What about the recalculation into housing?

The standard view is that the Fed pursued an excessively easy money policy in 2002-03, which drove interest rates down to 1% and blew up the sub-prime housing bubble.  Everything about this view is wrong.  The Fed’s policy wasn’t excessively easy, it did not cause the low rates, and the low rates did not blow up the sub-prime housing bubble.

Sometimes it is necessary to go back to the basics of classical economics.  Imagine a production possibilities frontier for two goods, business investment and residential investment.  Now imagine that there was massive over-investment in some types of business investment during 1996-2000.  In 2001 it becomes apparent that over-investment in tech and communications has occurred, the floor drops out of the business investment sector, and business investment falls sharply.  What happens to the economy?  In the classical model a well-functioning economy should reallocate resources into other sectors, like housing construction.  This will happen automatically, without any government help.   All that is required is that monetary policy be stabilizing, that it keep NGDP growing at a fairly steady rate.

Is there any way to prevent reallocation into housing?  Sure, the Fed could adopt a very tight monetary policy (as in 2008 or 1930) and NGDP would fall, reducing output in almost all sectors.  But why would they want to do that?  And if they did do that then nominal interest rates would not rise, they would fall close to zero, just as in the 1930s, or as in Japan in the 1990s, or the US in 2009.

Or the Fed could run a more stable monetary policy, keeping NGDP growth up near 5%, and the economy would avoid a recession.  There would merely be a period of economic sluggishness as resources got reallocated from business investment to residential investment.  Interest rates would be slightly below normal, due to the weak business investment sector.

In fact the Fed did something in between these two extremes.  Easy enough money to keep NGDP growing a bit in 2001-02, but not easy enough to maintain 5% NGDP growth.  So we had a very mild recession, and interest rates fell, but not all the way to zero.  If money had been much tighter, rates would have fallen to zero.  If money had been much easier, rates would have been higher, as in the 1970s.  Indeed money was much easier by 2006, and rates were much higher.

So a reallocation from business investment into housing was entirely appropriate in the early 2000s if we were to avoid a depression.  Fed policy worked pretty well.  So what went wrong?  The problem was not growth, we need the economy to grow; the problem was foolish sub-prime loans.

But isn’t that a failure of the free market?  Not entirely.  Housing is not a free market.  The money being loaned out was essentially government funds (due to FDIC insurance), and thus the government needed to regulate the use of those funds to insure that banks were not taking excessive risks.  When I bought my house in 1991 you needed to put 20% down or else buy mortgage insurance.  I believe that requirement was phased out during the 1990s.  That was the cause of the sub-prime bubble, not easy money.  Money wasn’t easy.  The job of monetary policymakers is to keep NGDP growing at a low and steady rate.  The job of regulators is to correct for market failures, which includes other government policies that distort economic decision-making.  The regulators failed in the early 2000s, not the Fed.  (Of course the Fed is one of the regulators, so they are partly to blame.  When I refer to ‘the Fed’ I mean the monetary policy unit within the Fed.)

PS.  Real rates were also pretty low in the early 2000s, but the Fed has very limited control over real rates.  The low real rates reflected some combination of low business investment (post-tech bubble), or high savings rates (in Asia?)  I don’t have a theory as to what caused the low real interest rates, other than that it definitely wasn’t the Fed.  A better term would be ‘easy credit,’ not easy money.

PPS.  If it is hard to visualize how low rates might not be easy money, consider this counter-factual.  Instead of cutting rates to 1%, the Fed only cut them to 3%.  The economy does much worse, and then the Fed reacts to that much weaker economy by eventually cutting rates to near 0%.  A mere hypothetical?  No, I’ve pretty much described the 4 years after 1929, which is why the 2000 tech stock crash was not followed by a Great Depression.

PPPS.  If someone has pneumonia, and is running a fever of 102, I don’t deny that putting them in a freezer will lower the fever.  And if business investment is tanking, and resources are flowing into housing, I don’t deny that really tight money will prevent a housing boom.  I simply question the wisdom of that policy.


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45 Responses to “What about the recalculation into housing?”

  1. Gravatar of Morgan Warstler Morgan Warstler
    26. July 2010 at 07:28

    Tech and housing are not the same.

    Technology over-investment will recover quickly, did recover quickly on its own.

    Building more houses is fine AS LONG AS the price of housing is being driven down by oversupply. Did the price of housing fall? Wait, why are housing prices so sticky? Perhaps it is because MBS Securities were purchased – who cares if they are “guaranteed” – the Fed could have said no damn way.

    Again, this doesn’t happen in a vacuum – if starting in 2000, the government began a trend towards technology based productivity, rates could have been kept higher AND growth would have continued.

    This is why we need:

    1. Housing prices to fall.
    2. Government productivity.

  2. Gravatar of MW MW
    26. July 2010 at 07:32

    Say I accept your argument. Isn’t the Fed getting (or likely to be getting) some kind of “macro-prudential” supervisory authority? And if so, what makes you think they’ll avoid screwing up again? As I recall, Gramlich warned Greenspan on subprime since 2000 and Greenspan did nothing.

