The Price of Everything

by Eduardo Porter

  EPILOGUE

  When Prices Fail

  THERE’S A WEB SITE called Zillow that will spit out a price estimate for pretty much any house in the country. Its algorithm, based on the sales history, the prices of homes sold nearby, and other public data, has a fair track record. In New York and Los Angeles, its estimates have a median error of about 12 percent.

  I used to visit Zillow to keep an eye on the Los Angeles condo that my wife and I lived in before moving to New York in 2004. It’s a pretty town house a ten-minute walk from the beach, with a wind-swept roof deck full of cacti and a view of the ocean. But it’s not the house I pined over. I was nostalgic about the financial gamble, possibly the best deal I will ever make. We bought the place for $369,000 and sold it for $575,000 less than three years later. That is a $206,000 return, on a down payment of only $70,000. Like looking at the worn snapshot of a loved one, keeping an eye on the price of my old home brought me closer to that odd burst of luck. Perversely, it taunted me with the hint that I could have made more.

  Financial ruminations of this sort can produce whiplash, however. I felt a pang of envy as the place zoomed past $800,000 a year after we sold it. Then it dipped, reassuringly, seesawed, shot back up past $900,000, dropped precipitously, bounced, and ended 2009 around $700,000. The roller-coaster ride has taught me one thing: it’s hard to tell how much a home is worth. The rise and fall of my former L.A. condo offers a bigger lesson: prices can fail. They can get it wrong in a very big way, in fact—steering our decisions in unprofitable directions.

  These decisions can be very costly. Skyrocketing house prices persuaded many to spend all their money on homes they would never be able to sell at a profit. Billions of dollars coursed through the Los Angeles real estate market every day. The fortunes of millions of people depended on the price of their homes. But evidently nobody had a clue about what houses in Los Angeles were really worth. So it was across the country, as house prices went for a feverish ride and took our prosperity with them.

  The financial disaster unleashed by the collapse of housing led to the sharpest economic contraction in the United States since the 1930s—pushing unemployment above 10 percent for the first time in more than a quarter century. Ricocheting around the world, it knocked $3.3 trillion off the world economy in 2009. Who knew the price of houses could pack such destructive power?

  PRICES DO A pretty decent job organizing the world, much of the time. Both shaping human behavior and shaped by it, prices distill people’s knowledge, beliefs, and preferences about the choices that lie before them. A quarter century ago, an economist at UCLA published a study titled “Orange Juice and Weather,” which showed that the prices of orange-juice concentrate futures did a better job predicting the weather in Florida than the National Weather Service. Concentrate prices incorporated what investors knew about the prospects for the orange crop. If they had reliable data that the weather would be favorable, they would bet on low prices. If instead it seemed a cold snap was around the corner, they would bet prices of concentrate would rise. Distilled from a large set of investors’ decisions, the prices amalgamated the world’s collective knowledge about Florida’s weather.

  Prices provide the most important signals in an economy, guiding people’s decisions on where to invest their resources to get the best return they can. People who shop around to get the best possible price for their plasma TV are doing us all a favor. They get a better machine, have more money left over to buy other things, and improve the odds of success of the company that makes good products for less, boosting the economy’s efficiency. Successful technology companies that profit from the work of highly qualified workers will offer higher wages—a higher price—to attract better-qualified applicants. Workers will keep raising their qualifications as long as the return—measured in better wages—is worth the investment in time, money, and effort.

  This virtuous cycle, however, depends on relative prices being right. They must do a good job assessing the relative costs and benefits of different types of TVs. When prices go wrong, these decisions are distorted, often to devastating effect. This, unfortunately, happens depressingly often. Between 2000 and 2006, housing sucked in an unprecedented share of U.S. resources, as Americans rushed to buy a home in the belief that home prices would rise forever. The rush of money boosted house prices by some 70 percent on average. Builders rushed to build more. Then the bubble popped. Home prices fell almost a third from their peak in the spring of 2006 to their trough in early 2009.

