I usually agree with just about everything David Beckworth posts, but I can’t quite buy the argument he makes here.  David argues that low interest rates fed the 2001-06 housing boom.  And not just low interest rates, but a Fed policy of low interest rates (which I see as a completely different argument.)

When the tech bubble burst, business investment plummeted.   How should the economy react to that shock?  In a classical world interest rates should fall sharply (regardless of whether a Fed even exists) and other types of output, such as residential investment, consumer goods, and exports, should pick up the slack.  And that’s about what happened.

In my view interest rates are a very poor indicator of the stance of monetary policy.  Both David and I favor roughly 5% NGDP growth targeting.  As long as NGDP is growing at about 5%, monetary policy is on target, regardless of whether interest rates are 1% or 100%.  And if you look at NGDP growth during the Great Moderation, it was in fact pretty close to 5%, on average.

During 2001 and 2002 NGDP growth fell a bit below 5%, and that’s why the Fed cut rates to 1%.  In the subsequent expansion NGDP growth rose a bit over 5%, and the Fed reacted by raising rates sharply.  I can see how someone would have thought money was a bit too easy during mid-2003 to 2006, when NGDP growth was above 5%, but I can’t see any catastrophic failures that could account for the spectacular sub-prime fiasco.  We had even faster NGDP growth in the 1960s, 70s, 80s and 90s, none of which had a destructive housing bubble.

Update, 12/5/10:  Marcus Nunes sent me the following:

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Having said all this, if I could go back in a time machine and run the Fed, I’d have raised rates faster in the 2003-04 period.  But that’s not because I would have expected a much superior NGDP performance, but rather as a second best policy to address a catastrophic failure in our regulation of banking.

There is a widespread view that economists on the right favor “deregulation,” and economists on left favor increased regulation of banking.  And the events of 2007-08 allegedly showed the left was right and the right was wrong.  And I can understand why many people feel that way.  Some right-wing economists did in fact offer poor policy advice–touting places like Iceland and Ireland as models of deregulation.  But I think that’s the wrong way to think about regulation, I’d argue that places like Canada and Denmark are the true models of deregulation.

The problem is that people tend to think of the term ‘regulation’ as meaning something like ‘restraint’ whereas in the left/right debate over the role of government it means something closer to ‘intervention.’  Consider the advent of zero money down, no income verification mortgages.  Does allowing banks to make those mortgages constitute “deregulation?”  Not in my book.  As I taxpayer I have always strenuously opposed all the federal interventions that make it easy to borrow money to buy a house–Fannie and Freddie, FDIC, FHA, etc.

Consider FDIC.   Despite the fiction that banks pay the cost of FDIC insurance (about as likely as assuming gas stations pick up the cost of the federal excise tax on gasoline), FDIC insurance is a burden on us taxpayers.  In a perfect world we’d have NGDP futures targeting and there’d be no need for FDIC.  But in the world we live in deposit insurance is unavoidable intervention into the free market.  I’d like to limit its reach as much as possible.  I resent my tax money insuring banks that make sub-prime mortgage loans, or risky construction loans.  I’d like to ban FDIC-insured banks from making housing loans with less than at least 20% down.  I am not opposed to allowing sub-prime loans, just not with FDIC-insured money.  If some unregulated financial intermediary wants to make such loans, that’s fine with me.  I am no expert on this area, there might be alternative regulatory fixes that involve substantial private mortgage insurance, or some mix of insurance and equity.  The point is that any and all acts that reduce the ability of banks to make FDIC-insured loans is “deregulation” in my book— it reduces the size and scope of the inefficient FDIC.  For instance, I consider the Bush administration’s attempt to regulate the GSEs more tightly (opposed by my Congressman, Barney Frank) to represent deregulation.

There are actually two Republican parties in America.  One wants to do real deregulation, to actually reduce the role of the government in the economy.  The other Republican party (which I fear is the more powerful one) wants to do “deregulation,” to remove all constraints on business, banking, the medical industrial complex, energy, for-profit colleges, etc, so that they can systematically loot the taxpayers by taking advantage of the enormous moral hazard that has seeped into almost all aspects of our modern regulated economy.