  3. Gravatar of MW MW
    26. July 2010 at 07:55

    Link to Gramlich/Greenspan/subprime story:
    http://www.nytimes.com/2007/12/18/business/18subprime.html

  4. Gravatar of Benjamin Cole Benjamin Cole
    26. July 2010 at 08:44

    Ths is a brilliant analysis–and again I have died and gone to heaven. At last, an established economist mentions the high and growing global savings rates and low interest rates in the same breath.

    Huge pots of capital are forming globally (and despite low official US savings rates, large pots of capital are forming in the US, through insurance companies (not counted as savings) and high net worth indidviduals, and public pension plans–indeed, from mutual funds to money market funds to ETFs, everybody has too much capital to invest).

    I have yet to see an insightful analysis into what high savings rates mean–this capital has to be deployed, either as equity or debt. It tends to be deployed as debt, thus possibly building up unmanageable levels of debt.

    Some say, “Oh well, lower interest rates will cure that.”

    Oh really? Some cultures are savings oriented. Also, do middle class people stop saving for retirement? To buy a home? For college eduation? And very wealthy people simply can’t spend all their money–after your second and third home, and several luxury cars, a few lovers stashed away, really what is left?

    I think the answer is much more equity investment in the private sector, or possibly luxury taxes to finance infrastructure buildouts, but I would like to hear Dr. Sumner’s views.

    Also, while this savings glut may be good for the economy, it suggests low returns for savers. Supply and demand–and there is a lot of supply.

  5. Gravatar of Benjamin Cole Benjamin Cole
    26. July 2010 at 09:30

    BTW-the cover story on the LA Times today is deflation.

  6. Gravatar of Doc Merlin Doc Merlin
    26. July 2010 at 10:19

    “But isn’t that a failure of the free market? Not entirely. Housing is not a free market. ”

    Couldn’t agree more!
    Also, the reason the tech bust didn’t yield a depression is that it was equity based, not debt based. The tech companies had so much cash and so little debt that they were not brittle at all.

    After SarbOx, debt was legally favored over equity, so we got into a more debt based investment strategy. When things went belly up, the leverage ratios the brittle system to break.

  7. Gravatar of Joe Calhoun Joe Calhoun
    26. July 2010 at 10:28

    Scott,

    If policy wasn’t easy how do you explain the fall in the dollar from 2002 to 2008?

  8. Gravatar of ssumner ssumner
    26. July 2010 at 10:37

    Morgan, I agree we need gov. productivity, and I’ll let markets determine housing prices.

    MW, When you look at the finreg bill, which doesn’t even ban sub-prime loans, I have no trouble imagining that they will screw-up again.

    Benjamin, You are being too kind–you’ll inflate my ego. :)

    Seriously, I agree on the debt equity question. I hope to do posts soon on our tax system, which encourages debt and discourages equity. I’d also like the high-tax/welfare state model to be replaced with a low-tax/forced saving model. With a high savings economy we could afford to build more infrastructure (public or private, preferably private) I think you’d find better infrastructure in economies that save a lot (like Singapore.)

    Doc Merlin, You said:

    “Also, the reason the tech bust didn’t yield a depression is that it was equity based, not debt based. The tech companies had so much cash and so little debt that they were not brittle at all.
    After SarbOx, debt was legally favored over equity, so we got into a more debt based investment strategy. When things went belly up, the leverage ratios the brittle system to break.”

    Yes, and it was also taxes, not just Sarbox.

    You are right about the debt/equity difference from 2000 to 2008, but the reason was indirect in my view. The debt problems caused difficulties in banking. And the Fed got emmeshed in banking bailouts and lost control of monetary policy. With banks not able to easily lend anymore, much lower real rates were required in late 2008 for macroeconomic equilibrium. And the Fed was consistently behind the curve, not starting QE until March 2009, by which time GDP had already plunged for 6 months.

  9. Gravatar of Morgan Warstler Morgan Warstler
    26. July 2010 at 10:41

    Scott I thank you for your efforts on my behalf with this post, I’ll try to stay inside your paradigm… please take half as much time to really think through and answer my point. I’ve easily got a hundred hours into you, I feel comfy asking for real feedback.

    “So a reallocation from business investment into housing was entirely appropriate in the early 2000s if we were to avoid a depression. Fed policy worked pretty well. So what went wrong? The problem was not growth, we need the economy to grow; the problem was foolish sub-prime loans.”

    This is not logically valid. Not even close. First, liberals will moan that 50%+ of “sub-prime borrowers” actually could have qualified for prime loans, but the incentives for the brokers was to get that spread up and push people to sub-prime. This is of course a silly argument, for them AND YOU, because regardless of whether these loans were called there were far too many of them.

    Second, the Fed bought $1T+ in MBS. You say well those are GSE guaranteed so they are just like Treasuries, I say if they didn’t buy them, there would be far less loans written.

    You do not even come close to proving that without Fed’s involvement with MBS – we’d have the same amount of housing debt.

