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Housing bubble? What housing bubble?

Meet Paul Willen, a Boston Fed economist preaching a bad-news gospel: We won’t see the crash coming next time, either.

In the years since the start of the biggest American financial crisis in generations, the reasons for the meltdown have begun to harden into conventional wisdom. Everyone agrees on the root of the problem: a housing market that ballooned wildly, then collapsed. But exactly where to place the blame is a matter of dispute. Conservatives tend to point the finger at the individual homeowners who took out loans they were incapable of paying back—and ultimately, at the government that pushed for looser lending standards in the first place. Those who lean left point squarely at the financial industry, which flooded the market with deceptive mortgages and then sold the risk off in the form of complicated new securities.

Then there’s Paul Willen, a research economist at the Federal Reserve Bank of Boston.

Willen, a 44-year-old father of two who lives in Brookline, moves through the world in a state of dismay and occasional fury at the fact that absolutely no one—not the media, not the public, and not his fellow economists—seems to understand the truth about what happened. Since 2008, Willen, a mortgage specialist, has pored over troves of data and emerged with a powerful, counterintuitive conclusion: that the real reason everything ended so badly wasn’t adjustable rate loans, or government housing policy, or esoteric financial instruments. Rather, it was a single underlying assumption that almost everyone in the market, from bankers to home buyers, shared: that American house prices would continue to go up indefinitely.


“What economists should be saying more [is], ‘We don’t know.”’ — Paul Willen


Willen has spent the past four years trying to persuade people of what he sees in the data: that everyone in the drama acted perfectly rationally. Under the assumption that the real estate market would continue its steady rise, it made sense for families to buy homes they couldn’t afford, and it made sense for bankers to buy up subprime mortgages. This belief —Willen thinks of it as a mass delusion—fueled an immense bubble that could not be reliably identified for what it was.

If he’s right, then the finger-pointing that’s occurred since the crash—the belief that the various actors should have understood that housing was overvalued, that credit was being extended too freely, that somehow the Fed could have cooled it down—is beside the point. Rather, Willen argues, we should humbly come to terms with the frightening fact that when economic delusions take hold, none of us may be able to tell that we’re being swept up in them.

Since 2008, Willen has been pressing his theory about the crisis in a series of academic papers and lectures. But while his job at the Fed gives him access to policy makers in the central bank, he has found himself firmly in the role of outsider in his own field. Critics say he underplays the extent to which the crisis was made more grave because of reckless decisions by lenders and bankers, and some suggest it’s a cop-out—a way to spin the problem so that no one, especially the Fed, has to take any blame for what went wrong.


But if this theory excuses economic policy makers in the short term, in the bigger picture it attacks the very foundations of what they claim to do. Ultimately, Willen’s argument can be seen as an indictment not of the players in the crisis, but of the field of economics, which he believes is fundamentally incapable of delivering the kind of insights and wisdom that some of its practitioners, as well as members of the public, believe it can.

“People think the bubble was driven by reckless underwriting,” Willen said in an interview at the Boston Fed recently. “But the truth is the bubble was this thing that emerged kind of organically, and we don’t really understand where it came from.”

Americans rely on economic experts to forecast large-scale trends, to be able to do things like identify bubbles and to craft policies to prevent them. But in reality, Willen argues, there is nothing in economic theory to suggest that we can detect when something costs more than it’s worth, or that prices have been inflated by speculation, or are about to collapse. Bubbles, in his view, are mysterious, damaging, and—quite possibly—unavoidable. All we can do to prepare for them is resist building policy on false certainty. “We don’t have that kind of understanding of how the economy works, and I think people think we do,” Willen said, adding, “What economists should be saying more [is], ‘We don’t know.’”



It was in the summer of 2008, after the collapse of Bear Stearns and just a few weeks before the Lehman Brothers bankruptcy, that Willen had his revelation.

