How the Housing Bubble Threatens Depression

I don't think we're headed to depression, but that's the word used by Steven Gjerstad and Vernon Smith in a Wall Street Journal article that is well worth reading.  I wrote about how we got into the mortgage mess in a five-part series:

Part 2 explains the role of the Great Moderation and the mild housing cycle in the 2001 recession.

Part 3 explains the role played by securitization of mortgages.

Part 4 explains how the 2001 recession set up the trigger for the current crisis.

Part 5 looks at the future and provide some suggestions for policy.

The Gjerstad-Vernon article is generally consistent with my analysis, but adds some interesting points:

• Laboratory simulations of fairly simple, transparent markets generate bubbles.  (Smith won the Nobel Prize in economics for this research.)
• A change in how the Consumer Price Index is calculated, away from using home prices to using rental equivalence, helped mask the inflation rate, in turn confusing the Fed.  (I reached the conclusion that Greenspan erred in this blog post, but without the sharp insight that the change in CPI methods was involved.)
• Gjerstad & Smith compare the 2001 stock market drop with the housing price decline and ask, "How can one crash that wipes out $10 trillion in assets cause no damage
  to the financial system and another that causes $3 trillion in losses
  devastate the financial system?"  Good question.  Their answer: leverage.  The stocks that dropped in the tech crash were mostly unleveraged, whereas tremendous debt loads support housing investment.

What does this all mean for the outlook?  It doesn't tell us much about the course of 2009, but it does tell us what to expect over the longer run:  more bubbles.