Did tight money cause part of the housing bubble?

Lots of people have argued that easy money contributed to the housing bubble.  I mostly disagree, as money wasn’t particularly easy.  Just to be clear, I’m not denying that a couple points of the increase might have been caused by faster than 5% NGDP growth around 2004-06, but growth in NGDP wasn’t that unusual, and we didn’t see national housing bubbles in other decades.

But almost no one argues that tight money caused the bubble.  Indeed you could probably remove “almost” from the previous sentence.  Since I like nothing more than a challenge, I’ll make that argument.  More precisely, I’ll argue that it caused a portion of the bubble, perhaps one half.

Next we have to discuss what we mean by ‘bubble.’  Most people mean a sharp rise in prices, followed by a big decline.  I agree with most people.  More sophisticated people define ‘bubbles’ in terms of market inefficiency, deviation from the EMH.  Since I believe markets are efficient, that’s obviously not my definition, or else I’d have to argue that bubbles don’t exist.  So let’s stick with the conventional definition.

In my view there is too much focus on the upswing part of bubbles.  Housing prices also soared in the 1970s, but no one called that a bubble.  The price of Microsoft stock soared in the 1990s, but that wasn’t a bubble either (except perhaps in 2000).  Why not?  Because prices didn’t collapse afterward.  Housing prices kept rising in the 1980s, and while Microsoft stock has bounced around, it’s always maintained a pretty high market cap.  To have a bubble you need a big rise followed by a big fall.

By now you know where I’m going with this.  I believe the second half of the decline in housing prices was due to the very tight money policy of late 2008, which depressed NGDP growth about 9% below trend between mid-2008 and mid-2009.  The first half of the decline was due to “other factors,” which might have included the immigration crackdown and/or mistakes in forecasting by housing market participants.

To better understand this argument it might help to look at global home price trends:

This is a graph showing real home prices in many countries.  It is hard to read so I’ll just tell you that the gray line shows US prices rising about 50%, peaking in early 2006, and then falling back to their original levels.  (The peak is earlier than in other countries.) Many people wrongly think that the big increase in real home prices shows that housing was too expensive in mid-2006.  That “what goes up must come back down.”  Not so, as you can see real home prices in most countries went sideways after 2006.

But if you take a close look at the pattern, you will see that foreign real home prices tended to continue rising after 2006 and then fell in 2009, when world NGDP plunged.  Thus foreign markets (excluding possibly Ireland and Spain) didn’t seem to be affected by the problems that hit the US in 2006.  The modest declines you see in the other markets occurred for the same reason that the US market kept falling in 2008-09.  Falling NGDP.

If NGDP hadn’t declined in the US, prices would still have fallen modestly in 2006-07, but not enough to be such an obvious bubble.

If prices had leveled off at the peak, no one would call it a bubble.  Because they fell all the way back down, everyone except Eugene Fama calls it a bubble.  If they fall modestly then it would have been a “borderline bubble.”  (This happened in my hometown of Newton.)

Tight money in 2008-09 turned a borderline bubble into a gigantic bubble.  The beautiful symmetrical shape we actually observe for US prices, like that classic volcano in the Philippines, is half due to real factors and half due to tight money.

Here’s an easier to read graph with 4 other English-speaking economies.

Notice that since the US peaked in early 2006 those countries have mostly seen prices go sideways (up a bit in two and down a bit in two.)  Prices move around all the time, no one would consider those examples of “bubbles.”  Real prices are still quite high in all 4 countries.

I don’t see why it was “obviously irrational” for American home purchasers in 2006 to expect future real homes prices in America to follow the same sort of pattern as future home prices in Canada, Britain, Australia and New Zealand.  But Fama and I seem to be about the only people on Earth who feel that way.  Everyone else is convinced that everyone around them is completely irrational about home prices.  But if “everyone” is completely irrational about home prices, why should I accept “everyone’s” view that markets are obviously irrational?  Would you poll residents of a lunatic asylum to ask which inmates were insane?

PS.  Matt Yglesias has a great post that is loosely related to this one.  He discusses the sort of crisis we should have had.  The one that would have occurred had NGDP not plunged in 2008-09.



45 Responses to “Did tight money cause part of the housing bubble?”

  1. Gravatar of Benjamin Cole Benjamin Cole
    12. January 2012 at 14:50

    More excellent blogging.

