How markets fail summary per chapter

HOW MARKETS FAIL THE LOGIC OF

ECONOMIC CALAMITIES

JOHN CASSIDY

FARRAR, STRAUS AND GIROUX • NEW YORK

To Lucinda, Beatrice, and Cornelia

CONTENTS

Also by the Author Copyright Dedication

Introduction

PART ONE: UTOPIAN ECONOMICS 1. Warnings Ignored and the Conventional Wisdom 2. Adam Smith’s Invisible Hand 3. Friedrich Hayek’s Telecommunications System 4. The Perfect Markets of Lausanne 5. The Mathematics of Bliss 6. The Evangelist 7. The Coin-Tossing View of Finance 8. The Triumph of Utopian Economics

PART TWO: REALITY-BASED ECONOMICS 9. The Prof and the Polar Bears

10. A Taxonomy of Failure

11. The Prisoner’s Dilemma and Rational Irrationality

12. Hidden Information and the Market for Lemons

13. Keynes’s Beauty Contest

14. The Rational Herd

15. Psychology Returns to Economics

16. Hyman Minsky and Ponzi Finance

PART THREE: THE GREAT CRUNCH

17. Greenspan Shrugs

18. The Lure of Real Estate

19. The Subprime Chain

20. In the Alphabet Soup

21. A Matter of Incentives

22. London Bridge Is Falling Down

23. Socialism in Our Time

Conclusion

Notes Acknowledgments Index

INTRODUCTION

“I am shocked, shocked, to find that gambling is going on in here!” —Claude Rains as Captain Renault in Casablanca

The old man looked drawn and gray. During the almost two decades he had spent overseeing America’s financial system, as chairman of the Federal Reserve, congressmen, cabinet ministers, even presidents had treated him with a deference that bordered on the obsequious. But on this morning—October 23, 2008—Alan Greenspan, who retired from the Fed in January 2006, was back on Capitol Hill under very different circumstances. Since the market for subprime mortgage securities collapsed, in the summer of 2007, leaving many financial institutions saddled with tens of billions of dollars’ worth of assets that couldn’t be sold at any price, the Democratic congressman Henry Waxman, chairman of the House Committee on Oversight and Government Reform, had held a series of televised hearings, summoning before him Wall Street CEOs, mortgage industry executives, heads of rating agencies, and regulators. Now it was Greenspan’s turn at the witness table.

Waxman and many other Americans were looking for somebody to blame. For more than a month following the sudden unraveling of Lehman Brothers, a Wall Street investment bank with substantial holdings of mortgage securities, an unprecedented panic had been roiling the financial markets. Faced with the imminent collapse of American International Group, the largest insurance company in the United States, Ben Bernanke, Greenspan’s mild-mannered successor at the Fed, had approved an emergency loan of $85 billion to the company. Federal regulators had seized Washington Mutual, a major mortgage lender, selling off most of its assets to JPMorgan Chase. Wells Fargo, the nation’s sixth-biggest bank, had rescued Wachovia, the fourth-biggest. Rumors had circulated about the soundness of other financial institutions, including Citigroup, Morgan Stanley, and even the mighty Goldman Sachs.

Watching this unfold, Americans had clung to their wallets. Sales of autos, furniture, clothes, even books had collapsed, sending the economy into a tailspin. In an effort to restore stability to the financial system, Bernanke and the Treasury secretary, Hank Paulson, had obtained from Congress the authority to spend up to $700 billion in taxpayers’ money on a bank bailout. Their original plan had been to

buy distressed mortgage securities from banks, but in mid-October, with the financial panic intensifying, they had changed course and opted to invest up to $250 billion directly in bank equity. This decision had calmed the markets somewhat, but the pace of events had been so frantic that few had stopped to consider what it meant: the Bush administration, after eight years of preaching the virtues of free markets, tax cuts, and small government, had turned the U.S. Treasury into part owner and the effective guarantor of every big bank in the country. Struggling to contain the crisis, it had stumbled into the most sweeping extension of state intervention in the economy since the 1930s. (Other governments, including those of Britain, Ireland, and France, had taken similar measures.)