    —–

    Now the bigger point, that I cannot get you to really explore, is that liquidation is healthy, zombies are death, and when you seek recovery – the BEST WAY to get private capital taking “risks” is to give them the riskless deals they EXPECT and DESERVE.

    A foreclosed home that sold in 2008 for $400K, currently held by F&F, listed at $275K – is NOT A DEAL.

    Auction that bad boy starting at $1, require 30% down, don’t let banks participate in the buying – and Scott you will see a MASSIVE amount of economic activity.

    Why will you not think through the positive impacts of 1M $1 auctions? 1. Lower rents for those without capital. 2. Improved balance sheets for those with capital.

    Finally, I’m not sure you get my final bullet proof winning counterplan to your plan:

    Since you are SURE the Fed can target NGDP, then it only makes sense to FIRST do my plan… right now the justice ledger is unbalanced, the moral ledger is disgusting, so let’s knock down that $4T debt to asset value gap BEFORE we start inflating the currency to aid the debtors.

    —–

    Scott, ultimately it comes down to this:

    You imagine there are tens of millions of homeowners who have equity in their homes (you are one such guy), who are going to get to make use of that equity in the near or mid term. That’s wrong. They won’t.

    What’s really happening is that anyone who bought or refinanced from 2003 onward, is currently throwing good money after bad… they’d be much smarter to put the keys in the mailbox, and go rent.

    In your case, take your purchase price from 1991, grant yourself 2% interest, and that’s what your home is worth – and thats generous – the overbuilding of the housing market MUST MEAN the price of homes goes below trend.

  10. Gravatar of Edwin A Edwin A
    26. July 2010 at 12:42

    This reminds of a couple analogies from Paul McCulley regarding using regulatory tools instead of the fed fund rate to tame bubbles.

    “Accordingly, my quarrel with him was that hikes in the Fed funds rate until tech stocks cried uncle was equivalent to trying to get the attention of gluttons by starving anorexics. It’s bad macroeconomic policy, and it’s also morally wrong.”

    “If Mr. Greenspan were a bartender with one rowdy drunk,
    he would double the price of beer for all, in an effort to bankrupt the drunk more quickly, rather than simply cut off the drunk, letting the decent folk continue to act decently at an unchanged price.

    http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2005/FF_Jan_05.htm

  11. Gravatar of Morgan Warstler Morgan Warstler
    26. July 2010 at 12:47

    “A recent study by the Federal Reserve investigated the central question: at what point do underwater homeowners “strategically default” on their mortgages? Surprisingly, it found that when the decision is based on negative equity alone, the average borrower doesn’t walk away from his home until it is very underwater (negative equity of 62%). But the fascinating thing was that there was something that could trigger underwater borrowers to default much, much earlier – and that something was an interest rate rise. In fact, higher interest rates were even more significant in triggering defaults than higher unemployment.

    With a quarter of US mortgages underwater, the Fed must heed the advice of its own research if it wants to prevent a cascade of defaults and the consequent repercussions on the financial system and the economy. Hence, expect US interest rates to stay ultra low until millions of mortgages escape out of negative equity.”

    http://www.ritholtz.com/blog/2010/07/the-4-trillion-dollar-question-2/

    This is the WHOLE OF IT – the Fed’s entire effort is to keep home prices from falling – because people are willing to KEEP WASTING MONEY on negative equity, but will default if their ARM rates go up.

    If instead the Fed Shrugs, and liquidates the housing market, it can raise interest rates and we get on with our lives.

  12. Gravatar of StatsGuy StatsGuy
    26. July 2010 at 12:49

    PMI –

    Actually, PMI is still required for <20% down payment. Technically.

    Two issues:

    1) Banks underpriced PMI, since their calculations of the cost of PMI include both the a risk of decline in the value of the collateral an the probability of default. They underestimated both. By a lot.

    2) Since most entities selling loans didn't keep them in 2005, they had every incentive to help buyers game the PMI system. (And they did, very creatively – and attempts to enforce regulation on PMI were considered "anti-free-market" by the then-administration, which in 2003 was seeking re-election.)

    Example:

    http://ezinearticles.com/?How-to-Avoid-PMI-With-Less-Than-a-20%-Down-Payment&id=1004507

    Lenders STILL have incentives as described above, except NOW it's the government that's doing the loan repurchases.

    But in 2005 and earlier, remember the GSEs fought for market share because private funders were offering increasingly competitive bids for loan assets. You can argue the GSEs preceded that, but the GSEs were losing share…

    http://www.aspiriant.com/library/insight/08q3/images/GSE.gif

    NOTE: in 2003, nearly 45% of loans were resold to GSEs. In 2006, it was under 20%. So, during the RUNUP in housing prices, when all the bad loans were being created, it was PRIVATE buyers who were eating up the goodies. Seeing how profitable the GSEs were, they wanted in on the game.

    EconomistsView has an article on the GSEs covering the same issue, but I can't repost their links here without hitting a filter.

    In any case, it's very popular in libertarian circles to blame the GSEs for lax lending, but the timing is exactly the opposite of what this narrative predicts.