    The Fed cracked the real estate market (including commercial, which had an identical bubble) and hard—most likely the Fed was unaware it was passively tightening the money supply as much as they did, or they were concerned about commodities prices (though the latter is set on global markets, many inside the Fed seem to think the US monetary supply controls the price of gold).

    The Fed showed exquisitely poor timing. Sort of like asking an Afghanie today if he is “pissed off” about the recent videotape of US soldiers. Poor timing.

  2. Gravatar of Brito Brito
    12. January 2012 at 15:51

    Sumner, I don’t think bubbles require individual irrationality, only group irrationality. As in, individuals acting in their rational self interest can cause the group of individuals in aggregate to engage in irrational actions. So it may have been rational to purchase housing backed assets, but only because other people thought it was rational and you were just following the trend: a feedback loop. The self fulfilling expectations like this are rarely sustainable, in this case it caused the market value of mortgage backed securities and other assets to massively diverge from their fundamental value, which was either low or completely ambiguous. There is only one other requirement for this, ignorance. But I don’t think ignorance in this case is irrational. What happened is that people were generally unaware of how risky these assets were, partly because some banks were massively concealing or losing information about the credit worthiness of many borrowers, and partly because the assets were so exotic and complicated that you would need to be very smart to calculate their risk.

    But once the ambiguity over the value of these mortgages were realised when house prices started to decline, the value of these assets plummeted immediately, that was the real problem, and I’m not sure the fed could have done much about that to prevent a financial crisis. I agree however that the fed could have prevented the financial crisis from causing such a deep recession (though it would require extraordinary action), and could have prevented house prices to plummet as a result of the crisis. I think it’s more important to focus on the MBS bubble, if the assets were correctly priced or risk properly estimated then the housing bubble wouldn’t have caused the financial crisis, and the housing bubble probably wouldn’t have occurred anyway as these assets would be much less valuable.

  3. Gravatar of PrometheeFeu PrometheeFeu
    12. January 2012 at 16:02

    Your argument is symmetrical with the one you oppose. The problem is that people in 2004-2006 saw NGDP growing at X% (Why is finding NGDP numbers so hard? Google first autocorrects to GDP and then the first page is Nick Rowe, You, David Glasner and a comment on Nick Rowe) and everyone assuming X% was the new normal. So everyone writes nominal contracts assuming X% NGDP growth. Turns out they were wrong. In 2007-2008, NGDP growth is Y%. Turns out X>Y so people don’t have enough money to make good on their nominal obligations. What you’re basically saying is: we didn’t have a bubble because X was bigger than Y, we had a bubble because Y was smaller than X. It’s the same thing!

  4. Gravatar of Martin Martin
    12. January 2012 at 16:05

    “I don’t see why it was “obviously irrational” for American home purchasers in 2006 to expect future real homes prices in America to follow the same sort of pattern as future home prices in Canada, Britain, Australia and New Zealand.”

    Neither do I, if you look at the female population-employment ratio and you look at the housing prices you see that they both rose together and a simple linear regression will yield an r^2 of 0.88 over the period ’75-’03.

    Now perhaps there is some sort of underlying factor, but as I see it a lot of household production became market production and that made us considerably richer. It’s no wonder that we’re then willing to pay more for houses as those are – generally – bought together.

    Expecting – implicitly – that this trend would continue is hardly irrational. Now I didn’t expect it to continue in Holland in 2006, but the end is something reasonable people can disagree about without calling each other irrational/’stupid’.

  5. Gravatar of W. Peden W. Peden
    12. January 2012 at 16:45

    “But if “everyone” is completely irrational about home prices, why should I accept “everyone’s” view that markets are obviously irrational? Would you poll residents of a lunatic asylum to ask which inmates were insane?”

    I’m with Brito on this section. Logically, it is possible to believer either that individuals are rational but markets are not rational or that individuals are irrational but markets are rational (or neither). What is true of the group need not be true of the whole e.g. the Swiss are rich, but Switzerland is not a rich country.

    I’m sympathetic towards weaker versions of the EMH, but I don’t want to be committed to any claims of rationality on the part of investors. You can compare this kind of position with Karl Popper’s views on science: individual scientists can be (and often are) highly irrational, whereas the scientific process (and often is) is a rational one. I know that “rationality” in philosophy of science debates and in EMH debates means something different, but the logical point about composition and emergence is true of both.