“Dr. Greenspan,” Waxman said. “You were the longest-serving chairman of the Federal Reserve in history, and during this period of time you were, perhaps, the leading proponent of deregulation of our financial markets . . . You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements.” Waxman read from his notes: “ ‘There’s nothing involved in federal regulation which makes it superior to market regulation.’ ‘There appears to be no need for government regulation of off-exchange derivative transactions.’ ‘We do not believe a public policy case exists to justify this government intervention.’ ” Greenspan, dressed, as always, in a dark suit and tie, listened quietly. His face was deeply lined. His chin sagged. He looked all of his eighty-two years. When Waxman had finished reading out Greenspan’s words, he turned to him and said: “My question for you is simple: Were you wrong?”

“Partially,” Greenspan replied. He went on: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms . . . The problem here is something which looked to be a very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out what happened and why, I will change my views.”

Waxman, whose populist leanings belie the fact that he represents some of the wealthiest precincts in the country—Beverly Hills, Bel Air, Malibu—asked Greenspan whether he felt any personal responsibility for what had happened. Greenspan didn’t reply directly. Waxman returned to his notes and started reading again. “ ‘I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We have tried regulations. None meaningfully worked.’ ” Waxman looked at Greenspan. “That was your quote,” he said. “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Now our whole economy is paying the price. Do you feel that your ideology pushed you to

make decisions that you wish you had not made?” Greenspan stared through his thick spectacles. Behind his mournful gaze lurked a

savvy, self-made New Yorker. He grew up during the Great Depression in Washington Heights, a working-class neighborhood in upper Manhattan. After graduating from high school, he played saxophone in a Times Square swing band, and then turned to the study of economics, which was coming to be dominated by the ideas of John Maynard Keynes. After initially embracing Keynes’s suggestion that the government should actively manage the economy, Greenspan turned strongly against it. In the 1950s, he became a friend and acolyte of Ayn Rand, the libertarian philosopher and novelist, who referred to him as “the undertaker.” (In his youth, too, he was lugubrious.) He became a successful economic consultant, advising many big corporations, including Alcoa, J.P. Morgan, and U.S. Steel. In 1968, he advised Richard Nixon during his successful run for the presidency, and under Gerald Ford he acted as chairman of the White House Council of Economic Advisers. In 1987, he returned to Washington, this time permanently, to head the Fed and personify the triumph of free market economics.

Now Greenspan was on the defensive. An ideology is just a conceptual framework for dealing with reality, he said to Waxman. “To exist, you need an ideology. The question is whether it is accurate or not. What I am saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I have been very distressed by that fact.” Waxman interrupted him. “You found a flaw?” he demanded. Greenspan nodded. “I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak,” he said.

Waxman had elicited enough already to provide headlines for the following day’s newspapers—the Financial Times: “ ‘I made a mistake,’ admits Greenspan”—but he wasn’t finished. “In other words, you found that your view of the world, your ideology, was not right,” he said. “It was not working?”

“Precisely,” Greenspan replied. “That’s precisely the reason I was shocked. Because I had been going for forty years, or more, with very considerable evidence that it was working exceptionally well.”

This book traces the rise and fall of free market ideology, which, as Greenspan said, is more than a set of opinions: it is a well-developed and all-encompassing way of thinking about the world. I have tried to combine a history of ideas, a narrative of the financial crisis, and a call to arms. It is my contention that you cannot comprehend recent events without taking into account the intellectual and historical context in which they unfolded. For those who want one, the first chapter and last third of the book contain a reasonably comprehensive account of the credit crunch of 2007–2009. But unlike other books on the subject, this one doesn’t focus on the firms and characters involved: my aim is to explore the underlying economics of the

crisis and to explain how the rational pursuit of self-interest, which is the basis of free market economics, created and prolonged it.

Greenspan isn’t the only one to whom the collapse of the subprime mortgage market and ensuing global slump came as a rude shock. In the summer of 2007, the vast majority of analysts, including the Fed chairman, Bernanke, thought worries of a recession were greatly overblown. In many parts of the country, home prices had started falling, and the number of families defaulting on their mortgages was rising sharply. But among economists there was still a deep and pervasive faith in the vitality of American capitalism, and the ideals it represented.

