Markets behaving badly again?

The Obama administration $25 billion deal struck with the nation’s five biggest mortgage servicers tops numerous other approaches to boosting the housing market that have conspicuously failed to prop up the economy.

However, such attempt at propping up real estate prices to the levels achieve at the height of the previous bubble is a questionable objective. First, it disregards the ability to pay of homeowners and second it risks creating a new financial bubble.

Indeed, the financial bubble seems to be already blowing if one looks at the chart below where we compare the evolution of house prices (measured by the Case-Shiller Index), with the trend in real estate investment funds (measured by the Ishares Real Estate Trust) and the stock market (measured by S&P 500 index).

The chart shows that there is again a large differential between the price of financial assets (IYR) and the price of their underlying real assets (houses). Although some lagging between real and financial assets is normal, wide deviations usually occur in bubbles or crashes. This fact is important for homeowners as well as to macroeconomic policy and monetary quantitative easing in particular.

Back in the 1930s, the debate between Keynes and Hayek on the efficacy of stimulus policies discussed the relationship between asset prices and production prices. Hayek believed that markets left to their own would restore the prices of assets without increasing those of production. In contrast, Keynes argued that piling up bank balances or purchasing existing securities to bid their prices to previous levels would cause the release of real resources (capital and labour) while failing to find new opportunities to invest them due to a lack of confidence (“animal spirits”). As it turned out the recovery only came about after a number of years through government stimulus of the worst kind (armament and war spending).

Therefore, modern Keynesians like Paul Krugman who are sceptical about the sustainability of quantitative easing should be less soft on quantitative easing and more committed to devise deficit stimulus packages that have a less costly multiplier effect. My own suggestions about the government spending multiplier can be found in this post.