  6. Gravatar of blaha blaha
    12. January 2012 at 16:57

    Where is the “tight money”?

  7. Gravatar of Morgan Warstler Morgan Warstler
    12. January 2012 at 17:35

    As said before, if the corrections 2002-2006 were made, via level NGDP targeting there would have been no housing bubble.

    Money would have gotten tighter, housing prices wouldn’t have risen like they did.

    The BIGGEST problem with a bubble is that it lets the least productive shit that should be ended during small recession austerity, is not be ended.

    In this case, public employees would have not gotten the massive pay increases they were not supposed to get, leading all the way to GM should be DEAD, not owned by the UAW.

    There are real and meaningful distant effects from easy money. There are significantly better alternative universes very near ours where money was tighter when it was supposed to be.

    Scott, the easiest way to sell your plan is to be clear that it would have kept the 2002-2006 bubble from occurring, not talking about 2008.

    Sell the prevention, not the band-aid.

  8. Gravatar of Brett Sheckler Brett Sheckler
    12. January 2012 at 17:35


    Let’s look at this…

    Across America mortgage originators were extending so-called liar loans that had a high probability of going bad.

    The big financial centers appear to have understood this since the evidence suggests that they created CDO’s that, in effect, were designed to fail.


    Gullible entities around the world bought these CDOs, and individuals bought houses–unaware that housing prices were being driven, at least in part, by the mass creation of mortgages that had a high probability of going bust.

    I don’t know if any of this qualifies as “irrational,” but I do think this strikes a serious blow at the notion of efficient markets.

  9. Gravatar of Pennist Pennist
    12. January 2012 at 18:08

    Are you joking? This is all the Mulligan talks about.

  10. Gravatar of Greg Ransom Greg Ransom
    12. January 2012 at 18:25

    Scott, in the 2nd half of the 00s they were bulldozing mostly completed houses in North Los Angeles County because it would cost more to complete and sell the houses than they could receive if they sold the houses. Try YouTube if you would like to see the bulldozers in action.

    There are mostly completed yet still unfinished houses and condos scattered across Nevada, Florida, and California. Try YouTube if you would like to take a video tour of many of these sites.

    Now, why did the world of finance, credit, leverage, money, banking etc. get “tight” in the 2007-2008?

    Well, as Credit Suisse economists http://hayekcenter.org/?p=2954 and many others point out, the jig was up, and everyone knew that the expanding stock of “shadow money” represented by bundled & securitized mortgage finance instruments (CDOs, etc.) could expand no longer and indeed, the fantasy belief in the underlying stream of mortgage payments backing up the whole house of cards was fraudulent and depended on an impossible ever increase in house prices, and payments made by folks who NEVER had the income to service these mortgages.

    And what happened is that this massive stock of “shadow money” completely lost its asset value and its liquidity — i.e. there was a massive shrinkage in shadow money or quasi money that had been generated by the financial system and the market, completely altering the financial situation of major banks, major financial institutions, major investors, and millions of individuals across the economy. The story is told in all sorts of books, telling how these mortgage backed securities were used as reserve assets, and the role they played in credit default swap securities, and the role the collapse of these CDS instruments played in altering the solvency, liquidity, lending capacity, and reserve ratios of all sorts of major financial institutions.

    More remarkably, in a series of papers BIS chief economist William White and his associates (and other economists) were telling the unfolding of this story, not only as it happened, but before it happened, making reference to the work of Hayek, Selgin and Minsky, among others.

    It seems to me all of this unfolded just as William White and others anticipated — and on a timing schedule that vindicates a Hayek / Minsky picture of unsustainable and artificial shadow & Fed money expansion, production discoordination and malinvestmenand — leading to inevitable shadow money collapse, income stream collapse in mainvestment sectors, etc.

    As the facts continue to come in or and preliminary data gets correct — and the fraudulent data reported by Fannie Mae etc. gets replaced — the facts more consistently in the direct of further supporting the Hayek / Minsky story (with special characteristic shaped by contingent historical institutional factors, e.g. Freddie & Fannie, U.S. regulatory operations, the CRA, the evolution of financial instruments and institutions, etc. etc.).