For decades now, economists have been insisting that the best way to ensure prosperity is to scale back government involvement in the economy and let the private sector take over. In the late 1970s, when Margaret Thatcher and Ronald Reagan launched the conservative counterrevolution, the intellectuals who initially pushed this line of reasoning—Friedrich Hayek, Milton Friedman, Arthur Laffer, Sir Keith Joseph—were widely seen as right-wing cranks. By the 1990s, Bill Clinton, Tony Blair, and many other progressive politicians had adopted the language of the right. They didn’t have much choice. With the collapse of communism and the ascendancy of conservative parties on both sides of the Atlantic, a positive attitude to markets became a badge of political respectability. Governments around the world dismantled welfare programs, privatized state-run firms, and deregulated industries that previously had been subjected to government supervision.

In the United States, deregulation started out modestly, with the Carter administration’s abolition of restrictions on airline routes. The policy was then expanded to many other parts of the economy, including telecommunications, media, and financial services. In 1999, Clinton signed into law the Gramm-Leach-Bliley Act (aka the Financial Services Modernization Act), which allowed commercial banks and investment banks to combine and form vast financial supermarkets. Lawrence Summers, a leading Harvard economist who was then serving as Treasury secretary, helped shepherd the bill through Congress. (Today, Summers is Barack Obama’s top economic adviser.)

Some proponents of financial deregulation—lobbyists for big financial firms, analysts at Washington research institutes funded by corporations, congressmen representing financial districts—were simply doing the bidding of their paymasters. Others, such as Greenspan and Summers, were sincere in their belief that Wall Street could, to a large extent, regulate itself. Financial markets, after all, are full of well- paid and highly educated people competing with one another to make money. Unlike in some other parts of the economy, no single firm can corner the market or determine the market price. In such circumstances, according to economic orthodoxy, the invisible hand of the market transmutes individual acts of selfishness into socially desirable collective outcomes.

If this argument didn’t contain an important element of truth, the conservative movement wouldn’t have enjoyed the success it did. Properly functioning markets reward hard work, innovation, and the provision of well-made, affordable products; they punish firms and workers who supply overpriced or shoddy goods. This carrot- and-stick mechanism ensures that resources are allocated to productive uses, making market economies more efficient and dynamic than other systems, such as communism and feudalism, which lack an effective incentive structure. Nothing in this book should be taken as an argument for returning to the land or reconstituting the Soviets’ Gosplan. But to claim that free markets always generate good outcomes is to fall victim to one of three illusions I identify: the illusion of harmony.

In Part I, I trace the story of what I call utopian economics, taking it from Adam Smith to Alan Greenspan. Rather than confining myself to expounding the arguments of Friedrich Hayek, Milton Friedman, and their fellow members of the “Chicago School,” I have also included an account of the formal theory of the free market, which economists refer to as general equilibrium theory. Friedman’s brand of utopian economics is much better known, but it is the mathematical exposition, associated with names like Léon Walras, Vilfredo Pareto, and Kenneth Arrow, that explains the respect, nay, awe with which many professional economists view the free market. Even today, many books about economics give the impression that general equilibrium theory provides “scientific” support for the idea of the economy as a stable and self-correcting mechanism. In fact, the theory does nothing of the kind. I refer to the idea that a free market economy is sturdy and well grounded as the illusion of stability.

The period of conservative dominance culminated in the Greenspan Bubble Era, which lasted from about 1997 to 2007. During that decade, there were three separate speculative bubbles—in technology stocks, real estate, and physical commodities, such as oil. In each case, investors rushed in to make quick profits, and prices rose vertiginously before crashing. A decade ago, bubbles were widely regarded as aberrations. Some free market economists expressed skepticism about the very possibility of them occurring. Today, such arguments are rarely heard; even Greenspan, after much prevarication, has accepted the existence of the housing bubble.

Once a bubble begins, free markets can no longer be relied on to allocate resources sensibly or efficiently. By holding out the prospect of quick and effortless profits, they provide incentives for individuals and firms to act in ways that are individually rational but immensely damaging—to themselves and others. The problem of distorted incentives is, perhaps, most acute in financial markets, but it crops up throughout the economy. Markets encourage power companies to despoil the environment and cause global warming; health insurers to exclude sick people from coverage; computer makers to force customers to buy software programs they

don’t need; and CEOs to stuff their own pockets at the expense of their stockholders. These are all examples of “market failure,” a concept that recurs throughout the book and gives it its title. Market failure isn’t an intellectual curiosity. In many areas of the economy, such as health care, high technology, and finance, it is endemic.

