Imaginary Squabbles Part 5: Comparing Krugman’s 2005 Housing Bubble Forecasts to Mine

New York Times columnist Paul Krugman has recycled another phony argument about something I wrote many years ago. 

He begins by citing Matt O’Brien who found that Fed governor Janet Yellen in October 2005 was predicting there would be no great impact on the economy “were the house-price bubble to deflate.” O’Brien concludes that, “Back in 2005, she didn't appreciate how much shadow banks relied on AAA-rated mortgage-backed-securities (MBS) as collateral to fund their day-to-day operations—or how much even this supposedly high-quality collateral could go bust if housing did.” But that is “What Janet Yellen and Everyone Else Got Wrong,” as Krugman’s column is rightly titiled. Nobody in 2005 grasped what a precarious house-of-cards was being built, worldwide, on U.S. mortgage-backed securities. 

O’Brien found another quote suggesting Yellen did get it right by December 2007. Yet the recession had already started by then, and blogger Bill McBride and others were worrying that rising unemployment would cause mass foreclosures (not the other way around).

“We had a monstrous housing bubble,” writes Krugman, “and Janet Yellen recognized it in real time [December 2007].... It’s important to notice that just being willing to see the obvious here puts Janet Yellen way ahead of a lot of people who still presume to give us advice on the economy.”   

He links to a 2008 list of 28 people who were supposedly way behind Yellen in “being willing to see” that house prices had fallen 21.6 percent by December 2007, even though nearly all of those 28 references were from 2003–2005. My name is at the top of that list, of course. But why am I on it while Krugman and Yellen are not?

The “Unofficial List of Pundits/Experts Who Were Wrong on the Housing Bubble,” was compiled by a finance lawyer who blogs as “Economics of Contempt.” He worked as a legislative aide to a House Democrat and dealt with derivatives at Lehman Brothers. The list of 28 could find no investment bankers who got it wrong, even at Lehman or Bear Stearns, but it did find a lot of conservatives and libertartians.   

Unlike all these 28 people stubbornly denying the obvious, said the Economics of Contempt, “Paul Krugman argued [on August 8, 2005] that there was a housing bubble, and ... Krugman was right—again.” Krugman too keeps pretending that same column was prescient, while “the mother of all bubbles ... was denied and ignored” by those on his right. What makes this so brazen is that Krugman’s August 2005 column was actually incredibly sanguine about the prospect of falling house prices. Krugman assured us that “news that the U.S. housing bubble is over won't come in the form of plunging prices; it will come in the form of falling sales and rising inventory" [emphasis added]. This prediction that house prices would never plunge, even in cities where prices had soared the most, does not seem like something Krugman should now be inviting readers to compare with what I had written eight months earlier (when home prices were substantially lower).

My two columns that Krugman and his blogger fan find so erroneous were dated January 8, 2005 and October 6, 2006. Those dates matter, because Krugman gives Janet Yellen a pass for being seriously wrong nine months after my first column, and gives her special credit for noticing a recession was starting 14 months after my second article.

I certainly did not deny in January 2005 that house prices had been rising much too fast in several famous cities, but emphasized that “huge increases in home prices were mainly confined to hot spots in California, Florida, Nevada and New England.” This was not just a U.S. danger, I noted, since “the drop in world interest rates raised home prices even more in foreign cities like London, Dublin and Sydney.” Krugman likewise described bubbles as a highly localized issue in his August 2005 column, confined to “areas like New York, Miami and San Diego.” By 2009, I showed that the subsequent mortgage crisis was overwhelmingly dominated by “the foreclosure five”: Nevada, California, Arizona, Florida and Michigan. We both missed Arizona in 2005.

The Case-Shiller index of house prices was up 16.3 percent for the 12 months ending in January 2005, following 11.8–12.5 percent increases in the previous two years.  Far from denying that this was inviting leveraged home-flipping in Nevada, California, Arizona, and Florida, I suggested that “investor disenchantment with housing could be the best reason for expecting home prices to decline in overpriced areas. That would be unpleasant news for home sellers, but good news for buyers.” I suggested it would take a big rise in mortgage rates to pull prices down nationwide, however, and debunked predictions by Krugman and Nouriel Roubini that Bush budget deficits threatened to hike mortgage rates by two percentage points.

The big difference between what Krugman wrote in August 2005 and what I wrote that January is that I thought prices would come down in overpriced areas, while Krugman predicted only “falling sales and rising inventory.” 

My second column in October 2006 could not possibly be guilty as charged of denying a boom in housing prices. Why not? By then the Case-Shiller index had fallen for six months, from 206.65 in April to 203.51 in October. I was instead describing “modestly softening prices for some homes in some cities.”  I asked, “If something has gotten too expensive, shouldn't we be glad when it becomes cheaper? ... It has been undeniably tough for first-time homebuyers in many cities where prices went through the roof.”  

My October 2006 column expected that “a significant nationwide housing bust would follow (rather than lead) a rise in interest rates and unemployment.” That is, it would take a recession to create a foreclosure crisis. I did warn that “the combination of rising oil prices and a tighter Fed policy has usually ended in recession,” but I thought that risk “diminished because oil prices and interest rates have been falling.” That soon changed in a big way. West Texas crude was less than $60 a barrel in October 2006, but it then rose to nearly $96 by the end of 2007 and above $145 by July 2008. That is what tanked the economy, and therefore housing and related finance. I briefly hoped we still might avert crisis at the start of 2008 only because I mistakenly believed that oil prices would fall much sooner and the Fed would cut rates much faster.

Contrary to Krugman and the Economics of Contempt, in both January 2005 and October 2006 I explicitly wrote that house prices were ridiculously inflated in California, Nevada, and Florida, and I explicitly predicted those overinflated prices were likely to fall. Krugman’s August 2005 prediction that home prices would not plunge, by contrast, was clearly incorrect.