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The return of Hayek?
Except his name is John Taylor:
Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.
Here is the paper. A Hyman Minsky fan, however, might challenge whether this data really supports Hayek's theory. An alternative theory is that markets are bubble-prone and that easy monetary policy was simply a trigger that set off an irrational speculative excess. The Austrian story is that "the government distorted price signals to the market." Are those two accounts really so different? Do we need metaphysics to resolve that question? Take the classic "thin skull" case in the law. Austrians won't describe it this way, but they are postulating a very thin skull for markets and then blaming government for the disaster which results from government's glancing blow to that skull.
Keep in mind that no entrepreneur looks at price signals exclusively, rather they interpret prices in the context of the real economy and other bits of knowledge Was it so hard for investors to say to themselves?: "I see that one price (short-term rates) has changed in favor of greater housing investment. But other parts of my brain tell me that real estate prices won't go up forever, levered positions are dangerous, and that I should be cautious."
Let's say that the government subsidized the price of bananas, you bought so many bananas, put them on your roof, and then the roof collapsed. Is that government failure or market failure? The price was distorted, but I still say this is mostly market failure. No one made you put so many bananas on your roof.
If Minsky and Hayek are running in a race for interpreting the last two years of the U.S. macroeconomy, Hayek has something to offer but so far Minsky is in the lead.
Posted by Tyler Cowen on January 2, 2008 at 09:03 AM in Economics | Permalink
Comments
Would the Austrians not argue that the skull is thin due to past interventions. Woudln't people learn from smaller more frequent, more local bubles?
Posted by: Floccina at Jan 2, 2008 9:34:14 AM
Suddenly I fear I don't understand what "market failure" means. I always thought of "market failure" in terms of things like adverse selection. Why is my predilection for bananas a failure of the market, and not simply a failure of my own thought process? Or is your point that the latter *is* the former?
Posted by: Rich at Jan 2, 2008 9:43:02 AM
But many people started to ignore the price of the house and only looked at the monthly payment, as long as the monthly payment seemed OK the price of the house was ignored. If you have a fixed rate loan and you don't plan to move, you are still doing OK. You have a large house with an affordable fixed payment. But if you took a risk on your loan, or who looked to flip your house, you are in trouble. (As are those who must relocate or sell for some reason.)
The market knew that the Fed action was temporary and many felt that they had to act quickly to exploit the opportunity. But the Fed action had the largest impact on adjustable rates. Overly optimistic views of the future of housing prices led to many buyers taking greater risks then they should. Markets like Chicago saw a temporary shortage in housing, which led to prices increasing much quicker then incomes. Many buyers were willing to take on greater risk, to buy into a hot market, out of fear that the shortages would continue into the future.
I was shocked at parents telling young adult children that they should stretch to buy a home because the children would never see such low interest rates again. These parents remembered the high interest rates of the seventies. So prudent debt levels were ignored and many house buyers became monthly payment buyers.
Still the vast majority of buyers are not defaulting. Ohio and Michigan are having troubles but the cause is a weak local economy not a housing bubble. Florida and California are having trouble, in part do to excess speculation in housing. But the history of Florida is filled with such housing bubbles - as is California. Some fraud occurred as people tried to exploit a heated market. Some people made terrible choices. Some lenders played hot potato with loans.
Did low short term rates cause a bubble? Yes, to the degree that people were willing to ignore traditional affordability guidelines and take on greater risk. Yes, because it increased short term speculation in housing markets.
Posted by: DanC at Jan 2, 2008 9:53:19 AM
I think deciding if things are a market failure or government failure depends on your point of view.
Every time the government increases the subsidy for something they increase the rewards for the people who were the greatest speculators. Those people earn more money than less speculative people and in future have more economic decision making power. If the process continues then eventually people do start building roofs out of bananas.
Is this a government or market failure? I guess as long as the government was responding to market forces (kickbacks) it is market failure. For people who think the government should only deal with things like enforcing the rule of law it would be a government failure.