    I'm sure the anti-GSE narrative is popular with libertarian/conservative readers, but it doesn't square with the timing. If you really believe the GSEs were the immediate problem here, you should explain why the market was accelerating purchases of MBS at the beginning and middle of the boom while GSEs were losing share.

  13. Gravatar of Benjamin Cole Benjamin Cole
    26. July 2010 at 12:55

    Scott Sumner–It just gets better and better–I look forward to your posts. You are addressing topics I have always wondered about. I can’t understand why there are not more economists like you out there. Perhaps you are letting logic get in the way of your biases.

    And remember–The Fed believes the psychic income it derives from zero inflation is equal in value to the real income that Americans loat in obtaining that goal.

  14. Gravatar of Benjamin Cole Benjamin Cole
    26. July 2010 at 13:08

    BTW-A couple hundred years ago, when I was in grad school, if memory serves…I read a book by economist Robert Solow. I think he very obliquely suggested that federal deficits be financed ex nihilo (within reason). That is, instead of borrowing money to finance a three percent deficit, just print it. And no way does a three percent hike in money supply threaten hyperinflation.

    It sounds a bit sinful, and yet no long-term debt for grandkids to pay off, yet stimulus. Is my memory nutty, and is this idea worth anything?

  15. Gravatar of John Hall John Hall
    26. July 2010 at 13:54

    Just some other economic facts non-residential investment spending toughed in Q1 2003. From the earlier top to the trough, non-residential investment fell -13.9% while residential investment rose 10.2%. However, from the trough until the top of residential investment in Q4 2005, non-res investment rose 18.9% and residential investment rose 23.9%. Shouldn’t the recovery in non-residential investment pushed back down residential investment by this analysis. Or more precisely both increased at the same time because the production possibilities frontier expanded outward (so why did this happen over this specific period?).

    Suffice it to say, I don’t think monetary policy was easy until the end of 2003 and wasn’t particularly easy after Q4 2005.

    http://www.philadelphiafed.org/research-and-data/real-time-center/survey-of-professional-forecasters/data-files/NGDP/

    Coincidentally, from Q4 2003 to Q4 2005, the one year ahead expected growth of nominal GDP was more than 0.5% above the 10 year historical average (for simplicity I am simply using the expected nominal growth for the prior ten years as the trend, you could very well use something else and get similar results). At some points over this period the expected nominal GDP growth was more than 1.5 standard deviations above average. Is that not a sign of easy monetary policy in your framework Scott? I have no idea what I’m missing.

    “A better term would be ‘easy credit,’ not easy money.” – Again, I don’t really see what we’re arguing about here. I don’t really care about the distinction easy credit/easy money. What matters is whether monetary policy was easy and not some other terms that aren’t as precise. Your criterion for evaluating monetary policy is how quickly nominal GDP was expected to grow relative to some trend. In this case it was expected to grow more than the historical average over a period that many people have associated with “easy money.” Hence, regardless of whether their standards are correct, Scott Sumners’ standard suggests monetary policy was easy over this period.

    According to his standard, I also have had to concede that monetary policy was also tight from Q1 2008 to Q2 2010. In addition, you could also make the argument that the recession was much more severe than it otherwise would have been due to a very sharp decline in expected nominal GDP growth over the next year in Q3 2008 through Q1 2009.

  16. Gravatar of Lorenzo from Oz Lorenzo from Oz
    26. July 2010 at 14:13

    Morgan, you asked: Wait, why are housing prices so sticky?
    Well, it depends on which housing prices. Not everywhere in the US had housing bubbles. Those places which did not have bubbles, where supply was permitted to respond to demand (such as Texas), do not have much reason to have falling house prices. Macro analysis only gets you so far, you are also talking about a variety of markets, many of which had regulatory interventions which restricted supply.

  17. Gravatar of Morgan Warstler Morgan Warstler
    26. July 2010 at 17:19

    @Lorenzo, I was speaking tongue in cheek. I live in Texas, home prices are still falling, they just aren’t falling like FL, AZ, CA, etc.

    The point is housing prices are ACTUALLY stickier than they should be right now because there is a huge chunk of inventory that is non-performing and being held off market – people aren’t being thrown out of their foreclosed homes, and bank reclaimed properties aren’t being thrown on the market at auction (as they should be) because insolvent banks are not being forced into insolvency.

    Mark to market would solve all of this.

  18. Gravatar of Rahul Rahul
    26. July 2010 at 17:35

    Dear Prof.

    1) Kindly explain how we had easy credit but non-easy money.

    2) I agree with your general view that during a slump (or reallocation) the right metaphor is like a bicycle going uphill. Fed is the cyclist pedaling vigorously. But if the effort is not about a certain threshold (NGDP) the bicycle will roll backward. You argue that the effort was below the threshold. I agree with this.

    3) While I understand the simplification, I am not convinced with housing vs tech. The reallocation should search for better (more investment worthy) assets. I don’t think housing was “better” asset. It was chosen (I think it was deliberately chosen) as it was the only one that could absorb large volume of investments. I believe, had we not interfered, markets would have discovered alternate energy or some other investment-starved sector.

