Very interesting column in the WSJ yesterday on Bubble economics by Steven Gjerstad and Nobel Laurelate Vernon Smith. (Longtime BP readers may recognize Vernon Smith’s name from this somewhat amusing incident).

They dissect the housing and credit bubbles, and how they fell apart.

My favorite part is their discussion of how absurd OER measurements are when it comes to identifying inflation in Housing:

“In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since “owners’ equivalent rent” is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.”

Good stuff.

One caveat: I was surprised to read some fuzzy thinking and unsupported assumptions in the piece, but the one that struck me in particular was this: “Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded.”

Its a giant non-sequitor. There is no explanation of how the political goal of increased home ownership led to the business decisions by loan originators and banks to decrease lending standards.

Other than that, its a thought provoking read . . .


A funny thing happened to me on the way to the studio tonight . . . (November 1st, 2003)

From Bubble to Depression?
WSJ, APRIL 6, 2009

Category: Data Analysis, Federal Reserve, Inflation, Markets, Real Estate

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

26 Responses to “From Bubble to Depression via Bad CPI Data”

  1. proton says:

    Their key message is that both this crisis and Great Depression had their origins in excessive consumer debt.

    It seems a long way to stabilization of housing prices and clearing of consumer debt to manageable levels. Realizing the mark to market losses on these suspect consumer debt should be helpful in that regard. Yet, our government is intent on helping the banks to mark them up. Something does not compute here.

  2. wally says:

    To cut the other way with the same sword: we are now in a strong period of deflation. Furthermore, Fed policy is completely ineffective – they can do absolutely nothing but wait for a turn and then try to claim credit.

  3. AmenRa says:

    Mish did a similar comparison of CPI vs CS-CPI
    He substituted Case Schiller for OER in the data.

  4. techy says:

    I am thinking of starting some shorts, how do i spot a reversal in the market??

  5. NJlou says:

    The CPI has been a fraud for years, thanks in part to the evil Allan Greenscam who helped in its implementation. (This man ought to be executed in front of a firing squad for the role he played in
    destroying America’s wealth and impoverishing the nation.)

    The people over at have been estimating the CPI using both the new and old methodologies documenting the fraud.

    They (BLS) have been substituting lower priced items in the basket of items used to measure price increases to artificially deflate the true cost of living. So if apples have increased in price this month, oranges will be substituted if the price is lower.

    They have done this for several reasons. Social Security, Federal salaries, or any COLA ( cost of living adjustments) that rely on the CPI are never inflation adjusted. This is why the elderly living on a fixed income are now impoverished and can’t pay for food, energy, medicine and housing. Their SS checks are not inflation adjusted. These people worked hard all their lives only to be impoverished by evil banksters like Allan Greenscam.

    COLA payments would, of course, increase the Federal budget deficits, so America’s true deficits are hidden from view.

    The phony CPI numbers are used to hide the true nature of the collapse of the US economic system.

    Using the substitution methodology, Americans are now supposed to substitute dog food for chopped beef.

    So last night I made a wonderful ‘meatloaf’ using Alpo, topped with wonderful tomato sauce from a Martha Steward recipe.

    You can smell the civil war in the air. It will be violent.

  6. Myr says:

    The academics at the Fed lack common sense. The OER issue was obvious at the time…it was discussed(loudly by us who saw the bubble) and ignored(by everyone else). Hell, the Fed poo-poohed the idea that there was a housing bubble at all so they can hardly be expected to understand that that the OER was causing the inflation numbers to be understated. They even ignored the insane lending standards of the time. In fact, even now they refuse to acknowledge the root cause of the problem: massive credit expansion relative to GDP. They looked at M3 back then and said to themselves, “because the economy is fine, this number that’s growing exponentially means nothing.” The Fed is simply a bunch of failed statistics professors who can’t trade their way out of a paper bag. We’ll know that this crisis is closer to the end than the beginning when the people finally turn on the Fed. We’re not even close to that point.

  7. danm says:

    Mish did a similar comparison of CPI vs CS-CPI
    He substituted Case Schiller for OER in the data
    Another problem with CPI is that it measures what you would pay if you were in the market now when most consumers are retreating.

    - How many people are buying new cars today vs. the number stuck in more expensive contracts?