Posted by: Jason at Jan 2, 2008 9:59:33 AM
I agree with DanC. The non-organic growth in housing prices was caused not directly by the low interest rates available, but by the ability for buyers to purchase "more home" with the same (initial) monthly payment, thanks to the spike in non-traditional mortgages. This quickly shifted from being able to purchase a larger or nicer home to being able to bid more for a smaller home to ensure that you get it in a frenzied market. This, in turn, fed the myth that housing is more than a safe investment, that it is a guaranteed goldmine. This, in turn fed the frenzy more, and the market spiraled upwards in bidding wars that never would have been able to occur in a world of only fixed mortgages. Add speculators to the mix and the bubble is complete.
The three things I fault the government with in relation to the bubble are:
1. Allowing too much rampant "creativity" in the mortgage market. I know that some people will argue that the government forced lenders to make loans to people of less means, but I am not referring to predatory practices here. I think most people knew the loans were risky but were wildly overoptimisitc about their investments, such as someone buying Internet stocks on margin in 2000. These types of mortgages should not be banned, but when the market first began to become so clearly distorted (~2005), something should have been done to curb these types of mortgages and the price spiral they encourage. Alternately, the fed could have raised rates to curb the bidding war, but I do not attribute the low rates as the direct cause. Why hurt everyone just to curb housing? Attack the source.
2. Continuing to be a cheerleader throughout the boom. MSNBC, Fox, and all the major nows outlets prefer optimism in business news (rightfully so). But when there is clearly something unprecedented going on in a market they tend to overplay the optimism card, having a panel of 4 bulls and 1 bear (if that)! Serious debate winds up being minimized and overpowered by rationalizations that we are in a new paradigm (tech stocks in 2000, housing prices in 2006). The Fed and the government should have taken a more sober look at what was going on. Instead they lended yet more force to the arguments of the cheerleaders.
3. Retaining mortgage interest expense as a tax write-off. This greatly distorts the rent-vs.-buy decision. Although in general it is a good thing to incentivize owning a home over renting, in this market it reinforced the myth of "you can never go wrong buying a house no matter what price you are paying." I held off purchasing my first home because I became convinced as of 2005 that we were due for a major correction. As a renter, therefore, I am frustrated by the distortion on my tax return!
Posted by: Erik at Jan 2, 2008 10:23:35 AM
First of all, buying a house is consumption, not investment. Therefore, price is very important. Lower interest rates means lower prices and consumers buy more when there is a sale.
As for investors, they are stuck with interst rates below the rate of inflation (a local bank is still paying less than 2% on savings). They have an incentive to borrow and an incentive to stretch for yield, searching out the extra percentages offered by riskier assets.
There were separate groups, consumers and investors, independently responding to price signals created by the Fed. It was financial innovation, not a bubble mentality, that linked the two groups.
Posted by: 8 at Jan 2, 2008 10:56:37 AM
If it is market failure, that term doesn't mean what most seems to think it means. When the roof full of bananas collapsed, it was either personal failure or engineering failure. That there are markets for bananas and structural engineering cannot mean that anytime a trader makes a bad deal in those markets the *market* has failed. The *market* succeeded at the moment of voluntary exchange.
The outcome of exchange is an individual assessment. The *market* wasn't trying to sell more bananas than a roof could hold, it was merely offering quantity at price. The abstract *market* is not aware of anyone's roof. Government, however, might have policy aimed at controlling quantity and/or price. The state is much, much more appropriately evaluated as if it were an individual sentience than any market. If government encouraged more bananas at a price, it could be seen to support individual failure. When the roof collapses, the government shares some responsibility, probably not through direct malice, but through the negligence of unintended consequences.
Posted by: foxmarks at Jan 2, 2008 11:40:53 AM
I agree with Tyler. The Austrian theory has always postulated a "thin skull." Ludwig Lachmann always complained about this! Incidentally, two of the major Austrians of the middle-generation, Lachmann and Israel Kirzner, were never hot on the Austrian theory of the business cycle. Kirzner once said about it, "What is so "Austrian" about this Austrian theory?" What he meant is that it has a very (too) simple theory of entrepreneurial expectations.