The Dems are more likely to want to try to tame the beast, but then keep passing laws that make the economy even more riddled with moral hazard.  Not much of a choice these days.

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.

A recent FT article by Vernon Smith and Steven Gjerstad discusses two big housing crashes, one occurred between 1928 and 1929, and the other occurred between 2006:1 and 2008:2.  Both were associated with substantial increases in RGDP.  Why didn’t real GDP decline during these two big shocks to a major industry?  Why was unemployment so low?

There are two reasons.  First, jobs in housing construction are not a particularly large share of total employment.  The direct loss of jobs was in the 100,000s, not millions.  In addition, many of the workers who lost jobs in construction gained jobs in other sectors.  Thus RGDP continued to grow.

The article by Smith and Gjerstad contains two of the best graphs I have ever seen for illustrating the amazing resilience of the US economy.  In 1929 (a boom year) housing output fell by roughly 30%.  The recent downturn is even more striking.  Notice the severe decline in housing for 9 straight quarters during a period where RGDP is trending upward. The ability of RGDP to grow while a major sector is contracting is quite amazing.  Yet for some odd reason they drew almost the exact opposite conclusion that I did; they argued that the housing crashes of 1928-29 and 2006-08 caused severe recessions.  Why is that?

In my view their key mistake was to misinterpret the role of monetary policy.  In each case, housing continued to decline further after the period I cited.  And in each case NGDP, which had been growing, suddenly began declining as well.  It was the decline in NGDP, not the additional fall in housing, which caused the severe recession and the job losses all across the economy.  If NGDP had kept growing at 3% to 5% after 1929, and after 2008:2, the housing downturn probably would have ended, and the economy would have avoided a severe recession.

You might ask; “Isn’t it a bit implausible that two severe recessions would be preceded by housing collapses, if those collapses had no causal role in the recessions?”  In fact, the housing collapses and the subsequent recessions probably were related, but in a very indirect fashion.  Here’s what probably happened in both cases.  As housing declined, the equilibrium “natural rate of interest” began to decline as well.  There was less demand for credit.  At some point the natural rate fell far below the Fed’s policy rate, causing monetary policy to tighten accidentally.  Because Fed officials (and many private economists) wrongly think that the level of interest rates are a good indicator of the stance of monetary policy, they failed to notice that monetary policy had tightened sharply.  But the markets noticed, and there were big stock market crashes in October 1929 and October 2008.

But that can’t be the whole problem, because Smith and Gjerstad do discuss the fall in velocity, and correctly attribute it to the decline in nominal interest rates.  And of course this fall in velocity is just another way of thinking about the fall in the natural rate of interest that I discussed earlier.  So they understand that a housing collapse can reduce interest rates, velocity, and hence NGDP.  So again, why do they reach such different conclusions?

I think in the end it has to do with their approach to monetary policy.  They view the fall in velocity as something that the Fed would have had a hard time counteracting.  And they would undoubtedly point to the fact that the Fed did in fact fail to counteract it.  In contrast, I am much more optimistic about the ability of the central bank to maintain stable expected NGDP growth in a period of financial turmoil, and believe that very little of the fall in velocity that Smith and Gjerstad cite was actually caused by the housing slump.  Instead, almost all of it was caused by two monetary policy mistakes.  One was the failure to do NGDP targeting, level targeting, which would have maintained positive longer term NGDP expectations.  And the other error was paying interest on excess bank reserves.

In his Big Think interview, Vernon Smith suggested that banks took excessive risks in the 1920s.  This seems plausible, after all, lots of banks failed in the 1930s.  But in fact banks were much more conservatively managed in the 1920s than today.  If you take a close look at this graph from The Economist, you will see that bank equity was above 10% of assets throughout the 1920s, and was close to 15% on the eve of the Great Depression.  So that wasn’t the problem.