  The enormous bubble that lifted home prices skyward before slamming them down again didn’t do much for homeownership. The share of Americans who owned their home increased by 1.5 percentage points between 2000 and 2004, to a peak of 69.4 percent. By the end of 2009 it had fallen back to 67.3 percent, where it was in the spring of 2000 before the party started. The fall, however, was devastating. For a few scary months, the world economy tottered perilously near disaster. The most hallowed institutions of American capitalism were humbled. The share prices of Citigroup and Bank of America fell more than 90 percent from their peaks. General Motors, whose chief executive had claimed more than half a century earlier that “what was good for the country was good for General Motors and vice versa,” collapsed into the government’s arms—unable to borrow money or sell cars.

  And this wasn’t an exclusively American drama. Between 2000 and 2007 house prices rose by some 90 percent in Britain and Spain. By the end of 2009, British home prices had fallen about 16 percent from their peak and Spanish homes about 13 percent.

  WHEN PRICES GO OFF THE RAILS

  The housing bubble might be the most painful case of financial excess in recent memory, but it surely isn’t the only one. Through the ages, virtually every potentially profitable new frontier opened up to investment has led to a speculative bubble, as investors have scrambled to tap into its promise only to stampede in retreat a few years later. A decade before the housing crisis we experienced the dot-com bubble. The NASDAQ index, heavy with technology stocks, quadrupled between 1996 and March of 2000. Drunk on information technology’s promise, people poured retirement savings into companies like Pets.com, which achieved fame, though never profit, on the strength of a cute ad with a sock puppet. In 2000, AOL could use its pricey stock to take over media goliath Time Warner, which had more than five times its revenue. By October of 2002 the NASDAQ was back where it had been in 1996. In 2010, Time Warner quietly spun off AOL for a tiny fraction of its price a decade before.

  The dot-com crash was preceded by the Asian financial crisis, with subsidiary bubblettes from Russia to Brazil, when a surge of money into promising “emerging markets” abruptly went into reverse. Similar dynamics caused investors to pummel the Mexican peso during the tequila crisis a few years before. Japan’s Nikkei 225 stock index tripled in real terms between January 1985 and December 1989, only to fall 60 percent over the next two and a half years.

  The very concept of a financial bubble is three hundred years old, added to the vernacular of finance in 1720 when French, Dutch, and British investors succumbed to euphoria over the potential of new trade routes across the Atlantic—pushing up stock prices before they ended in a precipitous crash. The British South Seas Company was established to buy the debt of the crown. To make money, it was given a royal charter to exploit trade routes between Africa, Europe, and Spain’s colonies in America. Spain and Britain being at war, the routes were of dubious value. But that didn’t stop investors from jumping on the vaunted opportunity. The share price of the South Seas Company soared. So did the shares of the maritime insurers covering its trips. Pretty soon, every investment looked like a great deal. Newspaper ads were offering a chance to invest in “a company for carrying out an undertaking of great advantage, but nobody to know what it is.”

  In a move ostensibly implemented to curb the rampant speculation but aimed in fact at protecting the royally chartered trading companies and maritime insurers from competition, in June of 1720 the British Parliament pas
sed a law barring companies that didn’t have a license from the Crown from raising money on the stock market. It also barred chartered companies from changing the purpose of their charter. The law was officially called “An Act to Restrain the Extravagant and Unwarrantable Practice of Raising Money by Voluntary Subscription For Carrying on Projects Dangerous to the Trade and Subjects of the United Kingdom.” But it came to be known as the Bubble Act. And many analysts have suggested that this single act precipitated the bubble’s rupturing. By September it had crashed, and in December, Jonathan Swift penned “The South-Sea Project,” which started:Ye wise philosophers, explain

  What magic makes our money rise,

  When dropt into the Southern main;

  Or do these jugglers cheat our eyes?