    4) Housing is wrong choice. It is a dual-good. It sometimes works as consumption good other times it is investment good. Possibly housing as a consumption good may have been a cushion. But as investment good, it was only other bubble. Subprime is not a shock but a logical conclusion of an investment good being pumped with excess investment.

    5) I think there is a threshold level for money ( I use term loosely) in the economy. If total money in the system goes higher than this the system (if we let it be) creates deflation to destroy this excess. This deflation happens at the hands of those who have money invested. It happens in the rich balance sheets. The problem is it often overshoots the ideal level hence we want to control the process. In our zeal to control the process, we shift the deflation hotspot to public balance sheet or citizens balance sheets. This creates a problem of affordability. The few rich balance sheets could have afforded to deflate to a large degree but many poor balance sheets cannot deflate even to hundredth of a degree. Further, the rich balance-sheets willingly took the risk of investment while poor balance sheets were stuffed. This is the socialization of losses we talk about.

    I am sorry I have digressed a lot here.

    Rahul

  19. Gravatar of D. Watson D. Watson
    26. July 2010 at 17:53

    Rahul,

    You might find an answer to the first question here with Beckworth. His conclusion after discussing the difference between base money (B) and the money multiplier (m) (B*m=M in MV=PY):

    “By the way, given the identity M=Bm we can see that technically the Fed has not increased the money supply a lot, it has only increased the monetary base a lot. In fact, if one looks at MZM or M3 they are actually down for the year.”

  20. Gravatar of D. Watson D. Watson
    26. July 2010 at 18:05

    “So a reallocation from business investment into housing was entirely appropriate in the early 2000s if we were to avoid a depression. ”

    Or a reallocation into brick and mortar stores (image a PPF with internet business and physical business…)

    Or a reallocation into overseas businesses

    Or a reallocation into digging trenches and filling them up again??

    I’m just not (yet) seeing that it had to be housing or that it would have been had the Fed not kept rates low for so long in addition to the rest of the story that you tell.

  21. Gravatar of travisA travisA
    26. July 2010 at 21:37

    I wonder if the housing boom in other countries (such as Britain and I believe Spain) can also be explained by idiosyncratic factors particular to those countries or whether it was too easy credit.

  22. Gravatar of Lorenzo from Oz Lorenzo from Oz
    26. July 2010 at 23:09

    travisA: Britain is much the same as California, Florida, etc. (The useful comparison is with Germany.) Not up on Spain, so cannot comment.

    The way I think of it is that credit is a flow and it is going to flow to places where prospects look bright. So, yes, it matters if the current is strong but which particular paths it goes down are going to depend on (amongst other things) institutional structures. So credit flowed into housing in Britain a lot, but not in Germany: in California and Florida, not so much in Texas, etc. Some assets were probably going to boom, which assets is a more particular question.

  23. Gravatar of Doc Merlin Doc Merlin
    26. July 2010 at 23:54

    @Lorenzo
    ‘The way I think of it is that credit is a flow and it is going to flow to places where prospects look bright. So, yes, it matters if the current is strong but which particular paths it goes down are going to depend on (amongst other things) institutional structures. So credit flowed into housing in Britain a lot, but not in Germany: in California and Florida, not so much in Texas, etc.’

    Texas is and has been one of the fastest growing states in the US for some time (both economically and population wise). The difference is that in Texas housing supply increased as demand increased, so prices didn’t rise substantially.
    From microeconomics: under perfect competition, when demand increases, but supply costs don’t increase, then supply increases to keep the MP=0 condition true. This keeps prices level. When there are high barriers to entry, this doesn’t happen and you get what looks like a “bubble” followed by a “price crash.”

  24. Gravatar of scott sumner scott sumner
    27. July 2010 at 05:52

    Morgan, I am not just opposed to sub-prime loans, I am against prime loans with less than 20% down.

    The Fed didn’t guarantee the MBSs, the Treasury did. Once the Treasury guaranteed them, it made little difference whether the Fed bought them or not.

    I’m all for liquidating property that has been defaulted on.

    Edwin, Fed President Strong said some similar in the 1920s: He said the problem is I can’t spank one child, without spanking them all.

    Morgan#2, Higher interest rates don’t mean easier money. it’s not that simple.

    Statsguy, I have a few questions.

    1. Russ Roberts says that the PMI requirement was (de facto or de jure, I forget) phased out in the 1990s. Is that wrong?

    2. You seem to assume I am arguing against regulation. But I am arguing for regulation.

    3. You said:

    “In any case, it’s very popular in libertarian circles to blame the GSEs for lax lending, but the timing is exactly the opposite of what this narrative predicts.”

    The timing is irrelevant. It is irrelevant who made the most subprime mortgages. What matters is where most of the bailout money is going. That is the public policy problem. I don’t care if commercial banks lose their own money. I care if they lose taxpayer money. Right now F&F are the biggest public policy problem, and FDIC is second.