Then what went wrong?  Why did so many banks fail in the 1930s?  The answer is simple, NGDP fell in half.  The funds people and firms use to repay loans comes from income.  If nominal income falls in half, there will be many defaults, regardless of how sound the loans seemed before the Depression began.

What about today?  It is more complicated.  This time Smith is partly right.  There were many foolish loans made during the past decade, and we know this because the sub-prime crisis occurred while the economy was still booming in 2007.  About all you can say in defense of the banks is that the fall in NGDP after mid-2008 made the losses several times worse than otherwise.  But even some of that is the banks fault, as they need to anticipate the possibility of at least a mild recession, although perhaps one can excuse them for not expecting NGDP to fall at the fastest rate since 1938.

In any case, it’s not about blame, it is about figuring out where we go from here.  And despite the fact that I diagnose the problem slightly differently from Smith and Gjerstad, I reach almost identical policy conclusions from those discussed by Smith in his recent Big Think interview:

1.  We should require much more collateral on loans and derivatives

2.  We should raise the price level 6% (although I would substitute NGDP for the price level.)

PS.   I couldn’t copy the FT graphs, but this one from The Economist shows just how much of the housing downturn had occurred before the recession even began.  Starts had fallen from over two million to roughly one million in late 2007.  In the early part of the recession, starts actually leveled off at close to one million, but then fell to 500,000 when NGDP declined sharply.

PPS.  Tyler Cowen links to a graph showing the effect of “recalculation.”  Oddly, a few weeks back I linked to a similar graph arguing that it showed recalculation was a minor factor in the current recession.  BTW, the graph he links to has an error; unemployment rose between July 2009 and November 2009, whereas it shows a decline.  But I shouldn’t throw stones as a commenter named Tom found errors in my graph as well.

I was born in Michigan, grew up in Madison, and went to grad school in Chicago.  These three areas encapsulate how I think about the recession.  Chicago is a cross-section of America, with a highly diversified economy.  Its unemployment rate is 10.3%, close to the national average.  Madison is blessed with unusually acyclical industries, and I don’t recall it ever experiencing high unemployment.  Because its economy is dominated by state government, college education, insurance, biotech, and dairy, it has only 5.5% unemployment.  At the other extreme is Detroit, with 15.4% unemployment.  Detroit has two problems.  First, heavy industry is unusually cyclical, and thus steel, autos, machinery, etc, will suffer more job losses when AD falls, even if there is no recalculation.  Of course the auto industry is the main problem in Detroit.  It is not true that the US auto industry is in a long term state of decline, but the Big 3/UAW auto industry is in a long term state of decline.  So Detroit’s unusually high unemployment rate is due to both cyclical factors and structural (recalculation) factors.

HT:  Mike Belongia

I am pretty sure the liberal bloggers won’t like John Allison’s interview.  Next to Allison, I’m practically a socialist.  I’ll start off with what I liked, and then discuss what I didn’t like.

Allison was clearly out to pin the blame for the current crisis on the government:

The government owns the monetary system in the US. In 1913, the monetary system was nationalized. If you’re having trouble in the monetary system, by definition, it’s a problem of government policy.

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I think getting rid of deposit insurance would be wonderful. In fact, 10, 15 years ago, the financial services roundtable actually went through an exercise looking at a cross guarantee program among the large financial institutions. I believe that if we put that program in place, similar to what happens with the insurance industry, what the brokerage industry has, we would never have had, even with the Federal Reserve, even with Freddie Mac and Fannie Mae, we certainly wouldn’t have had a misallocation of the magnitude we had. Deposit insurance played a huge role in the big failures, in the Golden West, in the Countrywides, in Washington Mutual, etc., etc. And the reason for that is the FDIC, this is my experience of that career, in good times, they don’t really impose any kind of discipline, and then in bad times they overreact. Right now, the FDIC is tightening like crazy, making it much harder to make loans.

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If we had a co-insurance pool, where the banks really were taking the risk, we would be far more disciplined to make sure the companies that were in our co-insurance pool had enough capital and had the proper kind of risk standards. So I’d vote to get rid of FDIC insurance, not that we don’t need it, we need some kind of insurance, but I think it ought to be an industry-based, industry-controlled pool where we would have a huge motivation to discipline all the participants in the pool.