    - How many people paying higher interest rates on their cards for stuff they bought a while back?

    - How many people paying much more in monthly mortgage payments due to resets or refi vs. the number paying less now than 2-3 years ago?

    I’m sorry but the monthly cost of living has only been going down only for those who are in the market now or for those who are walking away from their homes!

    The other interesting fact is that Americans spend less than 10% of their income on food while in Canada it’s closer to 15% and Europe even more. Something tells me that unless Americans start eating even more Doritos, Spam and Velveeta, they are due for some food inflation vs. the ROW.

    The other thing I’ve noticed is that Amercians keep on focusing on deflation always rehashing the argument that you can’t get inflation unless it goes into consumers pockets. The issue I have with that is that most other countries are net exporters trying to keep their currency cheap vs. the US dollar. Maybe Americans haven’t noticed but their policies are forcing other countries to stimulate like crazy to deflate their currencies. In Canada, we are seeing inflation! At one point we will be exporting it and since Americans are importers…

  8. Low Budget Dave says:

    I thought the OER and the price-to-rent ratio were used in an identical manner in the Gross Domestic Product?

    151% – 23% = 128% (inflation in housing unaccounted for). 128% inflation times 23% = 29% net effect on GDP. If real GDP has declined by 29% since January 1999, and real GDP as released by the BEA has only been 28%, then that means we have been in a recession for ten years now.

    If this was concentrated in 2004-2006, then the 2006 depression was roughly equivalent to 1934.

  9. MRegan says:


    I am going to assume that you have written the drollest comment ever on this blog. If I had a spleen, I would have coughed it up laughing…good thing I had it removed out of spite.

  10. ironman says:

    AmenRa and danm mentioned it earlier in the comments, but I’ll third the approach of replacing the Owner’s Equivalent Rent calculation with Case-Shiller housing sale price data in the Consumer Price Index – it’s very much a neat approach to addressing the problems inherent in the OER calculation and its non-responsiveness to significant market events.

    Picking up on danm’s comments, the lagging nature of CPI isn’t something that bothers me that much from an analytical point of view. The reason why is because changes in the rate of inflation tend to be steady for extended periods of time – once a trend has become established, one can reasonably project where it will go and make adjustments as needed.

    Finally, there’s a tantalizing correlation between changes in the size of the labor force and the rate of inflation, at least since 1960, with changes in the labor force preceding changes in inflation by two years in the U.S. It will be interesting to see how well that apparent relationship holds up.

  11. The authors do a fine job of pointing out the fraud that is the CPI. Inflation is often talked about but is very little understood. It is, as Milton Friedman repeatedly asserted, always a monetary phenomenon. It may be manifest in prices that don’t decline when cost and efficiency improvements demand that they should (2003), or it may be manifest in prices that decline less than they should (housing, today, and into the future). And then it might just show up as an increase in the general level of all prices (1979-1982, and at some future point in this latest episode of monetary mischief).

    Inflation numbers are just another way the government manipulates outcomes to its advantage, which is to say, to the advantage of the financiers to whom it is beholden. The economists at the Fed know full well what they are doing.

    If they were truly concerned with inflation, the signals were flashing red all over the international commodities markets that the Fed’s fight against what it perceived as the possibility of deflation in 2002-2007 was in fact wildly inflationary. Keeping true housing inflation out of the mix allowed them to continue their delusion until the markets that were over-built and over-supplied as a result of the delusion finally crashed. This latest effort at propping up housing prices will end badly, as well.

  12. sbailey says:

    I disagree with Gjerstad and Smith. Simply substituting the increasing price of homes for the OER will lead to an overestimate of inflation:

    A third of all households weren’t in the housing market, period. Then there are the households that have already paid off their mortgage. Then there are the households that remained in their home, and either had the same monthly mortgage payment or refinanced at lower interest rates and lowered their real housing costs.

    The households that were affected by price increases were first-time buyers and anyone with an ARM, but that latter adjustment came later, not in the earlier time period?

    Correct me if I’m wrong.

  13. VangelV says:

    ‘There is no explanation of how the political goal of increased home ownership led to the business decisions by loan originators and banks to decrease lending standards.”