  And ended:The nation then too late will find,

  Computing all their cost and trouble,

  Directors’ promises but wind,

  South Sea, at best, a mighty bubble.

  A REGULARITY THAT stands out in these spurts of overenthusiastic invention is the exuberance of the institutions providing finance. This can be prompted by newly discovered investment opportunities—like the Internet or the transatlantic slave trade. But it can also be fueled by changes in the rules governing financial institutions. During the housing boom, financial inventions like floating rate and reverse amortization mortgages were instrumental in bringing less solvent buyers into the American housing market, creating a whole new class of financial product—the subprime loan. In the years of the bubble’s rise, the monthly payments needed to buy a $225,000 house with a standard thirty-year, fixed-rate mortgage and a 20 percent down payment were about $1,079 a month. With an interest-only adjustable-rate mortgage, payments would fall to $663. With a negative amortization mortgage, initial monthly payments could fall all the way to $150.

  Mortgage banks wanted to lend but weren’t much interested in their borrowers’ ability to pay. They were slicing up the mortgages and gluing them back together into structured products called “Residential Mortgage-Backed Securities”—RMBS in the jargon—that they sold to other financial institutions, who often had no idea of what they contained. By 2007 the mortgage-backed securities market was worth $6.9 trillion, from $3 trillion in 2000. This euphoria had little to do with hard-nosed analysis of the “real” value of homes.

  Some eighty years ago the great British economist John Maynard Keynes provided a subtle explanation of how investors can take prices badly astray. In his book The General Theory of Employment, Interest and Money, Keynes compared picking stocks to a reverse beauty contest in which investors didn’t have to choose the most beautiful face but the face that was most popular among other investors. “It is not a case of choosing those [faces] which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes wrote. “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.” It wouldn’t be smart, Keynes observed, to simply buy shares of the company the investor believed to be a good investment. Regardless of the company’s merits, its stock wouldn’t rise if other investors didn’t share his belief.

  In the late 1990s, every investor was a sheep looking for the herd—paying top dollar for dubious Internet stocks in the belief that the next investor along would pay a higher price, regardless of the underlying companies’ profitability. It made little sense for an investor to bet against the flock. When there were enough fools who believed eToys would become the largest toy store in the United States and should be worth eighty dollars per share, it made perfect sense for the most hardheaded dot-com skeptic to buy the shares for fifty dollars even though he or she believed the company was around the corner from bankruptcy.

  So it was during the housing bubble. I doubt that at any point in the cycle of euphoria there was a banker who didn’t suspect home prices would eventually stop rising. Still, the dynamics driving investment into the sector depended on prices going up forever. To be able to keep paying the mortgage bill, the financially shaky subprime homeowners needed house prices to keep rising. That way they could either sell and plow the profit into a new property, or refinance at a higher price and pull “equity” from their home to make ends meet. Yet even those who knew that the music would eventually stop couldn’t drop out of this game of financial musical chairs.

  In the summer of 2007, as mortgage default rates were rising and the “subprime” mortgage market was starting to falter, the chief executive of Citigroup, Charles Prince, argued that “as long as the music is playing, you got to get up and dance. We’re still dancing.” Months later, Prince was ejected from his post. But he wasn’t wrong. He was referring to a long-acknowledged feature of finance: even if an investor were to correctly call a bubble, it could be expensive to bet against it. If other investors were still carried away by their enthusiasm, the bubble could stay inflated longer than the contrarian investor could remain solvent.

  SHOULD WE POP THEM?

  Bubbles leave no end of hardship in their wake: banking crises, recessions, and unemployment spikes, as well as more subtle consequences. One study found that the geographic mobility of people whose houses are underwater—worth less than the value of their mortgages—is about half that of homeowners in better financial condition. University students who graduate during a recession earn less throughout much of their careers. A study of Canadian graduates in the 1980s and 1990s found that those entering the labor market during a recession suffered lower earnings for up to ten years.