I am increasingly of the view that moral hazard is the central problem with our financial system.  This is partly because I was already leaning that way, and partly because I found Charles Calomiris’s recent interview on EconTalk to be quite persuasive.  Most people don’t think of it this way, but in 1934 we essentially nationalized the liabilities of the entire banking system.  We teach our students that when you deposit $5000 in your bank account you are actually loaning $5000 to that bank.  Not true.  You are loaning $5000 to the Treasury, and they are re-loaning the funds to the bank.  And the Treasury absorbs the losses if the bank defaults. 
Den ganzen Beitrag lesen…

Maybe everyone knew this already, but I didn’t:

Three trends in the U.S. housing market combined to dramatically magnify the losses of homeowners between 2006 and 2008 and to increase the systemic risk in the financial system. Individually, these trends – rising home prices, falling mortgage rates, and more efficient refinancing – were neutral or positive for the economy. But together, they lured masses of homeowners to refinance their homes and extract equity at the same time (“cash-out” refinancing), increasing the risk in the financial system, according to Amir Khandani, Andrew Lo, and Robert Merton. Like a ratchet tool that could only adjust in one direction as home prices were rising, the system was unforgiving when prices fell. In Systemic Risk and the Refinancing Ratchet Effect (NBER Working Paper No. 15362), these researchers estimate that this refinancing ratchet effect could have generated potential losses of $1.5 trillion for mortgage lenders from June 2006 to December 2008 – more than five times the potential losses had homeowners avoided all those cash-out refinancing deals.

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Using a model of the mortgage market, this study finds that had there been no cash-out refinancing, the total value of mortgages outstanding by December 2008 would have reached $4,105 billion on real estate worth $10,154 billion for an aggregate loan-to-value ratio of about 40 percent. With cash-out refinancing, loans ballooned to $12,018 billion on property worth $16,570 for a loan-to-value ratio of 72 percent.

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This ratchet effect can create a dangerous feedback loop of higher-than-normal foreclosures, forced sales, and, ultimately, a market crash. With home values falling from the peak of the market in June 2006, the study’s simulation suggests that some 18 percent of homes were in negative-equity territory by December 2008. Without cash-out refinancing, that figure would have been only 3 percent.

Does this matter?  I am not so foolish as to try to make moral judgments about millions of people I have never met, so you won’t catch me saying; “Aha, they weren’t taking out these mortgages to put a roof over their children’s heads, but rather to get cash to buy a big screen TV and a boat.”  For all I know the cash-outs were to meet unforeseen medical expenses.

But here is how it might matter.  Earlier I mentioned that in a world where first best policies are politically impossible  (i.e. eliminating FDIC, TBTF, Fannie and Freddie, tax deductibility of mortgage interest) then maybe we should consider second best policies such as a requirement that people put at least 20% down on mortgages.  At the same time I recognized that even that sort of regulation would be impossible to get through Congress.  It is true that countries such as Canada and Denmark make it tough to get sub-prime mortgages, but their political systems are probably much less corrupt than ours.  Perhaps if we formed 50 separate countries, as I advocated earlier, we might get sensible reforms in states (like Minnesota?) with cultures similar to Canada and Denmark.

But this NBER study suggests there might be a slightly more politically palatable alternative, which could be almost as effective.  What about simply requiring at least 20% down on all refinancing, but continue to allow sub-prime loans on home purchases?

I suppose people would try to evade these regulations by moving next door.  Of course that sort of subterfuge is very costly, a factor that cuts both ways when considering the pros and cons of this sort of regulation.  Or how about exempting only first time home buyers from the 20% down.  Would that be more politically feasible?  Would it be too costly to enforce?

My first choice is still for second best policies that require everyone put at least 20% down on all mortgage loans, as this sort of regulation would also address another government failure, the enormous disincentives to save built into our fiscal policies.