Posted by: Mario Rizzo at Jan 2, 2008 11:54:56 AM
Two issues. First, did low interest rates create a housing bubble? Two, did low interest rates contribute to the sub prime mess?
Lower interest rates did increase demand for housing. But that is hardly a market failure. People could afford more homes and in markets with limited supplies prices escalated.
Housing markets are designed to extract the highest possible price from the highest demand buyer so a minority of buyers can temporarily distort the value of a market. Housing markets are illiquid by nature so in an up market transaction prices are higher then the "true" long term price and in a down market transaction prices are lower then "true" long term prices. Did the Fed help create noise about the true market price by increasing some demand at the margin? Yes. Is that a market failure? Not really, most people had started to shake their heads at the prices the market had reached. The winning bidder in an auction always bids a price that others at the auction think is too high.
The bigger problem is the sub prime market. Did the Fed contribute to the sub prime mess? The Fed increased demand for housing but they did not change the guidelines for loans. The ability of lenders to play hot potato with loan papers and a move away from community based lending encouraged lenders to take greater risks. The lenders should have known (did know) the housing prices were above long term levels (based on affordability) and that zero down loans were risky. Some lenders saw great opportunity in these risky loans, they perceived that the market was incorrectly pricing the value of these loans. They were able to convince others that these loans, as a group, were relatively safe. Is it the Feds fault that the market mis-priced the risk of these loans? No
Posted by: DanC at Jan 2, 2008 11:57:16 AM
Isn't Tyler guilty of a mistake that he normally argues against, which is tacitly comparing second-best economics with first-best people and/or government? Distorted price signals make people extra dumb, but if we had private fiat currencies and therefore more stable monetary policies, wouldn't people act a little less dumb?
Posted by: Justin at Jan 2, 2008 12:00:47 PM
I think the wrong question has been asked. Whether the current problem is a market failure or a government failure is not a meaningful question. Whether the country would have been better off with a gold standard or some other type of monetary policy is really the bottom line. If markets are indeed prone to bubbles, I certainly think they are, what types of policies help limit them?
Posted by: Sam at Jan 2, 2008 12:01:02 PM
Another factor is county slow growth policies. Slow growth policies (over regulation) according Ed Glaeser lower the elasticity of supply helping to drive up prices when interest rates fall.
Posted by: Floccina at Jan 2, 2008 12:22:40 PM
I would assume Tyler understands atotbc very well, but based on how he describes it, I would think he either is under-explaining it to make his point or that his views on monetary policy have changed such that he doesn't give much weight anymore to the effects of interest rates on market forces.
Posted by: John V at Jan 2, 2008 12:50:14 PM
The Austrian [Business Cycle] theory has always postulated a "thin skull."
It may seem that Austrians believe all business cycles were due to central bank manipulation of interest rates, but isn't it reasonable that Hayek was describing a mechanism that could yield a cycle, without declaring that all economic downturns are due to that mechanism?
It is hard to believe that the dot-com boom/bust was a classic Austrian cycle. More likely, when market participants -- many of them young and inexperinced -- were faced with extraordinary new circumstances, they did not react with great foresight and bid stock prices up to unsustainable levels.
The argument for markets is not that outcomes are always perfect, but that markets are more likely to get it more right than alternatives. We can admit that free markets can experience bubbles without admitting a tendency toward bubbles or that other institutions could do better.
In contrast to the dot-com case the housing bubble may be more "Austiran". In the face of significant financial-market innovation (variable rate mortgages and securitization of sub-prime loans), market actors could be expected to not get everything perfectly right. But the number and scope of market errors may have been fueled by low interest rates the Fed employed to goose the economy after 9/11.
But why wouldn't entrepreurs realize that low interest rates were distorting the market and prevent the boom/bust cycle? Even if 90 percent of home buyers made no errors, many home buyers could still get in over their heads. And there are limited ways in which entrepreneurs could cool an overheated housing market by short-selling. If you see inflated house prices you can sell your own house, but you can't short-sell your neighbor's.
