Paul Krugman and the Housing Bubble

On July 1, 2011, in Economics, by sean.rosenthal

In his September 2, 2009 column “How Did Economists Get It So Wrong,” New York Times columnist and Noble Laureate Paul Krugman tried to delineate the shortcomings of the economics profession that resulted in the almost complete failure of economists to predict the housing bubble and its subsequent collapse. In his view, the failure of economists stemmed from a romanticized vision of free markets, an overestimating of human rationality, and an undervaluing of wise oversight and regulations. In criticizing other economists, he scoffed at how their mathematical equations foolishly depict an unrealistically stable free-market.

In deriding the “inherent” instability of a free-market economy, Krugman neglected to indulge in any self-reflection regarding his role in forming the housing bubble. For example, Krugman failed to mention that, on August 2, 2002, he remarked:

To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.

Despite directly calling for the Federal Reserve “to create a housing bubble,” Krugman defended himself in 2009, stating that the above comment “wasn’t a piece of policy advocacy, it was just economic analysis.” In other words, his statement wasn’t stupid; it was just “analysis.”

If Krugman’s statement diverged markedly from the rest of his writings, then people should forgive him for a transient moment of foolishness. However, since it reflected a trend in the Noble Laureate’s thought process, Krugman should not be exonerated from his consistent advocacy of policies that ruined the American economy. Explaining his economic thoughts during an interview in Germany in the late 90s, the Laureate said:

During phases of weak growth there are always those who say that lower interest rates will not help. They overlook the fact that low interest rates act through several channels. For instance, more housing is built, which expands the building sector. You must ask the opposite question: why in the world shouldn’t you lower interest rates?

Today, there are very few economists who will ask a rhetorical question like: what could possibly go wrong if the government stimulates housing? Experience has answered that question.

Yet, to be fair, the above remark did not specifically deal with what to do during the recession in the early 2000s. Perhaps, some of his supporters might believe, he supported keeping interest rates low to create a short term boost in housing, but he advocated discontinuing the policy before it contributed to the “irrational exuberance” that brought about economic disarray. Under this line of reasoning, the blame for the housing bubble would not have been temporary government interventions but instead keeping interest rates “too low for too long.” For people of this view, they would be surprised to know that, on August 10, 2004, the economist wrote:

Oh, and on a nonpolitical note: even before Friday’s grim report on jobs, I was puzzled by Mr. Greenspan’s eagerness to start raising interest rates. Now I don’t understand his policy at all.

According to Krugman, rather than keep interest rates too low for too long, Federal Reserve Chairman Alan Greenspan increased interest rates too quickly. In the view of the Noble Laureate, the economic climate justified the Fed stimulating housing more than it already had. If the Fed had followed the columnist’s advice, housing would have become an even larger bubble, which Krugman would have still blamed on the shortcomings of a “laissez-faire” economy.

Of course, everyone makes mistakes sometimes, especially economists. Many economists who advocated low interest rates during the early 2000s have since realized the detrimental effects of this policy, leading them to retract their statements and, in hindsight, criticize the policy. To vindicate Krugman, his devotees might contend that the Laureate made an understandable error in judgment, as sometimes happens to everybody. Rather than a defect in the policy itself, they could claim, the shortcomings of the policy still emerged from a misguided overstimulation of the housing market, as agreed by almost everyone now.

Unfortunately, despite agreement that the government actively stimulated housing and that housing prices subsequently soared and plummeted, not everyone does agree that active government efforts to promote housing contributed to the bubble in any significant way. On March 2, 2008, Krugman commented:

One argument I’ve been hearing a lot lately runs as follows: “Low interest rates got us into this mess, so it’s crazy to think that low interest rates are the solution.” Now, I don’t actually buy the first premise: I blame Greenspan for ignoring warnings about subprime and housing, but I still think keeping the Fed funds rate at 1% for a long time was justified by the economy’s weakness, which lasted until late 2003 or even beyond.

In making this statement, Krugman claimed both that it was a good policy to stimulate housing and, simultaneously, that stimulating housing played virtually no role in creating a housing bubble, a remarkable case of doublethink. In the economist’s view, the economic problem ensued from that the concerted effort to promote housing not being coupled with regulations to restrict the concerted effort to promote housing. Amazingly, the economist considers the lack of regulations to deal with the shortcomings of a government policy to be a “free-market failure” that shows how an unregulated market can self-destruct due to the irrationality of its participants.

After reflecting upon this remark, his most devout supporters might attempt to shift the blame from low interest rates and active government interventions to the excesses of unregulated capitalism and corporate greed. In response to this shift, these anti-capitalists should reconsider the first quote above, in which Krugman called for the Fed “to create a housing bubble.” Even without interpreting this line literally, Krugman’s supporters must agree that the Laureate supported a government plan to actively promote housing and, as it turns out, the government succeeded. To blame the problems in the housing sector on unregulated capitalism directly contradicts that creating a housing bubble—whether interpreted literally or understood simply to mean the creation of robust growth in the housing sector—was the goal of the government interventions. Rather than due to a lack of oversight, the problems resulted from too much oversight, with the government interferences creating a housing bubble that inevitably collapsed.

In returning back to the first quote, this completes the contradictory cycle about which Krugman needs to self-reflect. Instead of writing about the merits of Keynesianism and the deficiencies of the rest of the economics profession, the Laureate should devote his time to reflecting on the harmful policies that sprung from his own mind. If he would do so, he might change his reflective column “How Did Economists Get It So Wrong?” to a self-reflective piece “How Did I Get It So Wrong?”


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