    4. Are you taking into account not just the loans resold to GSEs but also the MBS bought by the GSEs, which created a derived demand for subprime mortgages?

    5. You said;

    “I’m sure the anti-GSE narrative is popular with libertarian/conservative readers, but it doesn’t square with the timing. If you really believe the GSEs were the immediate problem here, you should explain why the market was accelerating purchases of MBS at the beginning and middle of the boom while GSEs were losing share.”

    Isn’t this a odd charge to level in a post where I didn’t even mention the GSEs, and where I implicitly blamed private banks (and FDIC) for 100% of bad loans?

    Benjamin. Thanks. The Solow idea sounds nice, but printing money for a 3% deficit would lead to more than 50% inflation, as the monetary base is normally only about 6% of GDP.

    John Hall, Yes, I was referring to 2002 and 2003. By 2005 money was a bit too easy. I use NGDP as a metric, and it was growing too fast in 2005. But I don’t think that caused the sub-prime bubble. There have been many other occasions when it grew even faster without any bubbles.

    Because the Fed did not completely prevent a recession in 2002, but merely moderated it, there was some slack allowing growth in both types of investment.

    You said;

    “Your criterion for evaluating monetary policy is how quickly nominal GDP was expected to grow relative to some trend. In this case it was expected to grow more than the historical average over a period that many people have associated with “easy money.” Hence, regardless of whether their standards are correct, Scott Sumners’ standard suggests monetary policy was easy over this period.
    According to his standard, I also have had to concede that monetary policy was also tight from Q1 2008 to Q2 2010. In addition, you could also make the argument that the recession was much more severe than it otherwise would have been due to a very sharp decline in expected nominal GDP growth over the next year in Q3 2008 through Q1 2009.”

    I mostly agree, but would add that what matters is not just growth rates, but also levels. I favor level targeting, which requires a bit faster that 5% NGDP growth when in recession, and a bit less when overheated. Fast nominal growth is not a big problem when starting from a position of slack. So money wasn’t all that easy in 2004, despite fast NGDP growth. The problem got worse in 2005-06. Ditto for the slowdown. I could easily claim my NGDP approach explains the start of the recession in December 2007. But I don’t take the easy way out because the level of NGDP was still pretty high, and thus I don’t see any major problems until the third quarter of 2008, which you highlight as well.

    So we aren’t far apart.

    Lorenzo, Yes, 100% of the modest house price decline in Texas was due to falling NGDP.

    Rahul, Easy money is excessive NGDP growth expectations, easy credit is low real interest rates.

    You said:

    “3) While I understand the simplification, I am not convinced with housing vs tech. The reallocation should search for better (more investment worthy) assets. I don’t think housing was “better” asset. It was chosen (I think it was deliberately chosen) as it was the only one that could absorb large volume of investments. I believe, had we not interfered, markets would have discovered alternate energy or some other investment-starved sector.”

    To some extent the Federal government picked housing (Fannie and Freddie and mortgage tax deductions, etc) But the Fed didn’t pick housing–it simply conducted monetary policy and let the private sector (with Congressional interference) allocate resources.

    BTW, too much money creates inflation, not deflation.

    D Watson. You asked:

    “Or a reallocation into brick and mortar stores (image a PPF with internet business and physical business…)

    Or a reallocation into overseas businesses

    Or a reallocation into digging trenches and filling them up again??

    I’m just not (yet) seeing that it had to be housing or that it would have been had the Fed not kept rates low for so long in addition to the rest of the story that you tell.”

    We did also re-allocate into retail construction. Foreign investment does not use real resources, so you are comparing apples and oranges. The question is what we use labor to produce once we move away from business investment. Foreign investment doesn’t answer that question.

    Digging and filling holes is wasteful.

    Travis. Both factors affected the boom here, and I don’t doubt that both factors were important in other countries as well.

    Lorenzo, You said:

    So credit flowed into housing in Britain a lot, but not in Germany: in California and Florida, not so much in Texas, etc. Some assets were probably going to boom, which assets is a more particular question.”

    I generally agree with you 100% on housing, but here I think you made one telling error. Tons of credit did flow into Texas, lots of houses were built. But Texas did not have a land price spike (as you have explained elsewhere.)

    Doc Merlin. I guess we think alike.

  25. Gravatar of Morgan Warstler Morgan Warstler
    27. July 2010 at 06:24

    @Scott

    “The Fed didn’t guarantee the MBSs, the Treasury did. Once the Treasury guaranteed them, it made little difference whether the Fed bought them or not.”

    That’s head in the sand BS. If F&F, stacked up their very first guaranteed MBS, and the Fed said, “no we will not tacitly support your monetizing bad loans” then we’d have A LOT less GSE driven noise.

    Same thing: If the Fed said, before you can use your MBS for collateral, we’re going to need them all repriced mark-to-market, we’d have a very different world right now.

    @statsguy,

    “In any case, it’s very popular in libertarian circles to blame the GSEs for lax lending, but the timing is exactly the opposite of what this narrative predicts.