  11. Gravatar of Bonnie Bonnie
    12. January 2012 at 19:45

    I don’t know if tight money caused the perception of there being a housing bubble, but it did cause a spectacular burst of something more like a general debt “bubble”. Just so happens that a good part of the debt was mortgage-centric at the time, and with a glut of houses going up for sale as result, prices plunged. Now we’re seeing the rest of it, like all levels of government debt.

  12. Gravatar of ssumner ssumner
    12. January 2012 at 19:50

    Thanks Ben.

    Brito, I think it’s better to focus on the value of the houses themselves, not the MBSs. Houses were not a good investment in 2006, although they may have seemed so at the time. And that’s true both at the individual and group level.

    PrometheeFeu, I’m saying there were two parts to the housing bubble. House prices would have declined even with normal NGDP growth, but the 2008-09 slowdown caused them to fall much more.

    Martin, Good point.

    W. Peden, You said;

    “I’m sympathetic towards weaker versions of the EMH, but I don’t want to be committed to any claims of rationality on the part of investors.”

    That’s actually my view too.

    Blaha, The NGDP numbers show very tight money in late 2008.

    Morgan, Slower NGDP growth would have only made a small difference.

    Brett, But why did the big banks buy all that garbage? Are they also irrational?

    Greg, The tight credit occurred earlier, and is basically unrelated to tight money.

  13. Gravatar of Morgan Warstler Morgan Warstler
    12. January 2012 at 21:18

    Scott, you need it to be true, but it isn’t.

    And you are very selective about when you apply the effects of your plan.

    If in 2002, the Fed was GUARANTEEING NGDP was 4.5% – it would have meant that Fannie Freddie CAN’T HAPPEN.

    It can’t happen because we are a smarter people who KNOW that when the gvt backs up the shitty credit of sub-prime lending, it uses up the allotted NDGP growth for the year as rent seeking to the housing industry – which means interest rates are higher for others in the private sector.

    It means we KNOW that public employees getting raises eats up the allotted NGDP growth for the year, so they don’t get raises.

    As I keep saying, your idea is great because it ends confusion about what is going on in a planned economy…. by making the plan super duper simple. REAL private RDGP is good. Inflation is bad. But worse is public sector “investment” crowding out the private sector.

    Sine we KNOW there is a 4.5% allotment, we become far more protective that the growth is left to the real productivity + commodity based inflation…

    What you call a level, I’ll call a CAP, and then use the slightly too small a slice scare to make people hate govt. and handouts.

    What about my analysis is wrong?

  14. Gravatar of Andreas Reinsch Andreas Reinsch
    13. January 2012 at 00:20


    as a non-economist:

    I don’t understand exactly how your model works, that depressing NGDP results in lower housing prices, I would expect the opposite.

    As a simple model, the required return on a housing investment should probably be a long-term real risk free rate plus a premium for risk, illiquidity, etc. So when low NGDP depresses growth and therefore long term real rates, housing prices should go up as return on housing goes down.

    Now you might argue that risk perception has increased or liquidity preferences changed with lower NGDP, so that the premium one requires above the risk-free real rates has increased. But it is not clear to me, why this should be a larger increase than the decrease in risk-free rates.

    For existing homeowners during the time of decreasing NGDP expectations, the problem is of course that interest rates went down and therefore the value of their mortgage debt (and other debt) increased. But since people can refinance their mortgage at a lower rate, this holds only true if nominal home prices decrease, so that refinancing is not an option. This might exacerbate falling home prices (due to balance sheet problems), but it doesn’t explain why home prices fall in the first place.

    So in summary, I would expect housing to behave similar to very long term TIPS, which increase in value in times of slowing NGDP and falling long term real rates.

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  16. Gravatar of Neal Neal
    13. January 2012 at 03:54

    Just a quick question about EMH … “[the housing bubble was caused in part by] mistakes in forecasting by housing market participants.”

    How is that not a market inefficiency?

  17. Gravatar of Neal Neal
    13. January 2012 at 03:57

    (Ghetto edit: If the mistake you meant is not anticipating a contraction of the money supply, then I retract my question.)

  18. Gravatar of W. Peden W. Peden
    13. January 2012 at 04:56


    Under even the strong versions of the EMH, you can still get forecasting errors because the hypothesis proposes no more than that market prices reflect all PUBLIC information. They could still fail to represent private/non-existent information e.g. bad policy decisions, natural disasters, hidden corporate scandals etc. I don’t believe that, but even the strong EMH has a much weaker notion of “efficiency” than most people think.

