Markets operate under the assumption that key players act rationally in most circumstances.
Their premise is such that market stability is based on people acting to a set of according rules.
Much has been debated about this because economics as a science is cold and aloof; it is a matter of simply stating the facts.
Yet we have learned in the recent housing mania that market psychology and behavioral economics play a large role in how people interpret risk and what constitutes an investment.
As most bubbles in the past, such as John Law’s Banque Générale and the South Sea Bubble, many bubbles burst and leap into another bubble.
Why is this?
The argument goes that in a bubble profit is a major driving force distorting stable growth for radical cancerous increases that are only supportable for a short time.
After the glut of speculation is complete, those with a profit that cashed out on time feel the hunger for continued gains.
This desire precipitates another bubble in whatever form it may be; technology stocks, real estate, commodities, or foreign investment.
Either way, the pattern is such were a few successful insiders gut the system, leave burns on the psyche of a general public only to save up long enough to let the emotional scars to heal.
Then they jump into the fire again with their resources ready to be distributed to those at the top again.
It is a disturbing gamblers rush to the top because those that enter a Ponzi game late will have a fate that is predestined. Those that enter the game early will have great success at the expense of those that enter late; after all what you earn is predicated on an infinite number of entrants and as a society we have finite resources and participants. Once this is realized the game is over and those left with no chair realize the music has stopped playing. During the 1990s we had unprecedented growth in the stock market. Returns of 25% a year were more the rule than the exception. The economy was blistering red to the point that Alan Greenspan claimed that we were seeing “irrational exuberance.” For AG to say something along those lines is amazing given the fact how he championed adjustable rate mortgages and lowered the Fed rate to the point that money was practically free. During the early part of this decade, we saw an enormous growth in housing gains. Let us take a look at a few reference points:
| California Median: 1999 | California Median: 2005 | Growth in Percent |
| $178,160 | $548,400 | 207% |
Nationally the picture isn’t so drastic but we do see tremendous growth as well:
| US Median: 1999 | US Median: 2005 | Growth in Percent |
| $113,100 | $215,000 | 90% |
While this data may not come as a surprise, it is useful to use these measure as a guide to frame the mania we are currently in. Housing is consuming a large part of American’s discretionary income and has become a major source of financing spending on consumer goods. This relationship is important to note. Since income is not keeping up with housing costs and other expenses, the ability to withdraw home equity and create additional streams of credit has given consumers the ability to sustain this bubble for a longer period. In many high cost metropolitan areas housing is now consuming 40 to 50% of a family’s net income, a far cry from the conservative 28% which most financial experts suggest. As we are facing a housing led recession, will consumers adjust their spending habits in accordance with declines in home equity? I argue that they will not because of the Duesenberry Effect and the relationship is not a direct one.
Duesenberry Effect
Loss of productivity does not necessarily go hand in hand with a loss of appetite for high consumption. No one will doubt that as a society, we are the world’s large consumers. Our saving rate is negative. The average credit card debt an American carries is $9,200. The Duesenberry Effect argues that once folks get accustomed to a way of life, for example Plasmas and BMWs, a $1 decrease in productivity does not equate to $1 reservation from spending. If anything, on the way down things will accelerate because people will try to maintain their style of life regardless of the loss of income or equity in their home. It is a fall from grace. Financial prudence isn’t the forte of the American public and this massive readjustment and recession will cause a lot more pain than many are envisioning.
No rational argument can demonstrate that a stagnating home market and wages will force individuals to readjust their spending habit. If our national trade deficit is any indicator, we are only becoming more hungry on ways to finance our appetite via credit. The reason the subprime implosion is so crucial and important is because this funding source is now evaporating. Wall Street is not happy with Collateralizing any more funny money debt; the idea of mixing feces in a large sea of good money. Investors gathered that if the pool of funds was large enough, bad and risky debt would be hedged into the matter and mixed in to the point that any drop would be supported and not noticed. This was all in good when the subprime market was tiny. But given that we have over $1.2 trillion in subprime debt originated in the past two years, we are now swimming in a black pool of our own consumption.
Insiders Out. Public In.
In each bubble, there is a privilege being in the know. Those that have insight and the fortitude to jump out early make out like bandits. Examining insiders selling of companies like Toll and New Century Financial, we see that large percentages of top officers sold at peak prices in 2005 and 2006. In addition, selling out of these positions is easier than liquidating a piece of real estate which all subsequent monetary value is derived from; there is no NEW without housing and there is no Toll without people purchasing homes. Many wonder why bubbles go on longer than they should. Again this assumption relies on the fact that markets always act rationally. But in a mania, the market is anything but sane. Mania, as in acting without direction, highlights an amazing ability for stupid money to chase to stupid products by stupid people. It is inevitable that people will and are getting burned for their financial indiscretions. The media will portray these poor individuals as being burned by big bad corporations hungry for a profit. They came too late to the party and unfortunately they were not able to flip a 800 square foot home for $50,000 in 6 months. As we know from studying mob psychology if everyone around us is going crazy and we remain stable, we will start sensing that we are out of our mind. At some point we decide to join the mob and follow the herd. That is why after a bubble has burst, many ordinary people realize that the game could not go on forever. Bubbles are also fueled by credit expansion and perception of quick wealth. Monetarist would have you believe that controlling the flow of money is key to sustainability. Well as you can see, now that the Fed has raised rates back up people are still hungry for housing; even if it means getting negative-amortization-no-doc-1-percent-teaser suicide loans. Essentially this act of financial irresponsibility is the “I’ll double down on 16 with a casino margin because I know a 5 will come out.” And why not? For the past 7 years we have been in a historical global credit expansion fueled by housing. When your home is your Joe or Susie Bank, why worry about money when you can look in your basement and find $50,000 nestled next to your family heirlooms.
At this point there is no silver bullet. Rampant excess in the forms of the previous stock bubble and the current housing bubble will need to be purged. Simply put, the recession we intervened on in 2001 with easy money will come back with a vengeance either in 2008 or 2009. The course of action is already set and financial institutions have made their mint only to loot the market when it crashes. They are out and the public is in. Will enough people have the ability to get out on time? Probably not. We have an unsupportable Social Security system, a costly war, and inflation. Inflation? If you still believe the CPI is an accurate indicator of inflation than you probably believe war is peace and hate is love. The main items that consume your income are housing, healthcare, education, food, and energy. Do you think there is no inflation? Once this permeates into the markets and if there is a global fear, the Fed will be forced to raise rates or face a crashing dollar. They have come out publicly many times that their goal is to have a stable dollar. Trying not to sound like the "Architect" in the Matrix, Ergo the housing market is done.
Insiders have cashed their chips. Many in the public are looking at yesterday trying to predict tomorrow. This upcoming recession will undress the ability of Americans to cut back in the face of a contracting economy. Do you think this is going to happen?
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