Saturday, August 13, 2005


Toil and Trouble

I read Paul Krugman’s article earlier this week on oil prices. I have read analysis similar to his in several other locations. It looks, therefore, like he might be right that we will soon see an end to high oil prices. Yes, apparently the high oil costs we have been experiencing lately have been mostly due to a combination of fear and speculation, not actual shortages, that has driven oil prices to their record levels. Market factors can be expected to bring oil (and with it gasoline) prices back down to their normal levels very soon.

Fortunately, Mr. Krugman assures us that the drop in prices will not be as sudden as most other business analysis articles have warned. Even as a slow drop, however, Mr. Krugman says we should be worried about the coming reduction in oil and gasoline costs. It seems that many Arab sheiks and princes, who appear culturally unable to live within their means, have used the rise in oil prices to borrow heavily against their overvalued assets. They used this borrowed money to predominately purchase luxury items like yachts, fine clothes, and expensive vacations. A small percentage of these Arabs had the forethought to invest their windfall profits, but instead of diversifying many of these Arabs made their dependency on high oil prices even worse by either expanding their oil assets or purchasing new oil rights. Even a slow fall in oil prices will, therefore, bankrupt thousands of these financially naive and overextended Arabs. The financial devastation will then spread to the luxury product and high-end service businesses, since the lower income fuel-buying public (who would be the beneficiaries of lower oil costs) will mostly spend their savings on non-luxury items like medical care or saving for college tuitions. Unfortunately, there seems to be no way for us to maintain these high oil prices forever.

What’s that, you say: Shouldn’t we want costs to come down even if it hurts some pampered, undisciplined investors? This analysis doesn’t make any sense? You can’t see how economists throughout the business press could write such crazy things?… Well, you caught me. Paul Krugman’s latest article (and the bubble fad in the rest of the business press) isn’t really about the cost of oil. It is about the cost of housing. Replace the phrase “oil and gasoline” with “housing,” and the phrase “Arab sheiks and princes” with “the Me Generation” in the two paragraphs above and read them again. With this small change the two paragraphs above still don’t make sense, but they would sure look right at home on today’s business page.

As a society we should never want the cost of anything to remain high. It is only by lowering costs (through innovation or investment in capital goods) that we are able to enjoy a higher standard of living than previous generations and to pass along an ever higher standard of living to succeeding ones. We must, therefore, ruthlessly cut costs wherever we can and should not be happy when the cost of something that everyone needs, like housing, stays high. Also we should not want prices to be out of line of the real cost or value of items because such inconsistencies generate distortions in the economy and inefficient allocation of resources that further interfere with our efforts to improve everyone’s standard of living. If these business writers and economists were writing about high costs or price bubbles of a different item like oil or steel or coffee or computing power then they would be hoping for a reduction in any high costs and that prices would more accurately represent cost.

Krugman and other business writers worry about a reduction in housing prices for the same reason that an OPEC internal memo would worry about reductions in oil prices or that a DeBeers company newsletter would worry about falling diamond prices. Even though reductions in cost and prices helps society in general, there are sometimes specific investors and cartels that see their profits reduced. In the case of housing, a lot of the specific people who will be hurt from a drop in housing prices are expensive-home-owning Baby Boomers. This category of people probably includes Paul Krugman, many of his colleagues, and most of the readers of the NY times and other business publications.

Krugman claims, however, that we should all be worried about a bursting housing bubble because “the U.S. economy has become deeply dependent on” it. This makes no sense. Economies work on wealth creation. Pricing irregularities may move paper money around between people, but they don’t create any new wealth. The only thing dependent on a housing bubble is the fortunes of irresponsible Arab princes… er… I mean overextended Boomers.

Krugman says that our economy wouldn’t be growing so fast without the “soaring spending on residential construction, plus a surge in consumer spending largely based on mortgage refinancing” that is attributable to high housing prices. The increased spending on residential construction is happening because the high price leads people to believe that there is a shortage of housing. If housing prices drop, then those resources being spent on building houses won’t just vanish, they will instead be spent on other areas on the economy where there is a large demand, like building more gasoline refineries or designing an MP3-cellphone-gamepad-PDA. Artificially high housing prices don’t create wealth to spend on residential construction. It diverts wealth to fill an imaginary demand that could be better spent meeting a real need. By distorting economic activity, price bubbles make our economy grow slower not faster.