  19. Gravatar of W. Peden W. Peden
    13. January 2012 at 05:02

    (Actually my comment above is wrong: the strong EMH DOES imply that market prices reflect all private information. I’m not sure if it implies that markets anticipate lousy policy decisions.)

  20. Gravatar of dwb dwb
    13. January 2012 at 05:44

    under rational expectations and efficient markets, there should not be a price “trend” – the current price should fully reflect future real appreciation. In other words, if i expect outsize real returns to housing in the future, I should be bidding up the price today until those outsize returns dissappear. There should be zero (risk and liquidity adjusted real-) returns to housing. That said, i defer to the myriad charts and graphs over on calculated risk – there definitely was excess inventory of housing by any measure; but as you say prices did not need to decline sharply they could have merely stagnated in real terms for an extended period.

    One experience that definitely molds my thinking is the commodity “bubble” in 2008. commodities escalated sharply in early 2008 (some doubled in 6 months in early 2008). It was not a “bubble” – demand was high and short term commodity prices have a very steep SRAS curve. It takes 3 years to build a ship or open a mine and there was lots of activity which would have mitigated the price rises {now, go back and look at how many panamax and capemax vessels were canceled from shipyards because demand ended up not showing up}. In the face of this, the Fed saw imminent inflation and was reluctant to loosen money. demand inflation the Fed can control, but not supply inflation, and the sharp rise in commodities prices was supply-driven not demand. So I would say that certainly part of the problem is that really the Fed is not looking at the right price-increase metrics. {actually I would say focuing on prices is focusing on the tail of the dog anyway, the Fed should focus in wage and employment cost indices since this IMO drives the majority of damand-side inflation, focusing on prices is mostly after-the-fact}.

  21. Gravatar of ssumner ssumner
    13. January 2012 at 05:49

    Morgan. What’s wrong is that there was already a perception that NGDP was likely to grow about 5% a year over the next decade, and we let F&F run wild.

    Andreas, The house a person buys depends very much on their income. When incomes fall house prices fall. I agree that lower rates should boost houses (and stocks) but the effects of recession were much stronger.

    Neal, Not all mistakes are inefficiency, it depends on whether the errors were obvious at the time. In any case that sentence wasn’t also pointing out that market inefficiency is a possible reason. Although I happen to believe markets are efficient, I wanted to list all the possible factors. One possible factor is obviously that I am wrong!

  22. Gravatar of ssumner ssumner
    13. January 2012 at 05:51

    Bonnie, That’s right.

    dwb, Good points—I agree.

  23. Gravatar of dwb dwb
    13. January 2012 at 05:53

    … actually a lot of it boils down the Fed not being adequately forward looking IMO. If you looked at forward curves for a lot of commodities {which i did} back in 2008 you would have seen a very steep contango {meaning, the price was expected to drop significantly}. The Fed could have called up Goldman, Merrill Lynch or JP Morgan commodities and seen that the price rises were not expected to persist {sadly, no forward curve for housing or employment}. I see a lot of discussion in the transcript about conditions NOW but not about the future. The Fed should be mind-numbingly singularly focused on the future, about 1-3 years in the future, not the past or present.

  24. Gravatar of James in London James in London
    13. January 2012 at 06:25

    While beginning to appreciate the difference between money and credit you have never really addressed Greg Ransom and others (including me) issue with shadow banking and shadow money.

    The IMF think it is not credit but a form of money, or at least parts of it, like Repo. And it worried the Fed hugely back in Q4 2008 when they realised they weren’t on top of it. You never discuss their problems with this area back then, or at least I haven’t seen your comment.

    You still seem to be a bit behind the curve on it, seeming to prefer monetary theory and simple monetary measures to the mucky/murky real world of shadow money.



  25. Gravatar of Morgan Warstler Morgan Warstler
    13. January 2012 at 06:54

    “Morgan. What’s wrong is that there was already a perception that NGDP was likely to grow about 5% a year over the next decade, and we let F&F run wild.”

    Yes, and my analysis is what would have happened. at 4.5%, 4%, or lower…

    I’m using alternative universes here, where the expectation of 5% doesn’t happen.