The previous sentence might come as news to the editorial writers of The Wall Street Journal, but it isn’t saying anything controversial. For the past thirty or forty years, many of the brightest minds in economics have been busy examining how markets function when the unrealistic assumptions of the free market model don’t apply. For some reason, the economics of market failure has received a lot less attention than the economics of market success. Perhaps the word “failure” has such negative connotations that it offends the American psyche. For whatever reason, “market failure economics” never took off as a catchphrase. Some textbooks refer to the “economics of information,” or the “economics of incomplete markets.” Recently, the term “behavioral economics” has come into vogue. For myself, I prefer the phrase “reality-based economics,” which is the title of Part II.

Reality-based economics is less unified than utopian economics: because the modern economy is labyrinthine and complicated, it encompasses many different theories, each applying to a particular market failure. These theories aren’t as general as the invisible hand, but they are more useful. Once you start to think about the world in terms of some of the concepts I outline, such as the beauty contest, disaster myopia, and the market for lemons, you may well wonder how you ever got along without them.

The emergence of reality-based economics can be traced to two sources. Within orthodox economics, beginning in the late 1960s, a new generation of researchers began working on a number of topics that didn’t fit easily within the free market model, such as information problems, monopoly power, and herd behavior. At about the same time, two experimental psychologists, Amos Tversky and Daniel Kahneman, were subjecting rational economic man—Homo economicus—to a withering critique. As only an economist would be surprised to discover, humans aren’t supercomputers: we have trouble doing sums, let alone solving the mathematical optimization problems that lie at the heart of many economic theories. When faced with complicated choices, we often rely on rules of thumb, or instinct. And we are greatly influenced by the actions of others. When the findings of Tversky, Kahneman, and other psychologists crossed over into economics, the two strands of thought came together under the rubric of “behavioral economics,” which seeks to combine the rigor of economics with the realism of psychology.

In Part II, I devote a chapter to Kahneman and Tversky, but this book shouldn’t be mistaken for another text on behavioral economics. Reality-based economics is a much broader field, a good part of which makes no departure from the axioms of

rationality, and it is also considerably older. I trace its development back to Arthur C. Pigou, an English colleague and antagonist of John Maynard Keynes who argued that many economic phenomena involve interdependencies—what you do affects my welfare, and what I do affects yours—a fact that the market often fails to take into account. After using global warming to illustrate how such “spillovers” arise, I move on to other pervasive types of market failure, involving monopoly power, strategic interactions (game theory), hidden information, uncertainty, and speculative bubbles.

A common theme of this section is that the market, through the price system, often sends the wrong signals to people. It isn’t that people are irrational: within their mental limitations, and the limitations imposed by their environment, they pursue their own interests as best they can. In Part III, The Great Crunch, I pursue this argument further and apply it to the financial crisis, using some of the conceptual tools laid out in Parts I and II. The mortgage brokers who steered hard-up working-class families toward risky subprime mortgages were reacting to monetary incentives. So were the loan officers who approved these loans, the investment bankers who cobbled them together into mortgage securities, the rating agency analysts who stamped these securities as safe investments, and the mutual fund managers who bought them.

The subprime boom represented a failure of capitalism in the presence of bounded cognition, uncertainty, hidden information, trend-following, and plentiful credit. Since all of these things are endemic to the modern economy, it was a failure of business as usual. In seeking to deny this, some conservatives have sought to put the blame entirely on the Fed, the Treasury Department, or on Fannie Mae and Freddie Mac, two giant mortgage companies that were actually quasi-governmental organizations. (The U.S. Treasury implicitly guaranteed their debt.) But at least one prominent conservative, Richard Posner, one of the founders of the “Law and Economics” school, has recognized the truth. “The crisis is primarily, perhaps almost entirely, the consequence of decisions taken by private firms in an environment of minimal regulation,” he said in a 2008 speech. “We have seen a largely deregulated financial sector breaking and seemingly carrying much of the economy with it.”

