A reader asks: My 28-year-old son just purchased his first home. He has a job but makes very little money. Nonetheless, he was able to make this important first investment because the house was available for sale as a result of foreclosure. This economic circumstance reduced the price of the house to the point that, inspite of his meager means, he was able to afford it. Where did the difference in the foreclosed debt and the value in excess of the price he paid in the transaction come from? Ironically, he is entitled to the Government’s $8k tax credit for first-time home buyers which he did not need to affect the purchase.

This is another way of asking how something can be worth $100 one day and $50 a year later. It’s the same object. Nothing in it changed.

The short answer is, prices don’t always reflect an asset’s “value” accurately. (There’s a school of economics that believes in the “Efficient Market Hypothesis.” They’d disagree with me, but that’s a conversation for another day.)

The market can screw up. Maybe that asset wasn’t worth $100. Maybe its value is $50, but something went horribly wrong and people mistakenly thought it was worth $100. That’s what economists mean when they call it a “bubble.”

Or maybe its value is $100. Maybe something has now gone horribly wrong and people mistakenly think it’s worth $50. That’s what banks told us back in late 2008 and early 2009, during the whole “nationalization” debate. They said the price crash was only temporary. When markets regain their senses, they’ll realize the assets were worth $100 all along…or at least $90.

A lot of economists are writing a lot of books and papers to explain why house prices rose and fell so precipitously. I’m writing one of those books, so I can’t fully answer the question here. If you ask Robert Shiller, he’ll tell you it’s because people just get irrationally exuberant sometimes. If you ask Edward Glaeser, Joseph Gyourko, and Albert Saiz, they’ll say it’s because demand outpaced supply for awhile.

But home prices weren’t the only thing rising and falling. Debt — consumer credit, mortgage loans, etc — exhibited “bubble” behavior too. Many of us think the “credit bubble” caused the “housing bubble.” In this case, the price of debt was too low, causing people to borrow too much.

Economists have a lot of opinions about this bubble too. Raghuram Rajan argues that the Fed kept interest rates too low, and people couldn’t keep up with the interest payments when rates rose. Charles Calomiris and Peter Wallison blame Fannie Mae and Freddie Mac for originating mortgages to people who couldn’t pay them back in the long run (and for buying those mortgages, increasing the demand for them). Susan Wachter, Adam Levitin, and Andrey Pavlov rest the burden on Wall Street, whose insatiable appetite for securitized junk created a growing demand for risky mortgages.

So, to return to the question, where did the difference come from? Depends whom you believe. Wachter, Levitin, and Pavlov have the most convincing evidence to support their case. The other arguments have too many holes to be the primary cause, but all probably played a contributing role.

There’s another way to look at this question: How did $11 trillion of wealth disappear?

We tend to think of wealth as something we can hold in our hand. If someone’s wealth decreases, it must go somewhere, right? Not exactly. Wealth contains a lot of promises (that’s all debt is: a promise to pay in the future) and prices (which, as we’ve learned, can change in a heartbeat).

On that note, I’ll conclude by directing you to Princeton economist Uwe Reinhardt’s must-read answer to this question: Where All That Money Went.

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Coming from one of the world’s leading experts on econometric predicting, Hamilton’s improved mood says more than all of Jim Cramer’s rants put together. He cites increased activity in the auto industry, an uptick in home sales, a slight increase in consumption, increased expectations for third quarter sales in several large industries, and significant recovery in the Aruoba-Diebold-Scotti Business Conditions Index. (Full disclosure: Frank Diebold, one of the authors of the index, is a good friend and former teacher of mine. He is also a world-class econometrician, but I have not asked him for his outlook at present.) Indeed, those are most of the important measures of whether individuals and firms are starting to spend again, which is precisely what is needed to end a recession.

Hamilton is not taking a stand on whether the recession is over and cautions that the end of “Cash for Clunkers” could prick an artificial high in auto sales, personal income still hasn’t risen, and unemployment shows no signs of falling. But the latter two usually follow on the heels of the other indicators he cites, and the positives seem to greatly outweigh the negatives. So why isn’t Hamilton’s emoticon smiling?