High housing prices do allow some homeowners to borrow against the inflated value of their house, but it does not create a surge in spending as Krugman suggests. The money from these refinanced homes doesn’t come from creating some new wealth, so it must instead come from somewhere else. Lending money to splurging homeowners means that there is less credit available for businessmen and farmers who want to borrow money to buy new capital equipment. An aging Baby-Boomer who tries to recapture his youth by buying a motorcycle (and sending his wife to an expensive spa so she will agree to let him have the motorcycle) will not generate as much economic activity as a machine shop who buys a new CNC milling machine. The new business investment has the added benefit of directly creating more wealth. Yes, I admit that the Boomer couple may experience more “marital happiness” which is a form of wealth (though the GDP doesn't measure it, despite what its name would suggest) but as far as the rest of us are concerned it won’t compare to the amount of wealth that the new capital equipment could generate by turning lumps of steel into finished machine parts and improving the productivity of our workforce (thereby allowing higher real wages).

Another place that would see increases in spending would be young couples and lower income families that want to buy a new home. The high home prices may allow refinancing ex-hippie professionals to buy new toys, but it forces other home buyers to either adopt more miserly spending habits to make their payments or abandon their hopes of home ownership. The increases in economic growth that are instigated by high home price enabled deficit spending are more than offset by the economic growth that doesn’t happen because of lower income homebuyers curtailing their purchases and businesses that can’t get cheap credit to invest in improving their processes. I don’t believe for a second that we can get more economic growth by extending unjustified credit to higher income consumers than we could by extending that credit to young innovators that want to start a business or proven existing businesses that want to improve.

The housing bubble doesn’t grow the economy, it just grows the ability of older home owners to engage in irresponsible spending behaviors with unearned money at the expense of new home buyers and businesses. I hope that the housing bubble is real and bursts as soon as possible, not because I would begrudge the Me Generation free money but because the money they get from owning overvalued homes isn’t free and the economic distortions the bubble creates hurts the economy as a whole. The worst case would be that there really isn’t a housing price bubble, and that the costs to make new housing are really as high as home prices indicate. Correcting incorrect prices is relatively easy compared to the difficult job of actually lowering costs of some mature product like housing. Fortunately, there are innovative engineers and entrepreneurs that are working hard to bring those costs down. Hopefully one way or another housing prices will come down. We should be happy to see the price of homes come down just as we should be happy to see improved efficiency and productivity in any other field of human endeavor. We should be very careful of advice from Mr. Krugman and other economists who claim that our economic growth is tied to homes being expensive, lest it lead a federal Home Stabilization Corporation that buys homes from elderly voters at hugely inflated prices, or perhaps a Home Adjustment Administration to destroy homes and limit new home construction in an effort to “prop up” home prices. Meanwhile, if you are one of the people who have gotten a financial windfall from increased housing prices, you should ask yourself if you want to keep that money in housing, spend it on luxuries, or diversify some of that money into other investments.

As for Mr. Krugman, I have to wonder: Does he understand basic economics and is just lying to please his audience? Is he just an ignoramus? Or am I talking out of my hat? Any economists or Krugnam devotees who want to explain how a price bubble on anything can be to the general good, are encouraged to respond.

If you haven’t done so already please take my Transporter Philosophy Poll. I don’t yet have a statistically significant sample size.

"As for Mr. Krugman, I have to wonder: Does he understand basic economics and is just lying to please his audience? Is he just an ignoramus?"

I am pretty sure he is an ignoramus.

Anyway, very good and insightful post. I am an engineering student and looking to graduate in December, so I can't help but wonder what effect a housing bubble bursting might have on the tech job market in the near term. You say that better use of capital would help the "innovation sector" (and I agree), but in the short run, would there likely be some kind of ripple though the job market and the rest of the economy?
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