    I’m sure the anti-GSE narrative is popular with libertarian/conservative readers, but it doesn’t square with the timing. If you really believe the GSEs were the immediate problem here, you should explain why the market was accelerating purchases of MBS at the beginning and middle of the boom while GSEs were losing share.”

    I’ll do no such thing. There should be NO GSE support of the mortgage market period.

    Even guaranteeing one home pees in the credit pool – the ONLY valid source of lending is savings. And even that needs to be levered far less than it is today.

    I support:

    1. No mortgage deduction.
    2. No GSE.
    3. No support of banks sitting on empty housing stock.
    4. And since ending FDIC isn’t in the cards, I’d even make FDIC banks keep the loans they write on their books… let them cut costs by going virtual and mutual.

    Scott IF we liquidated all loans defaulted on, we could raise interest rates.

    That’s my whole point. What would make you believe that? What data do you need to see?

  26. Gravatar of Benjamin Cole Benjamin Cole
    27. July 2010 at 08:54

    Scott-

    I don’t know if anyone is still reading. The St. Louis Fed says MZM is about $9 trillion. How would printing up $500 billion and using that to finance a federal deficit result in 50 percent inflation?

  27. Gravatar of Doc Merlin Doc Merlin
    27. July 2010 at 11:47

    @Morgan

    Back in the day, any and all interest payments on anything were income tax deductible. This has gradually reduced as time has gone on, and housing is one of the last tax deductible interest activities.

  28. Gravatar of Morgan Warstler Morgan Warstler
    27. July 2010 at 13:42

    Doc, we need to absolutely trade away the value of home ownership improving communities. We need to weight mobility in the future for a number of reasons:

    1. Jobs are virtual. I know countless guys working from home. Living anywhere is the future for many of the best top jobs.
    2. Mobility in jobs increases pay.
    3. Mobility in location encourages competition between the states, punishes abuses, and reduces the value of land as investment.

  29. Gravatar of Morgan Warstler Morgan Warstler
    27. July 2010 at 14:31

    “About 18.9 million homes in the U.S. stood empty during the second quarter as surging foreclosures helped push ownership to the lowest level in a decade.”

    http://www.bloomberg.com/news/2010-07-27/vacancies-climb-as-u-s-home-ownership-falls-to-lowest-level-in-a-decade.html

    Jesus Christ. Scott, the Fed’s first focus should be getting these damn things pushed cheap to the balance sheets of the dry powder guys, NOT the banks living on reserves. The Fed is supposed to encourage the business cycle, not fight it.

  30. Gravatar of Mattias Mattias
    27. July 2010 at 21:21

    The standard narrative today seems to be that the Fed has kept interest rates too low the last decade which has created a bubble blowing economy. That’s why interest rates must be higher and every time a market goes up it is considered to be a bubble. I think this is a very counterproductive line of thinking. The strange thing is that people seems more scared of bubbles than ever before now, after the worst decade for most investments in a long time.

  31. Gravatar of ssumner ssumner
    28. July 2010 at 08:11

    Morgan,, No way the Fed would undercut the Treasury in that way. Won’t happen.

    Benjamin. The relevant denominator is the monetary base, which is normally around $850 billion, when we aren’t in a liquidity trap. Add $500 billion more base money and you get a lot of inflation.

    Morgan, No the Fed is supposed to fight the business cycle, not encourage it.

    Mattias, The Fed doesn’t determine real interest rates in the long run. So the Fed couldn’t produce a decade of low interest rates even if they had wanted to. The people who argue that simply don’t understand monetary theory. Markets set interest rates, the Fed controls the money supply.

  32. Gravatar of John Papola John Papola
    28. July 2010 at 12:40

    …unless you’re wrong and the productivity norm approach is right. Then, 5% NGDP growth produces easy money that can fuel speculative bubbles on top of real sectoral shifts.

    The 2000s was a period of productivity boom. It was a time when the prior 5 year’s tech investments finally operationalized into more efficient coordination and organization. We should have have productivity norm deflation. Targeting 5% NGDP growth was a mistake.

    The key here is to look at the causes of the upper turning point as the Fed began raising rates. Rising capital goods prices, asset booms that crushed profit margins in boom sectors. Wall Street chasing nickels with increasingly marginal borrowers. Were they getting all of those loanable funds for China? As rates rose, credit-expansion fueled demand collapsed and boom projects, already feeling inflation pressures from hitting the wall or real resource constraints, turned to bust.

    The rottenness in the boom is masked by drawing on inventories and “buffer stocks” and consuming capital while mistaking these for real profit. The turning point reveals that mistake when rates rise back to the natural rate or close to it and reveal that there weren’t enough savings in the system to fund all of this mal-investment.

    Your pointing at the heart of the austrian story with this question, Scott.

    If the Austrians are right, there is no reason for NGDP to grow. It should be stable. If Q is going up in the face of stable MV, P should fall. There’s no reason to pump P back up so that MV grows in the face of rising Q. And Q isn’t Q. Q is all kinds of stuff. Why should falling prices and rising output in technology be offset by inflating the price of some other good (like housing) so that the total remains the same? I just don’t get it.