A lot of it has to do with the “shape” of the recession, as economists have explained it to the public of late. A “V-shaped” recession, like we used to have in the 1960s and ‘70s, implies a sudden end to the recession and a sharp return to growth. A “U-shaped” recession, like we had earlier this decade, means growth will be slow and unemployment will continue to rise for awhile even after the recession technically ends. Because consumers are still “deleveraging”—that is, because they have more debt than twentieth-century consumers had—most economists predict the latter, as spending won’t return full-force until they pay off their debt. If nothing else, such an expectation warrants a neutral face instead of a smiling face. The economy may grow again, but it’ll be a long slog before we return to the good old days.

There is, however, a third possibility: a “W-shaped” recession. Granted, it’s rare and frightening, but several well-known economists warn it is very possible. The last time it reared its ugly head was the early 1980s, when the economy dipped into two recessions within the first three years of Ronald Reagan’s first term, and before that, it was the Great Depression, when the initial recovery was brought to a halt by deficit hawks who forced Franklin Roosevelt to raise taxes and balance the budget in 1937.

Investors disagree. All summer, the story has been the stock market rally that looks to be pulling us out of the recession. After a terrifyingly close call from the collapse of Lehman Brothers to the passage of fiscal stimulus, banks have raised capital, Detroit has escaped bankruptcy, and one-by-one economic data seem to be following the stock market’s lead and forming a bottom.

But something is amiss. “We’ve never had six-month period before where we’ve lost two million jobs and the market’s gained 50%,” says Wall Street expert Barry Ritholtz. “That’s simply unprecedented.” Ritholtz thinks the rally will reverse, and if today’s dismal performance is any indication, investors should pay attention.

So who’s right? Let me first say that you should never ever make a financial decision based on my opinions. If financial economics teaches us anything, it’s that the stock market is next-to-impossible to predict, and even if it weren’t, I’m not confident enough in my financial savvy to be responsible for your risk-taking. That said, I’m with Ritholtz on this one, for the following reasons:

1. As indicated above, unemployment will remain high for some time, and with unemployment comes…
2. …foreclosures, which show no sign of slowing down. Government intervention has helped many people, but if we want to make a dent in the larger economy, stronger intervention is required.
3. A whole slew of adjustable-rate mortgages still haven’t reset—which is to say, some homeowners are about to get hit with higher interest rates—so you can expect more defaults.
4. Repeated reports indicate banks still have too many toxic loans on their books. If the Obama administration had taken the advice of many of us and run the worst offenders through FDIC receivership, we wouldn’t have this problem, but alas investors will start to get worried if these reports keep coming.
5. September is historically a bad month for the stock market.
6. Far more insiders—people who know what’s under the hood, so to speak—are selling than buying.
7. The easiest way to measure valuation is the price-to-earning (P/E) ratio. If stocks are selling for a lot more than their companies are earning, beware. The historic P/E average is 15. Right now, it’s 100+! Even if you use the more stable “operating earnings” because you think reported earnings have been depressed too low by the credit crunch, it’s still overvalued at 20+.
8. The output gap—the difference between what we should be producing and what we are actually producing—is still significant. Some economists recommend another fiscal stimulus. I worry about dynamic timing, which is economist-speak for “It took you so long to spend the last stimulus, how do I know this one won’t be delayed until the recession is over?” The last stimulus clearly boosted the economy before most of it was even spent. John Maynard Keynes would call that the result of “animal spirits”: Consumers knew the economy was about to get a jolt, so they started spending again. If the stock market dips or foreclosures increase, however, another immediate stimulus should boost “consumer confidence” like the first one did. If Congress can’t get its act together fast, though, it’ll only add excess inflation after the recession ends.

Economists have two fears: (1) From March till now, we have been in a “bear market rally,” which means the rise in stock prices has been false hope amid a longer decline. (2) The entire economy will turn down again.

The first is a financial concern, the second a broader economic one—though of course the first affects the second. I am not predicting anything, but I am saying that we should be cautious for the 8 reasons above. And I am admonishing the Obama administration and Congress for failing to prevent these fears with mortgage cramdown, a larger stimulus with fewer tax cuts and more spending, and nationalization of certain banks. As James Kwak said earlier today, the fact that the TARP loans are showing profits—which Ritholtz rightly debunked as incomplete analysis—only indicates that the government made a bad bet and got lucky. I hope they (and we) continue to get lucky, but for now I’m with Jim Hamilton: I’ll smile when we’re sure this is all over.

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