“False Profits” by Dean Baker

Making a change from the usual run of the genre (ie, books about the “financial crisis” by people who didn’t tell you that there was a bubble while it was going on, but who nevertheless expect you to be interested in what they have to say about it now that it’s been and gone). A book about the bubble in the US, written by someone who was absolutely right about it, provably, ahead of time and in writing, and who is a lot more angry about the whole mess than those authors who just regard it as a great big game in which some entertaining characters made money at the expense of their dumb counterparties. Despite the comparatively microscopic size of his promotional budgets, I think Baker might have caught the spirit of the times a bit better than Andrew Ross Sorkin or Michael Lewis[1].



(Full disclosure –I got a promotional review copy of “False Profits”. Normally I don’t count the very occasional review copies I get as constituting a declarable interest because I am short of shelving space and so the gift of a book is only a good thing for me if it is a good book anyway – if it is crap, the publisher has gifted me the chore of lugging the thing to Oxfam. But I thought False Profits was a good book, and I am probably going to get some help on a different project from the person I am giving my copy to after I’ve finished this review, so purists might think me compromised).

“False Profits” has the big advantage that it gets the crisis right and doesn’t mess around with all the obfuscation that has been put into the debate by people who were trying to sell the line that “The Global Financial Crisis” was a very complicated thing that ordinary voters couldn’t possibly understand but nonetheless had to cough up ungodly amounts of money for. This wasn’t a global financial crisis; it was a crisis of US real estate valuations. Whatever else went on, whatever shady dealings or irresponsible banking practices or misplaced belief in models or whatever else, it wouldn’t have had much of an effect on the world if it hadn’t all been based on a foundation of overvalued property prices. True, a lot of the disastrous financial wizardry was aimed at justifying and enabling the property bubble to continue and (as John points out in a couple of CT posts) the causal relationship between financial malpractice and the property bubble was two-directional, but it’s necessary to be clear here – the original sin here was the real estate bubble, a bubble which could and should have been the object of anti-bubble policy, and which wasn’t, because of a massive, ghastly policy error on the part of the Federal Reserve. This is Dean’s thesis, and he names the guilty men.

My god, by the way, does he ever name the guilty men. One of the very attractive characteristics of Dean Baker’s economics writing, shared with the best bits of Paul Krugman and Doug Henwood, is that he is a left-liberal writer about economics who completely lacks the ‘cultural cringe’ common to the species. He doesn’t feel the need to call people like Martin Feldstein “really smart” and he doesn’t waste time giving house room to the normal platitudes of market theism or pretending that his view of the world is really properly considered quite close to orthodoxy. In general, he doesn’t crawl around seeking the approval of the economics profession. I would surmise that the constant torrent of scorn would get depressing at length (as I think it sometimes does on his blog), just as a boy who kept on shouting out that the emperor was bare-arsed every ten seconds would eventually get on your nerves, but really, we can cross that bridge when the airwaves are full of self-confident liberal economists giving their message as if they expect it to be agreed with and The Economist is a minor newsletter.

But anyway, the explanation of what happened and its consequences is clear and simple – this is economics the way it ought to be done, focusing on simple causal relationships and adding-up constraints. None of the arguments made by housing bulls during the bubble made a lick of sense, for the simple reason that the ratio of house prices to rents was constantly increasing – any fundamental change in the economics of housing ought to have shown up equally in the rental market as in the market for house purchase, and the “buy versus rent calculation” wasn’t an anomaly or a quirk – it was a simple and easily comprehensible piece of information showing that prices were in a bubble, which was almost universally ignored. The model that fits the data is a simple, myopic-expectations one under which people were prepared to invest in housing at ever higher rental multiples (or alternatively, ever lower rental yields) because they were making an implicit comparison of the cost of renting a house versus the up-front, teaser-rate cost of buying one on mortgage, with the highest level of gearing that the market would give them. Such a model works until it doesn’t, and then we had the crash.

As I mention in a bit more detail on my own blog, this pretty much gives the lie to any comparisons with the Internet bubble – there really were a lot of new technologies invented between 1997 and 2001, many of which did in fact change the whole structure of economic life. But rent is rent and has seen basically no technological progress since the Domesday Book. Failure to spot the housing bubble was much more unforgivable than failure to spot the dot com bubble, and the case for anti-housing bubble policy is therefore much stronger than for anti-stock-market-bubble policy. I am not sure that I agree with all of Dean’s views on the TARP (not necessary, massive con), bank nationalization (should have happened) or policy solutions going forward (rather heavier on IMO meaningless financial technocratic fixes), but the facts are that I’m much more prepared to listen to them because they come from someone who was actually right about this damn thing, and who did indeed sell his house at a profit. And his key policy prescription, on the subject of the Federal Reserve Board and anyone who served on it in the last ten years(sack the bastards!), is a good point well made; there really does have to be some sort of accountability for this sort of thing.

[1] Capsule review of the Lewis book – definitely don’t bother with the hardback, it costs 25 quid, and is basically a collection of chortlesome anecdotes. On the other hand, Liar’s Poker was also basically a collection of chortlesome anecdotes and that was a very good book; Lewis does get the finance right and explains it in very clear terms (he even gets the analogy right, between a CDO and a housing block – this was the only way I found to explain these structures too). The cast of characters are interesting and well-researched and if it wasn’t for the constant rankling of the expense of the book, I think I would have wholeheartedly enjoyed it. In paperback it will be a very good read and probably cleanses Lewis’s soul of the accumulated sins of a decade of ghastly magazine articles. Now he just has to write something to make up for The New New Thing and he can probably go to heaven.