    What you are failing to understand is how quickly a rate raise increases if the expected slow down doesn’t happen.

    Nothing can run wild at 4% Scott.

  26. Gravatar of Morgan Warstler Morgan Warstler
    13. January 2012 at 06:58

    I agree with James that Scott doesn’t answer.

    But I think that ending the shadow side is simply a choice between:

    1. no rules, but gvt. backstop expected – none ever coming.
    2. using regulatory to require much higher reserves, lower lending leverage.

  27. Gravatar of Neal Neal
    13. January 2012 at 07:26

    Okay, I think I see. One of these days (read: after qualifying exams, when I’m putting off a thesis), I’m going to get into the EMH. At the moment, I’m skeptical since I tentatively believe that EMH is equivalent to P = NP, which is probably not true.

  28. Gravatar of Brendan Brendan
    13. January 2012 at 07:45

    Real rates historically low and declining for a few decades. Stock valuations(measured as earnings yields or dividend yields) rising for last few decades and pretty high right now considering economic pessimism. Gold/CPI at all-time highs. Housing relatively cheap from long-term perspective.

    I know housing is not a perfect substitute for other assets (bonds/stocks/precious metals). But given the long-term rise in valuations among so many asset classes and accepting the idea that much of the housing collapse was caused by the Fed, doesn’t it follow that housing is going to be a great investment once NGDP growth gets back on track?

  29. Gravatar of Brendan Brendan
    13. January 2012 at 08:01

    Just real quick on the EMH. Beliefs in market efficiency are a matter of degrees I think. The fact is that markets are more efficient than most people think- just look at the failure of most active money managers, failure of most economic prognosticators, etc.

    But markets are not even close to perfectly efficient either. Investors uncover stock frauds from publicly available information all the time and make a killing. Surveys show that investor beliefs in future returns are STRONGLY inversely correlated with actual future returns. I don’t think Scott actually believes that the Nasdaq was an equally could buy in 2000 as the S&P 500 was in March 2009. In general, I think he believes that overconfidence, hindsight bias and data-mining cause most people to dramatically underestimate market efficiency and this leads them to a bunch of bad policy views.

    I apologize if I’m wrong about your views.

  30. Gravatar of James Oswald James Oswald
    13. January 2012 at 08:02

    If you look at countries without contractionary monetary policy in 2008, you will find no bubble. I picked Switzerland, Australia, New Zealand, and Sweden, and there are no bubbles to be found. This might be a useful graph to add to reinforce your point.

  31. Gravatar of Ken Ken
    13. January 2012 at 09:20

    Several thoughts on this:

    1. I’d love to hear more about the distinction between “easy money” and “easy credit”. It seems that Scott looks at “easy money” by looking at NGDP growth. That makes sense to me. But what, if anything, is “easy credit”? I’d say it refers to periods in which large amounts of loans are being priced too cheaply. What’s “too cheaply”? One could result it (as does Scott to define a bubble in retrospect) or one could try to make logical arguments as to why the loans were obviously mis-priced. Either way, just talking about “easy money” and “tight money” seems to miss the important qualitative distinctions between the type of credit being created.

    2. It would be interesting to see international graphs of housing affordability over time. I think that would capture an element of the situation that the included graphs might miss.

  32. Gravatar of Ken Ken
    13. January 2012 at 09:26

    For any given level of NGDP growth, what are the differential economic results and optimal policy responses depending on different amounts of definitively foolish lending, i.e. lending that by definition cannot be repaid?

    In other words, in Economy A, say there is 5% NGDP growth and all credit created is for things that lead to 3% real growth. In Economy B, say there is 5% NGDP growth and all credit created is used to hire people to dig holes. What happens?

  33. Gravatar of Greg Ransom Greg Ransom
    13. January 2012 at 09:26

    Scott, “tight credit” is clearly not the core of what I’m talking about.

    What is your argument for claiming that the private finance/economy and quisi-money & shadow money don’t expand and contract the supply of money — in ways that the Fed can’t control in the short term?

    This is the Hayek argument — the private economy and private finance and banking can expand and contract the supply of money, and that this takes place in conjunction with the expansion and contraction of the time structure of production, i.e. the stream of value creation via alternative investment / production streams extending across time.