How could such a thing happen? Bad economic policy decisions played an important role. In keeping interest rates too low for too long, Greenspan and Bernanke distorted the price signals that the market sends and created the conditions for an unprecedented housing bubble. Greed is another oft-mentioned factor; stupidity, a third. (How could those boneheads on Wall Street not have known that lending money to folks with no income, no jobs, and no assets—the infamous “NINJA” mortgage loans—was a bad idea?) In the wake of the revelations about Bernie Madoff and his multibillion-dollar Ponzi scheme, criminality is yet another

thing to consider. At the risk of outraging some readers, I downplay character issues. Greed is ever

present: it is what economists call a “primitive” of the capitalist model. Stupidity is equally ubiquitous, but I don’t think it played a big role here, and neither, with some obvious exceptions, did outright larceny. My perhaps controversial suggestion is that Chuck Prince, Stan O’Neal, John Thain, and the rest of the Wall Street executives whose financial blundering and multimillion-dollar pay packages have featured on the front pages during the past two years are neither sociopaths nor idiots nor felons. For the most part, they are bright, industrious, not particularly imaginative Americans who worked their way up, cultivated the right people, performed a bit better than their colleagues, and found themselves occupying a corner office during one of the great credit booms of all time. Some of these men, perhaps many of them, harbored doubts about what was happening, but the competitive environment they operated in provided them with no incentive to pull back. To the contrary, it urged them on. Between 2004 and 2007, at the height of the boom, banks and other financial companies were reaping record profits; their stock prices were hitting new highs; and their leaders were being lionized in the media.

Consider what would have happened if Prince, who served as chief executive of Citigroup from 2003 to 2007, had announced in 2005, say, that Citi was withdrawing from the subprime market because it was getting too risky. What would have been the reaction of Prince’s rivals? Would they have acknowledged the wisdom of his move and copied it? Not likely. Rather, they would have ordered their underlings to rush in and take the business Citi was leaving behind. Citi’s short-term earnings would have suffered relative to those of its peers; its stock price would have come under pressure; and Prince, who was already facing criticism because of problems in other areas of Citi’s business, would have been written off as a fuddy-duddy. In an interview with the Financial Times in July 2007, he acknowledged the constraints he was operating under. “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Four months later, Citi revealed billions of dollars in losses on bad corporate debts and distressed home mortgages. Prince resigned, his reputation in tatters.

In game theory, the dilemma that Prince faced is called the prisoner’s dilemma, and it illustrates how perfectly rational behavior on the part of competing individuals can result in bad collective outcomes. When the results of our actions depend on the behavior of others, the theory of the invisible hand doesn’t provide much guidance about the likely outcome. Until the formulation of game theory in the 1940s and 1950s, economists simply didn’t have the tools needed to figure out what happens in these instances. But we now know a lot more about how purposeful but self-defeating behavior, or what I refer to as rational irrationality, can develop

and persist. In Part III, The Great Crunch, I show how rational irrationality was central to the

housing bubble, the growth of the subprime mortgage market, and the subsequent unraveling of the financial system. Much as we might like to imagine that the last few years were an aberration, they weren’t. Credit-driven boom-and-bust cycles have plagued capitalist economies for centuries. During the past forty years, there have been 124 systemic banking crises around the world. During the 1980s, many Latin American countries experienced one. In the late 1980s and 1990s, it was the turn of a number of developed countries, including Japan, Norway, Sweden, and the United States. The collapse of the savings-and-loan industry led Congress to establish the Resolution Trust Corporation, which took over hundreds of failed thrifts. Later in the 1990s, many fast-growing Asian countries, including Thailand, Indonesia, and South Korea, endured serious financial blowups. In 2007–2008, it was our turn again, and this time the crisis involved the big banks at the center of the financial system.

For years, Greenspan and other economists argued that the development of complicated, little-understood financial products, such as subprime mortgage– backed securities (MBSs), collateralized debt obligations (CDOs), and credit default swaps (CDSs), made the system safer and more efficient. The basic idea was that by putting a market price on risk and distributing it to investors willing and able to bear it, these complex securities greatly reduced the chances of a systemic crisis. But the risk-spreading proved to be illusory, and the prices that these products traded at turned out to be based on the premise that movements in financial markets followed regular patterns, that their overall distribution, if not their daily gyrations, could be foreseen—a fallacy I call the illusion of predictability, the third illusion at the heart of utopian economics. When the crisis began, the markets reacted in ways that practically none of the participants had anticipated.

