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Why we — and everyone — missed the bust

Maybe it's because there are signs that the housing market could be stabilizing — for now — and the financial markets have gotten past panic mode. But lately a lot of readers complain that those of us who follow these things for a living completely missed the boat on warning readers that it was coming.

When economic journalists miss an $8 trillion housing bubble, I suppose it's to be expected that they will miss other important stories …
— Robert R., address withheld

I was stunned by (this Newsweek article) on how the economists missed predicting the crash when historically it would have been easy to see…
— Dennis M., Colorado Springs, Colo.

Mail like this reminds me of sports talk radio fans berating managers for not pulling the losing pitcher soon enough. No one complains when the same manager gambles and wins. Then he's a genius.

Respectfully, no one can predict a market crash. If they could, there would be no crashes. You might as well ask aloud why governments can't predict riots or businesses can't predict the next consumer fad or TV executives can't predict the next hit show or Web producers predict the next big viral video. What sends the video of one skateboarding dog flooding into millions of inboxes around the world while the next one never gets past the first posting?

The article that caught your eye, Dennis — by Newsweek’s (always insightful) Robert Samuelson — describes the recent folly of a set of economic theories based on mathematical models that many believed had reduced or eliminated the risk of a financial market collapse. The same kind of “new paradigm” thinking was behind the tech bubble and crash of 2000. Likewise, the crash of '87 wasn’t thought possible because of a game-changing invention called “portfolio insurance.” Same movie, different showing.

You certainly could see conditions forming in the middle of this decade that, in hindsight, created a high risk of the housing collapse and recession we're living through. In April 2007, we wrote that rampant mortgage fraud threatened to send millions of homeowners in default. In October 2007, two months before it officially began, we warned readers that a recession might be on the way. It would have been ridiculously irresponsible at those points to "predict" the collapse of the banking industry and the deepest global recession since the 1930s. That outcome was by no means certain.

Crashes and bubbles are the unintended consequence of financial imbalances created by mob psychology. If you can accurately predict the behavior of a mob seized by fear and/or greed, hang out a shingle and charge a fortune. You'll be a billionaire many times over.

Sure, there are plenty of folks now who wonder why so many people — including this columnist — "missed" what is now "obvious." My inbox is full of this stuff. Where were all these soothsayers when we were headed for the cliff?

Of course there are a handful of prognosticators who, in fact, "called" this crash publicly and are now taking credit for their prescience, gleefully linking back to their gloom-and-doom blog posts. They're the same folks who, over the past three decades, have predicted three out of the last 15 crashes ('87, '00 and '08.) If you make enough "crash" predictions, eventually you'll get one right. As the old saying goes, a broken clock is right twice a day.

Over the past several decades there have been multiple "forecasts" that turned out to be completely false alarms. The collapse of the savings and loan industry, for example, brought predictions of a drop in housing prices of as much as 50 percent. It was certainly plausible, given the magnitude of the lending collapse. But aggressive government action, in the form of the Resolution Trust Corp., contained the fallout.

The government's response this time around may have done the same. Or not. We won't know for some time. Until then, send me your predictions and we'll take a look next year and see how well you did.

I feel that the amount of liquidity being put into the economy right now will result in significant inflation (some are saying "hyperinflation") as the economy recovers. Do you agree, and if so, what kind of timeline might we be looking at in terms of when we'd see it?
— Alex W., Centennial, Colo.

No one knows. The Federal Reserve is certainly well aware of the potential problem. It remains to be seen whether there's anything central bankers can do about it.

The argument against hyperinflation is that the liquidity from Fed actions and stimulus spending has been more than offset by the rapid destruction of trillions of dollars of asset value in housing and stock prices. The worry — and one of the key drivers of Fed policy — is that the resulting deflationary pressure from the collapse of this historic asset bubble could be much more harmful than inflation. The two worst examples of the harm caused by deflation were the Great Depression and the Japanese recession of the 1990s.

The latest U.S. consumer price data would seem to indicate that inflation is not a problem. Relatively low long-term bond rates are another sign that inflation expectations are contained. (Investors worried about inflation usually demand higher interest rates to compensate for the loss of purchasing power brought by inflation.) But a recent upturn in rates may be a sign that those inflation fears are coming back. Or it could be a sign the economy is recovering. Or both.

But, yes, the prospect of higher inflation — or even expectations of future inflation — remains the single greatest threat to recovery that we can see. Since the Financial Panic of 2008 began, the Fed has pumped more than $1 trillion in fresh cash into the system. If that money isn't drained back out before the economy recovers (which it will eventually), it's hard to see how we avoid an inflationary surge. If it drains the money off too quickly, it risks sending the economy back into recession and/or prolonging a period of weak growth.

Maybe some of our prescient readers could advise the Fed on its next move.

Why is it that very few people are honest with the American public? It is unfathomable to me that our economists, and MSNBC, are always trying to “be positive.” It seems to be some kind of cultural thing that we always have to say nice things. I think it better if you and your organization told it like it is, as a bit more raw reality than sugar-coating.
Ken E., Oregon

I'll make a deal with you — and every other reader.

Everyone who has written to me since the recession began saying that I'm "too negative" has to pay me $100. I'll then pay $100 to each of you who has accused me of being "too positive."

If everyone goes along, I can retire on the "too negative" crowd and write cookbooks.