    Your substance-less assertions that you can’t accept this has no argument and doesn’t demonstrate that you’ve actually engaged the subject.

    What’s the argument?

    Are you simply invoking “and then a miracle occurs”, i.e. by an act of magic the Fed instantly controls the size of the money supply and demand?

    “Greg, The tight credit occurred earlier, and is basically unrelated to tight money.”

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    13. January 2012 at 11:14

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  35. Gravatar of Lorenzo from Oz Lorenzo from Oz
    13. January 2012 at 18:48

    Take a Friedmanite view (which David Glasner sets out nicely somewhere, but I can’t find it) that asset prices reflect estimates of risk, income and roles as a store of value across assets in an economy. (Bonds are pure-income assets, so easy to price: gold-kept-as-bullion is a pure store-of-value asset, so much hairier since 1971.)

    Take a Minsky view that long periods of macroeconomic stability encourage asset price surges due to discounting of risk and related factors.

    Then, if people have experience that some asset is an inflation-beating store of value, that will encourage investment in it, an effect strengthened by prolonged macroeconomic stability. If land-for-housing is systematically supply-constrained (e.g. by being in what Krugman calls the Zoned Zone), then such expectations will be set up. There is nothing irrational in this: people will have lots of evidence that Zoned Zone housing is an inflation-beating asset. For lots of people, substantial capital gains will be within their transaction horizon (period until asset is sold). Since no one knows if and when a turning point will occur, they have no authoritative reason to think it is within their transaction horizon: in particular, not sufficient to wipe out their entire gain.

    But this is all expectations. Change the expectations, and the pattern collapses. Tight money can certainly change the expectations. Australia has had no bubble (since you don’t have a bubble until the collapse occurs) because we have not had tight money; nor any other reason to sufficiently change expectations.

    So Scott, your story seems fine to me

  36. Gravatar of ssumner ssumner
    14. January 2012 at 07:31

    dwb, I agree.

    James, I know little about shadow banking. If it matters at all, it is to the extent that it impacts the demand for money (bank reserves.) The Fed can easily offset any impact of shadow banking.

    Morgan, I don’t think 1% makes that much difference, but perhaps some difference.

    Neal, Google my old paper on Richard Rorty and the EMH. The point is not whether it is “true,” almost nothing in economics (except tautologies) is literally true. The question is whether it is useful. I say it is, and more importantly the anti-EMH models are not useful.

    Brendan, I don’t really feel comfortable predicting markets. I’m invested in stocks, which seem like a good long term investment. Real estate probably is low because of low expected NGDP growth (fear of the Japan scenario) if we get back to 5%, then real estate may do well.

    You views on the EMH are close to mine, although I’d go a bit farther and say that it’s very hard for even level-headed experts to beat the market. I’ll have a new post on hedge funds soon, which haven’t done well recently.

    James, Thanks for that tip.

    Ken, I see easy money as fast NGDP growth and easy credit as being low real interest rates (or perhaps also looser lending standards.) I don’t view easy credit as a policy problem, unless it is entangled with bad regulations like the GSEs, FDIC, TBTF, etc. In that case you need regulatory reform, not tight money, to address the problem.

    Greg, NGDP is base money times base velocity. If near money changes result in higher velocity, the Fed can offset that with a lower monetary base. I don’t see a real world example of where this was a problem. If growth in NGDP was a bit too fast in 2004-06, no one would claim it was because the Fed had no tools to slow it down.

    Thanks Lorenzo, Regarding Minsky. the super stable 1960s did not lead to any big asset bubbles (in stocks, real estate, etc.)

  37. Gravatar of Morgan Warstler Morgan Warstler
    14. January 2012 at 10:44

    Scott, if you go back to 2002, and the Fed start raising rate when NGDP hits 4% level…

    When Fannie Freddie was just trying to get going, BUSINESSES would have started freaking out that giving a bunch of sub-prime loans was increasing their borrowing rates.

    I can’t figure out how you miss this.

    It would be brutal, we’d get essentially a class war between those with legitimate borrowing interests and the voters the Dems were trying to buy off.

    The NGDP is already at 4.2%!!! Giving out a bunch of shitty loans will drive it to 5%!!!

    ARM loans are probably even a political no-no.

    You get NONE of the Vegas, LA, South Florida, Phoenix run up — the entire slice and dice of MBS into tranches can’t get out the get because there are 50% less loans being written.