He and a colleague from the Federal Reserve Bank of Atlanta, Kristopher Gerardi, had been working on a report at the time about subprime lending, to be presented at the Brookings Institution. Willen had joined the Boston Fed about four years earlier, after teaching at Princeton University and the University of Chicago. At this point, he believed that the subprime crisis had been caused by investors buying mortgage-backed securities without understanding just how vulnerable those securities were to a possible drop in house prices. To support their hypothesis, Gerardi and Willen ran models on the mortgage data that was available to investors during the boom—but to their surprise, they kept finding evidence that in fact, the investors were perfectly aware of how much trouble they’d be in if housing prices fell.

“At some point, I had this moment where I’m like, you know, we’re wrong. They did understand that house prices crashing would lead to a ton of foreclosures,” Willen said. “They just didn’t realize house prices were going to fall.”


Today it might sound absurd to think that house prices would rise forever, but during the overheated 2000s it was easy to believe: There had been some ups and downs, but house prices had enjoyed a steady uphill march for generations. While some, including the Yale University housing expert Robert Shiller, warned of a bubble during the boom, the prevailing point of view, all the way up the ladder to Fed chief Alan Greenspan, was that the real estate boom wasn’t a bubble, but rather a reflection of fundamental changes in the economy.

Given the expectation that house prices were going to continue to rise, it’s not so surprising that naive homeowners and sophisticated investors alike thought subprime loans weren’t going to be a problem. A troubled borrower could always pay off the loan by selling the house, so the mortgage market was essentially safe. “If you think house prices are going up 10 percent a year, it doesn’t matter whether the borrower can afford the loan or not,” Willen said. “In 2005, the guy could lose his job—the guy may not even have a job—and [as the lender], I don’t care.”

To Willen, all follies followed from this basic misunderstanding: The exotic financial instruments, the sloppy investments, the foreclosure crisis all had their roots in a bubble that nearly everyone agreed wasn’t really a bubble.


“I’m in sympathy with him on this, that the real cause was the bubble,” said Shiller, who predicted the collapse of the housing market in 2005 and of tech stocks in 2000. Shiller added, “When you get a bubble mentality, people let their guard down and they will approve mortgages that they wouldn’t have approved before, they will become careless about which securitized mortgages they buy....The idea that the market is going through a boom and it can’t last—you can’t prove it!”

To promote his argument, Willen started writing papers—the latest, with Gerardi and his Boston Fed colleague Christopher Foote, came out in the spring—and delivering talks about what caused the crisis at real estate industry events, academic conferences, and government agencies. When he talks about it at his office on the ninth floor of the Federal Reserve tower in downtown Boston, he gets visibly heated, hitting his desk with his hands for emphasis while proclaiming, about the authors of a paper he strongly disagreed with, “Everything they did was wrong. Everything!”

The target of Willen’s wrath is the consensus view that has emerged among other economists: that the bubble was a symptom, not a cause. In this version, the seeds of doom were planted when banks stopped keeping the mortgages they issued, and instead began issuing loans just to make money by selling them off to other investors. This strategy—the so-called originate-to-distribute approach to lending—created the bubble by allowing for the giddy expansion of credit to unqualified homeowners. The crisis, when it happened, was drastically worsened by the complex mortgage securities held by investors around the world.

That account of the crisis has proved popular, as Willen sees it, because it offers a chance to cast blame—to say, confidently, that there are people who should have known better, and didn’t. “People would like there to be a morality play: There were good people and evil people and what we need to do next time is put in a bunch of rules to stop bad people from doing bad things,” Willen said, adding, “I’m not saying these people weren’t jerks, or didn’t do reckless things....But most of the problem was these people were incredibly arrogant. They wanted to believe that they had found the secret to eternal wealth.”

Economics is a contentious field, and other economists have greeted Willen’s argument with skepticism as powerful as his own. During a Q&A session at a recent academic conference, Willen’s presentation provoked so many questions that one economist prefaced his remarks by saying, “Let me join the mob of pitchforks and torches chasing Paul Willen.”