It is hard to imagine setting up short-selling mechanisms for such heterogeneous goods due to transaction costs. Ironically, securitization may be a necessary step toward a short market. There are ways to short mortgage-backed securities, though that would not bet a straight be on housing prices.
Posted by: John Kunze at Jan 2, 2008 1:19:59 PM
I wonder what some of the defenders of high executive pay are saying now.
Clearly the source of the credit crunch is that a lot of highly paid financial experts paid way too much money in the secondary market for subprime mortgages. Some snake oil salemen convinced them with a lot of hand waving that these things were AAA investments. This encouraged the suppliers of these items to ramp up production.
Before the end, they were making 100% loans to people whose whole income would not cover the mortgage payment after first reset....let alone a more normal level of 30-50 % of income. And why not? If you are just going to resell the loan, what do you care if is obviously going to default.
Posted by: RobbL at Jan 2, 2008 1:28:22 PM
Some errors are not failures. Sometimes, overconfidence is neither a market failure nor a government failure.
Everyone has bashed the financial forecasters employed by the lenders, the cheerleaders in the housing industry, the frenzied property flippers, and the optimistic government regulators. What about the ivory tower? Could an "objective" academic observer have believed, in 2005-2006, that the U.S. housing market had good fundamentals? See Nicolas Retsinas, as promoted by Harvard University's Joint Center for Housing Studies.
"Cassandra, though, can stop wailing: the expected price corrections mark a slowing in the rate of increase -- not a precipitous decline."
If you want to look up the whole piece, among the places the article appeared include the Providence Sunday Journal on September 24, 2006 (pretty late in the game).
I don't want to pick on Nicolas Retsinas, a study by the FDIC (February 2005) on the history of housing booms showed that only about half ended in busts.
Rising house prices, even at a slower clip, would have significantly reduced the incentive for lenders to resort to foreclosure. I really think people need to remember some of the lessons they learned as kids. Just because a play doesn't work does not mean that the play wasn't a good call when it was made. Expectations are going to be wrong a lot and that doesn't mean that there had to be either a market failure or a government failure.
But, if we have to blame someone for wrong expectations, I want to add the FDIC and Harvard's Joint Center for Housing Studies.
Posted by: tedm at Jan 2, 2008 1:50:02 PM
... I think the failure is with the idiot who decided to put bananas all over his roof.
I mean call me crazy...
Posted by: Jon at Jan 2, 2008 2:59:22 PM
Sub-prime represents a very small percentage of the mortgages in the U.S. While low interest rates did encourage people to supersize their house purchases, we are looking at a problem which goes beyond a housing bubble in the U.S. Some numbers on the extent of the sub-prime problem in the US:
http://mjperry.blogspot.com/2007/12/putting-subprime-in-perspective.html
The international liquidity crisis goes beyond a housing slump in the U.S. Several years ago, the international banking rules were changed increasing capital required for conventional mortgages. These stringent requirements did not apply however if mortgages were bundled into securities encouraging the proliferation of securitization of mortgages. When the market for these financial products evaporated, banks and financial institutions were forced to bringing these loans back onto their balance sheets and set aside capital to guarantee the loans thereby lowering global liquidity (ie. a bank can't loan capital that it is required to set aside).
The increased capital requirements were meant to strengthen the international banking system and they have produced the exact opposite effect, the proliferation of financial instruments that increased the leveraging of the financial sector. Here, it would appear to be both a government failure at the international level(ill-conceived public policy creating the opposite effect from the one intended) and a market failure (irrational exuberance).
Posted by: Sophie at Jan 2, 2008 5:52:11 PM
When you're wielding a baseball bat, everybody has a thin skull. Or when you're wielding a monopoly on the currency. In a competitive market the Fed would have driven itself out of business with such low rates. As it is, in the international market, which unlike the domestic currency market is competitive, its dollar is losing ground rapidly to the better managed euro.
