29 Days To Go: Let’s All Take a Deep Breath

Black Friday is to many adults what Christmas is to children. We go crazy with credit cards as the little ones lose control over toys. As much as we’d like to think we’re more mature, we can be every bit as petty and myopic—and not just with Christmas shopping. From one of my columns in the Hazleton Standard-Speaker last December, consider this your Black Friday warning:

There’s one thing about Jdimytai Damour that I can’t get out of my head.

By now, you’ve heard Damour’s tragic story repeatedly. At the age of 34, the Wal-Mart worker was trampled to death by early-morning shoppers on Black Friday. You’ve probably heard all the moralizations, too—fingers wagged at the decline of moral values and the rise of consumerism—but here’s the part I just can’t shake: We killed him.  

No, I know you and I were not in Valley Stream, New York, on the morning in question, but we were there all the same, weren’t we? Two thousand people just like us stormed through those doors. Damour wasn’t killed by toys or sales or religion gone awry. Maybe those culprits all played a role, but as they say about the gun, they didn’t pull the trigger.

It was our feet that pounded him one-by-one. I’d guess it’s a lot like drowning. The weight of the crowd compresses his body until he can’t feel individual feet anymore, just an ocean wave coursing over him. He opens his mouth, but he can’t breathe. He tries to roll over or push the wave off his chest, but he can’t move. He sees blood, but he can’t tell where it’s coming from. Just as he goes into the kind of shock that squeezes every organ in terror, the picture recedes to black in a shroud of unimaginable pain.

And that’s how we did it. People just like us. Of course, we’d all like to believe that we would have stopped it. We would have seen him and helped because we weren’t raised like that. We have morals. We don’t value a 25% discount on blenders over a human life.

But in a crowd of 2,000, there were plenty of people like you and me, and that didn’t save Jdimytai Damour. Maybe they didn’t see him. Maybe they didn’t care. One thing is for sure, though: They were there, and they were part of that crowd. The crowd that killed Damour.

Economists are quite familiar with crowds. Until recently, most of them have ignored them in their research, but economists generally see business cycles as inextricably linked to the behavior of crowds. Ask any sociologist, and they will tell you that people can act 180-degrees different from their normal disposition when you put them in a crowd. We know it as mob psychology. Economists know it as price bubbles.

case-shiller-updated-1024x804In the 1990s, the Case-Shiller Index, which measures housing prices across the country, had been flat overall (with a few gyrations) since World War II. In fact, since 1890, it had only risen 10%. Since WWII, that number was slightly negative. From 1997 to 2006, it rose by more than 80%. Unless the cost of building a house has increased exponentially (and it hadn’t), that’s a bubble.

The bubble itself occurred for all the reasons this column pointed out last week (and last year), but you’re probably wondering how it spiraled into a financial crisis.

Let’s say we place a bet on a basketball game. You bet on the favorite to win. They are national champions, first place in their conference, and undefeated. My team has only won half its games, but it’s looking for an upset. Lo and behold, we pull out one for the record books. You don’t understand. How could your team have lost? The odds were in your favor. Tough luck, you owe me.

That’s how Wall Street looked at the housing market. Housing prices had been going up at unprecedented rates since 1997, so they kept betting on them. They bet on mortgages, and then they bet on those bets. Then they bought insurance to cover their bets in case they lost, which made them bet more because they figured there was no downside so long as they bought enough insurance.

Just as your basketball team kept winning, housing prices kept going up—until the bubble finally deflated. Suddenly, everyone owed more money than they had because they made their bets on borrowed money. Since they didn’t know how many “bad debts” everyone had, they just stopped lending. Lending and borrowing is the lubricant of the economy, so you do the math.

Don’t forget they all bought insurance to cover their bets. Unfortunately, the insurance companies (especially AIG) didn’t think they would ever have to pay up. Like the banks, they thought housing prices would never fall. How could their team have lost? The odds were in their favor. Tough luck, they owe everyone, and they don’t have the money either.

Real estate economists Andrey Pavlov and Susan Wachter demonstrated this phenomenon—how Wall Street misprices assets and insurance by understating the risk they’ll go south—in 2006, but it must have fallen on deaf ears in Washington. In fact, they went in the opposite direction. In 2005, bank regulators told the Bush administration that unrestrained lending practices had led to this enormous bubble on which dangerous bets were being made, but lobbyists got the White House to ignore their warnings until it was too late.

Sure enough, the latest research by Pavlov and Wachter shows that the more aggressive the lending in a particular region, the more painful the housing price crash. Of course, they already knew that. Their recent paper applies to various regions across the United States in the current crisis, but over two years ago, they showed how “underpricing risk,” as it’s called in econ-lingo, exacerbates market crashes by looking at eighteen—count ‘em, eighteen warnings we ignored—other countries where this phenomenon took place. Everything old really is new again.

That’s the power of crowds. We may not have made dangerous bets or sold crazy mortgages, but we sank our teeth into debt, bought those houses, and never for a moment stopped to think that housing prices might fall. People just like you and me.

Note: The Pavlov-Wachter links direct you to the latest versions of these papers, so the publication dates may not correspond with those cited above. In my column, I was referring to the original drafts. (And in the interest of full disclosure, I have worked for and occasionally collaborate with Professor Wachter; I consider her a close friend and mentor. Her work, including much of the above column, will play a prominent role in my forthcoming book.)