Simple theories of the business cycle

…during a period of pretty stagnant incomes, people have been ratcheting up consumption based on increased wealth derived from their homes. People weren’t, however, actually selling their homes to get money and buy stuff. Instead, they borrowed. But with home values plummeting, now there’s big trouble.

That is from Matt Yglesias.  If you’re looking to apply "Austrian business cycle theory" to the current crisis, this point is a better place to start than by blaming Greenspan’s admittedly over-loose monetary policy.  No one made homeowners treat rising asset values to be the same in value as accumulated monetary savings.  But many of them did.  And the mechanism may be this: in private terms people treat accumulated money and rising asset values as the same.  But in social and macroeconomic terms the implications of those two forms of savings are very different.  In particular the social risk of saving through asset values is higher, given the correlation of market values and returns.  Nor are their liquidity properties the same if everyone needs to "rush for the exits."

Insofar as you think people are tricked by "savings that aren’t really there," asset values are the most likely the relevant mechanism.  This idea has played a surprisingly small role in business cycle thinking over the last century, although it has been floating around since at least the 1930s.

Right now everyone in London is wondering if a real estate bubble is about to pop.  Or does UK tax law, combined with greater international mobility, mean the new prices are more or less permanently high?

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