In telling this story, and bringing it up to the summer of 2009, I have tried to relate recent events to long-standing intellectual debates over the performance of market systems. The last ten years can be viewed as a unique natural experiment designed to answer the questions: What happens to a twenty-first-century, financially driven economy when you deregulate it and supply it with large amounts of cheap money? Does the invisible hand ensure that everything works out for the best? This isn’t an economics textbook, but it does invite the reader to move beyond the daily headlines and think quite deeply about the way modern capitalism operates, and about the theories that have informed economic policies. We tend to think of policy as all about politics and special interests, which certainly play a role, but behind the debates in Congress, on cable television, and on the Op-Ed pages, there are also some complex and abstract ideas, which rarely get acknowledged. “Practical men, who believe themselves to be quite exempt from any intellectual influences,

are usually the slaves of some defunct economist,” John Maynard Keynes famously remarked on the final page of The General Theory of Employment, Interest and Money. “Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

Keynes had a weakness for rhetorical flourishes, but economic ideas do have important practical consequences: that is what makes them worthy of study. If the following helps some readers comprehend some things that had previously seemed mystifying, the effort I have put into it will have been well rewarded. If it also helps consign utopian economics to the history books, that will be a bonus.

PART ONE

UTOPIAN

ECONOMICS

1. WARNINGS IGNORED AND THE CONVENTIONAL WISDOM

A common reaction to extreme events is to say they couldn’t have been predicted. Japan’s aerial assault on Pearl Harbor; the terrorist strikes against New York and Washington on September 11, 2001; Hurricane Katrina’s devastating path through New Orleans—in each of these cases, the authorities claimed to have had no inkling of what was coming. Strictly speaking, this must have been true: had the people in charge known more, they would have taken preemptive action. But lack of firm knowledge rarely equates with complete ignorance. In 1941, numerous American experts on imperial Japan considered an attack on the U.S. Pacific Fleet an urgent threat; prior to 9/11, al-Qaeda had made no secret of its intention to strike the United States again—the CIA and the FBI had some of the actual plotters under observation; as far back as 1986, experts working for the Army Corps of Engineers expressed concerns about the design of the levees protecting New Orleans.

What prevented the authorities from averting these disasters wasn’t so much a lack of timely warnings as a dearth of imagination. The individuals in charge weren’t particularly venal or shortsighted; even their negligence was within the usual bounds. They simply couldn’t conceive of Japan bombing Hawaii; of jihadists flying civilian jets into Manhattan skyscrapers; of a flood surge in the Gulf of Mexico breaching more than fifty levees simultaneously. These catastrophic eventualities weren’t regarded as low-probability outcomes, which is the mathematical definition of extreme events: they weren’t within the range of possibilities that were considered at all.

The subprime mortgage crisis was another singular and unexpected event, but not one that came without warning. As early as 2002, some commentators, myself

included, were saying that in many parts of the country real estate values were losing touch with incomes. In the fall of that year, I visited the prototypical middle-class town of Levittown, on Long Island, where, in the aftermath of World War II, the developer Levitt and Sons offered for sale eight-hundred-square-foot ranch houses, complete with refrigerator, range, washing machine, oil burners, and Venetian blinds, for $7,990. When I arrived, those very same homes, with limited updating, were selling for roughly $300,000, an increase of about 50 percent on what they had been fetching two years earlier. Richard Dallow, a Realtor whose family has been selling property there since 1951, showed me around town. He expressed surprise that home prices had defied the NASDAQ crash of 2000, the economic recession of 2001, and the aftermath of 9/11. “It has to impact at some point,” he said. “But, then again, in the summer of 2000, I thought it was impacting, and then things came back.”