    The ‘explanation’ is quite obvious. You have laws that promise to fine banks for discriminating against low income borrowers so they loosen up standards at a time when the Fed and the GSEs are making it very easy to borrow. The excess demand causes prices to go up and the initial loans turn out to be very profitable. As prices keep going up lending becomes a low risk activity and banks become far more aggressive. They figure out ways to increase yields by using more leverage and securitizing the loans. As the bubble grows the risks increase but will only be manifested when prices reverse. While some banks decide to reduce activities they are early and their stock performance and profits do poorly relative to their peers. Given the fact that the incentives are to keep making loans for as long as possible most of the players in the system chose to participate in the bubble. Eventually the bubble burst and the big players became technically insolvent.

    None of what happened would have been possible without the Fed’s loose credit policies the GSE’s reckless expansion of their balance sheets and Congress’ interference with the credit markets. Given that increased stability requires unhampered markets and small governments with limited powers to meddle it is doubtful that we will see any signs of it in our lifetimes. That makes it essential that we protect ourselves from the inevitable volatility by keeping some of our wealth in precious metals.

  14. usphoenix says:

    The drastic change of the CPI, with all of its new arbitrariness came straight from the Clinton White House. The same White House that wanted to “tinker” with Social Security based on false pretenses.

    Say one thing do another Clinton was shafting the public mightily. Greenspan and the Fed were simply basking in the glow.

  15. willid3 says:

    vangeliv, it wasn’t the banks who made the loans that are now toxic. that was the mortgage companies and brokers. they aren’t even subject to Federal laws (CRA for example). the private industry folks are again trying to shift their responsibility for their actions. and they are the ones who set up their PRIVATE pay plans to encourage even more loans, cause they had made a big bet that housing would go up (and not down) and that the bet on whether the loan would get repaid didn’t matter cause they could just have another loan (at higher payments) on the higher priced house. i think its also why incomes have been collapsing to encourage even more loans to make up consumers making less money. now we can say that the GSE’s were accomplices (since they enabled the mortgage market) but they had done that for 60 or so years without this debacle happening. but they did do one thing to assure their being collaborators, they lowered their standards. but that was done to match what the private industry was doing on its own. and the Fed keeping the interest rate low is another accomplice. in spite of being told about the bubble they denied it was happening. and the we could also blame the rating agencies. they rated bad junk as being sterling stuff. otherwise the banks wouldn’t have bought it. and none of it could ever happened had wall street wizards dreamed up ways to fund these notes using leverage. which was allowed by the SEC. it allowed the investment banks to make enormous bets using borrowed money. money they ended up not being able to pay back. but imagine that . not being to pay back more than 40 times what you actually had.

  16. Pat Shuff says:

    “Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded.”

    Home equity

    Americans’ percentage of equity in their homes fell below 50 percent for the first time on record since 1945, the Federal Reserve said. Homeowners’ portion of equity slipped to a revised 49.6 percent in the second quarter of 2007 and declined further to 47.9 percent in the fourth quarter – the third straight quarter it was under 50 percent.


    No data available on the actual ownership of the owner occupied car, owner occupied fridge, washing machine,
    flat screen or bedroom set. Nor the equity remaining in the owner occupied Orwellianspeak borrowed from the Queen’s English. Apparently the goal to expand homeownership government had inverse results, regressing to WWII levels of real not arbitrarily defined ownership.

  17. Pat Shuff says:

    The effort to ban bad mortgage lending practices at the state level was pursued to the Supreme Court.
    The Court ruled good mortage lending practices were illegal and bad lending practices were required.

    They Warned Us About the Mortgage Crisis
    State whistleblowers tried to curtail greedy lending—and were thwarted by the Bush Administration and the financial industry


    Hawke, a veteran banking industry lawyer appointed to head the OCC by President Bill Clinton in 1998, wouldn’t budge. He said he would reinforce federal policies that hindered states from reining in lenders. The AGs left the tense hour-long meeting realizing that Washington had become a foe in the nascent fight against reckless real estate finance. The OCC “took 50 sheriffs off the job during the time the mortgage lending industry was becoming the Wild West,” Cooper says.