    Nobody flips for a win. Bartenders don’t own 4 houses in Vegas.

    It is a full blown alternate universe.

  38. Gravatar of Lorenzo from Oz Lorenzo from Oz
    14. January 2012 at 19:05

    Scott: they did in Australia. We had a “bubble economy” in the late 1960s and early 1970s. Of course, we had a policy regime that systematically suppressed risk plus a “resources boom”. So not a strong counter-example.

    The other notorious element in the super-stable 60s was strong productivity growth. But I expect that a Minsky argument would require growth in asset prices beyond that from productivity growth.

  39. Gravatar of Greg Ransom Greg Ransom
    14. January 2012 at 22:10

    Soctt, you argument seemingly appeals to a version of the nirvana fallacy — IF the Fed perfectly knew what was happening and IF the Fed perfectly anticipated in advance what it should have done, then EVERY disequilibrium in the economy could have been instantly put to equilibrium. And because we can imagine the “An Then A Miracle Occurs .. And Another .. And Another”, the their is no room for my causal mechanism.

    It’s like the argument for Divine Design and against Darwin — And the form is this: Because we can imagine perfect miraculous design, then that somehow shows why and that the messy inefficient process of natural selection couldn’t be the explanation, because a perfect explanation with perfect knowledge and anticipation wouldn’t make any room for the messy process — I.e. if a Perfect agent could have left no room for the messy process , then the messy process can’t be the right answer, because we can imagine the Perfect agent doing better and eliminating that alternative causal possibility.

    The Fed imagined as the Perfect Agent, “proves” that the messy Hayek process isn’t the explanation, because a perfectly all knowing all powerful Fed could have stopped that messy process from Happening.

    And I say that is no more likely or possible than Perfect Planning and agency from the Soviet central planners.

  40. Gravatar of ssumner ssumner
    15. January 2012 at 07:19

    Morgan, I don’t think slower NGDP growth would have been associated with significantly higher interest rates.

    Lorenzo, I agree that this sort of thing can happen.

    Greg, No I don’t demand perfection; the policy of 1982-2007 was far from perfect, but still way better than what’s happened since.

  41. Gravatar of James in London James in London
    16. January 2012 at 02:55

    “James, I know little about shadow banking. If it matters at all, it is to the extent that it impacts the demand for money (bank reserves.) The Fed can easily offset any impact of shadow banking.”
    Always good to have a view on something you know little about. Or is that meant to be my role?

    My discussions with the Fed showed that they thought it incredibly difficult to deal with. But then maybe they know more about it than you. After all they have to deal with the very messy real world of money and shadow money (rehypothecated repo).

  42. Gravatar of ssumner ssumner
    16. January 2012 at 12:27

    James, I know little about quantum mechanics, can you give me a good reason why I need to know in order to evaluate monetary policy?

  43. Gravatar of James in London James in London
    17. January 2012 at 05:28

    Because the Fed didn’t understand how much money, traditional and shadow, there was in circulation they would (and did) struggle to know what was the best policy action to take.

    Sure they could have looked at expectations, as you would advise, but the collapse in shadow money supply was huge and unprecedented (see the IMF/Fed papers I linked to). It took them several months to fully understand the new world which had crept up on them, and us. The expansion in the Fed balance sheet is ample evidence that they were taking a lot of action, maybe not enough, but a lot.

    I don’t think it was forgetting their monetary theory that was the problem but their somewhat understandable lack of appreciation of the new monetary reality caused by the growth of shadow banking and shadow money.

  44. Gravatar of Assorted Links « azmytheconomics Assorted Links « azmytheconomics
    17. January 2012 at 13:34

    […] 2. A fun interactive graph of housing prices around the world. Note: crappy monetary policy -> bubble. […]

  45. Gravatar of ssumner ssumner
    17. January 2012 at 17:08

    James, The problem is that even if they have the data, it’s not clear what the meaning should be. If the data conflicts with the TIPS spreads, which do you put more weight on? I’d say the TIPS spreads.

    I’m sure that some economists (such as old style monetarists) would find your argument persuasive. But I’m now leaning toward 100% expectations driven policy. Perhaps you could argue for more transparency in the shadow banking system, so that expectations can be formed with more accurate data. That I could support.

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