By and large, the kinds of people buying houses in Levittown were the same as they had always been: cops, firefighters, janitors, and construction workers who had been priced out of neighboring towns. The inflation in home prices was making it difficult for these buyers even to afford Levittown. This “has always been a low- down-payment area,” Dallow said. “If the price is three hundred and thirty thousand, and you put down five percent, that’s a mortgage of three hundred and thirteen thousand five hundred. You need a jumbo mortgage. For Levittown.” When I got back to my office in Times Square, I wrote a story for The New Yorker entitled “The Next Crash,” in which I quoted Dallow and some financial analysts who were concerned about the real estate market. “Valuation looks quite extreme, and not just at the top end,” Ian Morris, chief U.S. economist of HSBC Bank, said. “Even normal mom-and-pop homes are now very expensive relative to income.” Christopher Wood, an investment strategist at CLSA Emerging Markets, was even more bearish: “The American housing market is the last big bubble,” he said. “When it bursts, it will be very ugly.”

Between 2003 and 2006, as the rise in house prices accelerated, many expressions of concern appeared in the media. In June 2005, The Economist said, “The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.” In the United States, the ratio of home prices to rents was at a historic high, the newsweekly noted, with prices rising at an annual rate of more than 20 percent in some parts of the country. The same month, Robert Shiller, a well-known Yale economist who wrote the 2000 bestseller Irrational Exuberance, told Barron’s, “The home-price bubble feels like the stock-market mania in the fall of 1999.”

One reason these warnings went unheeded was denial. When the price of an asset is going up by 20 or 30 percent a year, nobody who owns it, or trades it, likes to be told their newfound wealth is illusory. But it wasn’t just real estate agents and condo

flippers who were insisting that the rise in prices wouldn’t be reversed: many economists who specialized in real estate agreed with them. Karl Case, an economist at Wellesley, reminded me that the average price of American homes had risen in every single year since 1945. Frank Nothaft, the chief economist at Freddie Mac, ran through a list of “economic fundamentals” that he said justified high and rising home prices: low mortgage rates, large-scale immigration, and a modest inventory of new homes. “We are not going to see the price of single-family homes fall,” he said bluntly. “It ain’t going to happen.”

As the housing boom continued, Nothaft’s suggestion that nationwide house prices were unidirectional acquired the official imprimatur of the U.S. government. In April 2003, at the Ronald Reagan Presidential Library and Museum, in Simi Valley, California, Alan Greenspan insisted that the United States wasn’t suffering from a real estate bubble. In October 2004, he argued that real estate doesn’t lend itself to speculation, noting that “upon sale of a house, homeowners must move and live elsewhere.” In June 2005, testifying on Capitol Hill, he acknowledged the presence of “froth” in some areas, but ruled out the possibility of a nationwide bubble, saying housing markets were local. Although price declines couldn’t be ruled out in some areas, Greenspan concluded, “[T]hese declines, were they to occur, likely would not have substantial macroeconomic implications.”

At the time Greenspan made these comments, Ben Bernanke had recently left the Fed, where he had served as governor since 2002, to become chairman of the White House Council of Economic Advisers. In August 2005, Bernanke traveled to Crawford, Texas, to brief President Bush, and afterward a reporter asked him, “Did the housing bubble come up at your meeting?” Bernanke said housing had been discussed, and went on: “I think it’s important to point out that house prices are being supported in very large part by very strong fundamentals . . . We have lots of jobs, employment, high incomes, very low mortgage rates, growing population, and shortages of land and housing in many areas.” On October 15, 2005, in an address to the National Association for Business Economics, Bernanke used almost identical language, saying rising house prices “largely reflect strong economic fundamentals.” Nine days later, President Bush selected him to succeed Greenspan.

In August 2005, a couple of weeks after Bernanke’s trip to Texas, the Federal Reserve Bank of Kansas City, one of the twelve regional banks in the Fed system, devoted its annual economic policy symposium to the lessons of the Greenspan era. As usual, the conference took place at the Jackson Lake Lodge, an upscale resort in Jackson Hole, Wyoming. Greenspan, who had, by then, served eighteen years as Fed chairman, delivered the opening address. Most of the other speakers, who included Robert Rubin, the former Treasury secretary, and Jean-Claude Trichet, the head of the European Central Bank, were extremely complimentary about the Fed boss.

“There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System,” Alan Blinder, a Princeton economist and former Fed governor, opined. Raghuram G. Rajan, an economist at the University of Chicago Booth School of Business, who was then the chief economist at the International Monetary Fund, took a more critical line, examining the consequences of two decades of financial deregulation.