BTW, for what the analogy is worth, in law the entire responsibility, including the payment of all damages and normal and abnormal, falls on the person who touched without consent the guy with the thin skull. When it comes to doing things to other people without their consent, traditional law demands that the actor be very risk averse. Because, as the thin skull example shows, the person with the right of consent usually knows far more about the situation than the actor does.
Posted by: nick at Jan 2, 2008 8:58:03 PM
BTW, the main blame relevant to economists must fall on Econ 101 classes that teach about perfect markets and risk premiums but fail to teach about moral hazard and adverse selection, and how these create risks which often (as here) cannot simply be repackaged and traded away without increasing the risk. These investors and mortgage brokers, as well as a surprising number of economists, apparently never got beyond that kind of Econ 101.
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Posted by: nick at Jan 2, 2008 9:05:50 PM
So, when the government seizes the very thing that makes the market so effective - price signals conveying dispersed, tacit information - and causes failure, thats a thin skull? Huh.
"I see that one price (short-term rates) has changed in favor of greater housing investment. But other parts of my brain tell me that real estate prices won't go up forever, levered positions are dangerous, and that I should be cautious."
Investors said that quite often; I even know a few people who said that on the board of a publicly-traded bank. However, Wall Street's quarterly-obsession and the fact that the harm from credit crunches are spread out over all actors meant that banks faced strong incentives to lend anyways. We gotta keep up with the Jones' Bank this quarter, ya know?
Do we think that the short-term obsession of many shareholders of public companies is something which is natural in a stock market, or is the product of heavy intervention and regulation? How far do the unintended consequences of the SEC go? Can we even know?
Posted by: G at Jan 3, 2008 12:58:52 AM
Thanks to state intervention in the credit market, lots of people got a house at fixed interest rates and payments they can afford. The fact that the house may well fall a bit is not a problem for them. They jumped in to grab an opportunity that might soon go. Because lots of people were jumping in to grab a limited number of opportunities led to instability in prices. Lots of flippers made lots of money out of that. Then there are all those mexican housebuilders who take advantage of legal restrictions on housebuilders that do not apply to the home owner. They buy a small house on large land, do home improvement until it is a large house, and get rich by so doing.
None of these people are acting irrationally. They all made lots of money, or got houses at affordable mortgage payments a time when it is almost impossible to get approval to develop housing. The market is not thin skulled, rather people are reacting rationally and efficiently to artificial state inefficiencies.
Posted by: James A. Donald at Jan 3, 2008 2:58:05 AM
Blame the housing bubble on fraud and credit default swaps in the "off the books" shadow banking industry. Mortgage loan officers were paid well for originating loans (sub-prime, Alt-A and HELOCs) that had poor prospects of ever being repaid. Once the originator was paid, he wiped his hands of the loan and sent it to investment bankers or private equity funds that would securitize it through a network of insurers insuring insurers, until nothing was really indemnified. It became difficult to figure out who was responsible to the actual loan investor.
The boarded-up city of Cleveland, where the poorest home owners were encouraged to pour debt upon debt, stands as a monument to a system gone amuck. Massive Wall Street bonuses, paid by companies of dubius solvency to their financial engineering sociopaths, proved that crime did pay. The real estate values in Manhattan and Cleveland moved in opposite directions. As for government intervention, while most governments turned blind eyes to a rigged system, AG pimped adjustable mortgages (just as he was starting to raise rates).
Posted by: ral at Jan 5, 2008 8:09:13 AM
Jesu Christu, don't you folks follow the literature? Carilli and Dempster handled the "why don't entrepreneurs see ABCT coming" complaint several years ago!
Posted by: Gene Callahan at Jan 9, 2008 10:22:22 AM
"Do we need metaphysics to resolve that question? "
Oh, yes we do -- the Absolute, in postulating its own becoming, carries within it the seeds of ABCT.
Or, read another way, the above response is no less absurd than was Cowen's question.
Posted by: gene Callahan at Jan 9, 2008 10:30:54 AM