A number of the economists Willen has singled out for criticism declined to weigh in for this article. But one of them, Stijn Van Nieuwerburgh, who heads the Center for Real Estate Finance Research at NYU’s Stern School of Business, said in an interview that he thinks Willen is essentially dodging the question of the bubble’s causes.

“The assumption is that this happened for some random reason,” he says, “unrelated to regulation, unrelated to supervision, unrelated to anything....Economists like to call this a sunspot—something that came out of nowhere.”

In Van Nieuwerburgh’s view, the bubble does have a cause. “The Federal Reserve Bank, as well as Congress, were gradually, slowly but surely, relaxing their oversight of the financial sector,” he said. “And just to give you one number: There were something like 700 laws passed in Congress over this period, all of which made it easier for people to access their home equity, made the regulations on banks less, made the regulations on mortgage borrowers less, and so forth. And this obviously is the story that the Fed, including people like Paul Willen, who work for the Fed, don’t want to tell.”

In his most recent paper, Willen spends more than seven pages trying to pick apart that whole premise: Government mortgage policy didn’t loosen as dramatically as many people think, he says, and financial products didn’t change enough during the boom to explain the bubble. The question of cause, he says, doesn’t yet have a satisfactory answer. And while he doesn’t believe that the regulations introduced since the crisis are a bad idea, he warns that there’s no reason to expect they will prevent the next bubble.

Responding to Van Nieuwerburgh, Willen also dismissed the suggestion that his views are meant to defend his own employer. “There are plenty of people within the Federal Reserve, including the chairman, who hold the beliefs that we criticize in our paper,” he said.


I t’s important to realize Willen is doing more than just disputing other people’s beliefs about the 2008 crash. He is also leveling a critique of the entire field of economics, by making the troubling point that there’s a limit to what we can really know about the infinitely complex forces and trends that determine what our economy does.

Underlying the belief that the Fed should have acted sooner, or tried to tamp down the housing market, is the idea that it’s possible to tell when we’re in a bubble—and among the many things that even the most brilliant economists cannot understand, Willen says, are price bubbles, whether in stocks or real estate.

This point of view puts him on the pessimistic side of a longstanding debate. One side says it’s possible for policy makers to identify bubbles while they’re happening and try to “prick” them so they don’t cause big problems. The other says economics simply can’t detect a bubble until after it has burst, and that all we can hope for is a quick recovery afterwards. The debate cuts to the heart of what economics can tell us about value. To say a bubble exists is to argue that the price of something, like a house, has wildly exceeded its true value. But a basic tenet of economics is that the value of an asset is whatever people will pay for it: It’s impossible to say an iPhone isn’t “worth” $300 until the day comes when nobody will buy it for that much.

But even if the intrinsic or fundamental value of something is unknowable, some economists still believe that it’s possible to determine when the price of an asset has come untethered from reality—that is, to detect a bubble while it’s forming. If we could do that, then the Fed and the markets actually would be able to make smarter decisions that prevent bubbles. Even Willen is hopeful on that front.

“If it was really clear when there was a bubble,” Willen said, “the bubbles would never happen in the first place....So at some point, one could imagine that the economy as a whole, partly through our better understanding of these things, would just become a less volatile place.”

Willen warns that this vision is more fantasy than practical plan. For now, he argues, we need to start acknowledging the limits of what economics can tell us, and come to terms with the fact that next time there’s a bubble, we probably won’t know about it until it’s too late. Until we accept this deeply unsatisfying reality, according to Willen, we risk deluding ourselves into believing we are no longer vulnerable to the problems that led to the 2008 crisis.

“Going forward, what worries me is that sometime in my lifetime, not that far in the future, we will have another house price boom, and people will say, ‘We have nothing to worry about...because we’ve regulated away all the bad things that people did.’ That will be wrong.”

Leon Neyfakh is the staff writer for Ideas. E-mail