  Some social scientists have predicted the current crisis could favor extreme right-wing politics in Europe and the United States in coming years, as lower growth leads to hostility toward governments and taxes—spawning movements like the populist Tea Party in the United States. A study of the impact of economic shocks on politics between 1970 and 2002 concluded that a one-percentage-point decline in economic growth leads to a one-percentage-point increase in the share of the vote going to right-wing and nationalist parties.

  Still, it’s hard to know what to do about bubbles, even when we know they are going to pop up time and again. The cycle of investment surge and bust can bankrupt many investors but can also do good along the way. Investment booms built upon technological breakthroughs like electricity, railways, or the Internet ultimately revolutionized the world economy—fueling surges of productivity that could—at least temporarily—justify the exuberance.

  The long-standing American approach, shared by the chairman of the Federal Reserve, Ben Bernanke, as well as his predecessor, Alan Greenspan, has been that bubbles should be dealt with only after the fact. The Fed should be ready to pick up the pieces after they burst—flooding the economy with cheap money to encourage lending and help debtors avoid bankruptcy as the value of their assets deflates. But the government should do nothing to the bubbles themselves. Their point is that we can’t tell when a bubble is a bubble.

  This, to critics, sounds as crazy as a bout of euphoric investment in single-family homes. Why not lean against a bubble by gradually raising interest rates and cutting the flow of money into the new investment before things get out of hand? Allowing it to grow will ensure that the fallout from its implosion will be that much more painful. Yet while this seems clear-cut after the collapse of the housing bubble has sent us careening to the edge of another Great Depression, it’s not quite as easy to figure out beforehand what to prick and when to prick it.

  Economists still debate whether Greenspan was wrong to have kept interest rates low to boost employment as the United States emerged from recession from 2001 to 2003. Raising interest rates would have taken the air out of the incipient housing bubble, but it would have also slowed the economy, lengthening the recession and boosting unemployment. Had housing growth stalled, lots of construction-sector jobs—which provided a livelihood for many workers—wouldn’t have existed. “Whenever in the future the US finds itself in a situation like
2003, should it try to keep the economy near full employment even at some risk of a developing bubble?” wondered the economic historian J. Bradford Delong. “I am genuinely unsure as to which side I come down on in this debate.”

  Beyond the immediate impact on aggregate employment, what would happen with innovation if every time investors swooped upon a new technology the emergent bubbles were preemptively pricked? Big jumps in asset prices can lead to misallocated investments that squander productive resources. Bubbles generate enormous economic volatility as they inflate and burst. The damage is always most acute among the most vulnerable, who lose their jobs, lose their houses, and lose control over their lives. But speculation can also increase investment in risky ventures, which often yields benefits to society. The Internet is no bad thing to have.

  In 1922 James Edward Meeker, the economist of the New York Stock Exchange, wrote: “Of all the peoples in history the American people can least afford to condemn speculation in those broad sweeping strokes so beloved of the professional reformer. The discovery of America was made possible by a loan based on the collateral of Queen Isabella’s crown jewels, and at interest, beside which even the call rates of 1919-1920 look coy and bashful. Financing an unknown foreigner to sail the unknown deep in three cockleshell boats in the hope of discovering a mythical Zipangu cannot, by the wildest exercise of language be called a ‘conservative investment.’” What’s more, whatever we do to prevent financial turmoil, we must acknowledge an important limitation: we are unlikely to stamp out bubbles and crashes entirely.

  Financial crises spawned by investment surges, credit booms, and asset bubbles appear to be a standard feature of the landscape of capitalism. Economists Carmen Reinhart and Kenneth Rogoff found that of the world’s sixty-six major economies—including developed nations and the largest developing countries—only Portugal, Austria, the Netherlands, and Belgium had avoided a banking crisis between 1945 and 2007. By the end of 2008 no country was unscathed.