    Stable MV, not rising is the difference. 5% NGDP growth WAS easy money in 2004, 05 and 06.

  33. Gravatar of John Papola John Papola
    28. July 2010 at 13:18

    Sorry if I covered other’s people’s ground. I didn’t have a chance to read the comments. It’s my one moment of econ geek zen in a crazy day.

  34. Gravatar of Benjamin Cole Benjamin Cole
    28. July 2010 at 14:12

    Scott-
    I don’t know if you are still reading, but something doesn’t make sense to me. You say the monetary base is about $900 billion. But sheesh, there is nearly $900 billion in US paper money in circulation (although much outside the US). Paper currency rivals our monetary base?

  35. Gravatar of Morgan Warstler Morgan Warstler
    28. July 2010 at 14:44

    Morgan,, No way the Fed would undercut the Treasury in that way. Won’t happen.

    Morgan, No the Fed is supposed to fight the business cycle, not encourage it.

    Scott, this is the worm turning – SEE, when push comes to shove, you aren’t TELLING the fed what to do thats best, you are telling them to support the actions of Treasury.

    This makes you NOT right wing.

    Also, you are a fool about business cycle, the Fed’s job is to make sure the bears win as fairly as the bulls. Volumes could be written about this basic mistake you make.

  36. Gravatar of johnleemk johnleemk
    29. July 2010 at 04:39

    “Also, you are a fool about business cycle, the Fed’s job is to make sure the bears win as fairly as the bulls.”

    According to whom? Why should a monetary authority pick winners and losers?

  37. Gravatar of ssumner ssumner
    29. July 2010 at 07:36

    John, Neither you nor the Austrians in general have any causal explanation for why 5% NGDP growth causes misallocation. I haven’t seen any Austrian address the superneutrality of money. Until they do so, you are just talking to a blank wall. Why should monetary policy affect real variables? That’s the question you need to answer. faster NGDP grwoth doesn’t affect real interest rates, so why should it affect investment?

    Benjamin, During normal time more than 90% of the monetary base is currency held by the public. That was true for decades before 2008.

    Morgan, You said:

    “Also, you are a fool about business cycle, the Fed’s job is to make sure the bears win as fairly as the bulls. Volumes could be written about this basic mistake you make.”

    I look forward to reading these volumes.

  38. Gravatar of Benjamin Cole Benjamin Cole
    29. July 2010 at 09:35

    Scott, if you are still, still reading….

    At the risk of belaboring a point, if paper currency is the monetary base, and half of our currency is held outside the United States, and the monetary is so important…then would a repatriotation of offshore dollars mean a huge boom in the monetary base?

    Why is the monetary base so important compared to money supply?

  39. Gravatar of John Papola John Papola
    29. July 2010 at 12:47

    Scott,

    I’m going to seek the answer to that question, if there is one.

  40. Gravatar of ssumner ssumner
    30. July 2010 at 05:15

    Benjamin, Technically, the US base includes offshore cash. So technically it would be a fall in the demand for base money, which is also inflationary. But de facto it is an increase in the effective base circulating in the US.

    John, Let me know.

  41. Gravatar of MW MW
    30. July 2010 at 07:47

    “So a reallocation from business investment into housing was entirely appropriate in the early 2000s”

    I don’t understand this. Capital should flow to where the expected return is highest. Why should the expected return have been highest in housing except for 1) govt interference and 2) rates below expected return? And if 2) is true and you maintain that rates were not ‘too low’ then surely there was a big problem with expectations of house price appreciation?

  42. Gravatar of ssumner ssumner
    31. July 2010 at 07:24

    MW, I favor targeting NGDP and letting the market set rates. The market set rates very low in the early 2000s, in order to prevent another Great Depression after the tech bubble burst.

    Investment should not be determined by the government. I oppose government subsidies favoring housing, my point is that it’s not the Fed’s job to decide into which sector funds should flow. The Fed should not pay any attention to housing, that’s the job of Congress–they’re the ones that passed laws subsiding housing. The Fed needs to keep its eye on the ball, stable growth in NGDP to smooth out the business cycle.

  43. Gravatar of Lorenzo from Oz Lorenzo from Oz
    3. August 2010 at 22:25

    Yes, you and Doc Merlin are right, I expressed what I meant very badly. I was addressing the effect of credit flows on housing prices and failed to say what I meant: in Texas, credit flowed into housing production rather than prices, in the housing-price-boom places it flowed into housing prices because supply was constrained.

  44. Gravatar of Doc Merlin Doc Merlin
    4. August 2010 at 00:52

    @Lorenzo:
    Got yah, that makes far more sense than what I thought you meant. Anyway, that leads to me another thing we have to remember: artificial supply constraints can cause “bubble like” behavior. Maybe we can hammer that into the politco’s minds?… wait on second thought, they may try to take advantage of that.

  45. Gravatar of ssumner ssumner
    6. August 2010 at 06:28

    Lorenzo, I knew that you knew that.

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