize in Economics. But it is not one of the five Prizes established by Nobel’s will and some of his descendents are critical of the prize.

Smith contrasted the stock market crash following the dot-com bubble, in which losses were absorbed immediately by owners, with the housing crash, which was absorbed by the banking system first.

“You had that stock market crash in about 2000. Ten trillion dollars of value disappeared in that market and it had hardly any ripple effect on the banking system. The housing market we lost $3 trillion … and it devastated the banking system. Big, big difference.”

Some of the strategies used to spur the economy, like adjusting tax rates and reducing regulation didn’t help. Smith used a quote from economist Sir Dennis Robertson to criticize supply-side attempts at solving the problem.

“Monetary policy is like pushing on a string. … It takes buyers to pull it, OK, and there were no buyers. And you talk about the limit of supply-side economics – wow! There it is. You’re out there pushing and trying to make it real easy for people to borrow money and nobody wants to borrow it. And this thing started to really, really go to pot.”

In December 2007, Smith wrote an article in the Wall Street Journal placing much of the blame for the housing bubble on the Tax Relief Act of 1997, which was passed during the presidency of Bill Clinton.

“Clinton shared some of the blame, he thought that was the greatest thing since sliced bread, that he’d come up with this idea. … All you people are going to get an opportunity … the details weren’t available … but you would never have to pay a capital gains tax, ever, on your home. Boy was that popular; everybody said that was a great idea. To me, a zero tax on capital gains is fine, but please don’t choose just one asset because you expect money to flow into that.”

The money that flowed into housing, Smith claims, caused the housing bubble, which, when it crashed, set of a chain of events leading to the current global economic crisis. Smith divided the housing bubble in four major cities, into three categories based on home price and found out that the bubble was most pronounced for owners in the lowest tier of home prices.

“So here’s all the people that Fannie Mae, Freddie Mac, and all of us, the policymakers, wanted so badly to help. The ones with the least means and the bubble hurt them the most. How’s that for unintended consequences? Who do you blame? I’m telling you – people didn’t have to buy these thinking that the price was going to go up forever. Buyers, sellers, real estate agents, the banks, the mortgage repackages, people who guaranteed these loans, and people who rated these loans higher than they deserved to be rated. They’re all part of the problem.”

But earlier in his lecture, Smith said he doesn’t think that assigning blame is constructive.

“Everybody’s looking for someone to blame. Believe me, there’s lots and lots of blame to go around. Both in public policy and bad private incentives and don’t go there, that’s not going to help us solve the problem.”

Smith’s research is on experimental economics. He has placed groups of people in scenarios in which they buy and sell fake commodities and found that bubbles often occur: people spend more than the asset is worth, until the price crashes. That pattern hold true until a participant has experienced a bursting bubble two times. On the third time, wild speculation is uncommon and market fundamentalism becomes more common.

“You’re hearing a lot of anti-market rhetoric now. Be careful about that. There are problems in asset markets, yes. And we’re not sure exactly how to solve them. We need to give those attention. But let’s not kill the goose that’s been laying these golden eggs for so long, and is capable of continuing to lay them.”

Smith says there is a role for the government in “recapitalizing” banks, but he recognizes “that there’s long-term dangers in that in the sense that the banks may be tempted in the future to think they’re going to get bailed out, and not be prudent.” But in contrast to banks, Smith thinks that underperforming auto companies should be allowed to fail.

“I think Detroit has to go through bankruptcy. The simple fact is that Detroit has to get their costs down or they’ll never be able to compete in world markets with the automobiles. And I don’t care what kind of automobile they build, that’s not the issue. The issue is that every car they produce costs them more to produce than it does Toyota.”

A major reason why American-made cars are more expensive to produce is because, unlike many other industrialized countries, the United States does not have a national health care system and the cost of auto employer-sponsored health insurance is part of the expense of an American car. But Smith did not address that, nor did he mention that if the car companies go into bankruptcy, thousands of auto workers would lose their negotiated high-wage union contracts.

Despite the current economic disaster, Smith says he considers himself an optimist.

“The glass is still half full – it may even be 5/8ths full. And we’ll get past this, we’re going to survive this, the American economy, I am sure, we’re going to get past it. It’ll be painful in the meantime, and some of the people who are least able to take the pain will be hit the worst. And I think that it’s important for government policy to address that distress and make sure that consumption levels are adequate. I think that should be more the focus of the policy rather than ideas for bailing the economy out that we don’t even know will work and conceivably could make it worse by just delaying the inevitable.”

Smith says he is unwilling to speculate when the housing crash might end with a bottoming out of home prices.

The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel – 2002 lecture by Vernon L. Smith

Vernon Smith

Democracy now on the “Nobel Prize” for economics

Fannie Mae

Freddie Mac

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