    Assignee liability would radically reshape that market by making everyone involved potentially responsible when things go bad. Investment banks that created mortgage-backed securities and investors who bought them would be liable for financial damage if mortgages turned out to be fraudulent. The financial industry opposed assignee liability, maintaining that it would cripple the market for asset-backed securities. Major ratings agencies later agreed that allowing unlimited damages would be disruptive. The agencies threatened to stop evaluating many bonds tied to mortgages covered by the Georgia law.


    Mozilo of Countrywide took rather pointed, heated issue with assignee liability as one could well imagine.

    Office of the Comptroller of the Currency. Oh the dirty laundry. Oh the ironying. Whitewashing (by the) ton, DC.

  18. Chuck Ponzi says:

    That non-sequitor really bothers me too.

    I have been a student of the housing bubble now for almost 5 years and blogging about it for 4 of those. (

    I still cannot for the life of me explain the link between politics and the bubble.

    I also cannot for the life of me explain the link between the central bank and the bubble either. (only partially).

    The gigantic elephant in the room of the housing bubble discussion that everyone seems to conveniently ignore when they write about it is that home prices bubbled almost everywhere. Look at Spain. Look at New Zealand. Look at Australia. Look at China. Look at England. Look at Greece, Turkey, Italy, France, Dubai, Singapore, etc.

    It was a global synchronized housing bubble. Despite that most central banks were less accomodating than our own after 9/11.

    I can only surmise that the write has political agendas of their own to assign blame. I’m no fan of Greenspan (far from it), but how could he have controlled housing prices in Singapore or France or Spain?

    The more I learn about the bubble, the less I know about its cause.

  19. me says:

    “Mish did a similar comparison of CPI vs CS-CPI
    He substituted Case Schiller for OER in the data.”

    Or copied from someone else without attribution.

  20. steel breeze says:

    VangelV Says:
    April 7th, 2009 at 11:41 am

    ‘There is no explanation of how the political goal of increased home ownership led to the business decisions by loan originators and banks to decrease lending standards.”

    The ‘explanation’ is quite obvious. You have laws that promise to fine banks for discriminating against low income borrowers so they loosen up standards at a time when the Fed and the GSEs are making it very easy to borrow.

    So, it is against the law not to make a bad loan? Then why are so many banks not having problems?

    A bank that does not discriminate against low income borrowers will not be in business for long. Such laws as you suggest would seem to make banking itself effectively illegal.

    I think you are leaving out many relevant facts in order to present a biased “explanation”. In other words, you are full of shit.

  21. danm says:

    I’m no fan of Greenspan (far from it), but how could he have controlled housing prices in Singapore or France or Spain?
    By cutting the rates, it forced all countries around the world to cut. When their rates are too high vs. the US rates their currency goes up… can’t have that if they want to export!

    When rates dropped, there was a thirst for yield everywhere…. this made it much easier to dump crap on unsuspecting investors (MBS, CDO, etc)

    Money from London went into Spain… got to have that country house! Credit spreads got so low that Russians were finally able to have a McMansions of their own thanks to the Yen carry trade.

    It’s all about cheap money…. and it came from Greenspan

  22. Chuck Ponzi says:

    Pardon me DanM

    That’s not how I remember history. Other countries did not do the dramatic cutting we did. Japan was already at nearly 0 anyway.

    And, it doesn’t explain the lack of lending standards in Spain.

    But, I meant to say Greenspan or Bush or Clinton. I see no credible link between our presidents and the price of houses in New Zealand. (which had a very different monetary policy, btw)


  23. Chuck Ponzi says:

    Not disagreeing, just remembering it differently. Greenspan definitely deserves some of the blame, but not very much. He didn’t make borrowers commit fraud. Of course, he didn’t police his banking system either.

  24. Chuck,

    have you seen any charts delineating M3 growth in the OECD/”Industrialized” countries you’re mentioning?

  25. jr says:

    In enacting the SFDPA, Congress caused the Federal Housing Administration to have very poor lending standards. From an anonymous Author on TBP on February 24, 2009 (

    “The contentious practice is called “seller-funded downpayment assistance” (SFDPA). It is used to allow home buyers getting Federally-backed mortgages to bypass the need for a downpayment, supposedly for charitable reasons.

    On the surface, it sounds benign, but it is actually fraud and money laundering inflicted on the Federal Housing Administration (that is, taxpayers), the housing market in general, and in a sense, even the buyers!”