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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?
Posted by Tyler Cowen on February 15, 2008 at 02:34 AM in Economics | Permalink
Comments
Actually, I think the "savings that really aren't there" is THE reason. If you think about it, the "money supply" is the amount of money people THINK they have. Which in itself is a huge problem because if you have liquid assets, should they be treated as money or not?
However, blaming Greenspan IS a good start as well. If you look at the mechanism: mortgage IS creating new money. New money causes prices rise where they are spent first (aka non-neutrality of money). Logically: loose monetary policy causes prices of property rise. Nobody would have every had so much money to lend on consumer debt had there not been a central bank with it's printing machine and commercial banks confident that if they overblow it, they will be bailed out.
In my opinion the crisis always unfolds because the credit expansion causes people think "they have savings that aren't there". If the Fed doesn't help/intervene, the bad banks default and people realize that they indeed do not have the savings. If the Fed intervenes, it causes inflation and much more people realize that they indeed do not have as much savings as they thought. (don't dare call it moral hazard).
The problem is that without Fed expanding the money supply the whole bubble, that COULD be created by the commercial banks alone, would have bursted long, long ago. You would have seen high interest rates which would deter majority of mortgages from ever be made. The speculators could speculate on bank failure, on drop in interest rates. They cannot now because the Fed is stronger than all speculators combined.
Posted by: andy at Feb 15, 2008 2:50:35 AM
The rising value of assets did worry Greenspan deeply.
I still remember a radio financial adviser angry with Greenspan voicing his concern. He said something like, "Do you want your house values to go down? It looks like Greenspan does."
Posted by: thehova at Feb 15, 2008 3:36:42 AM
It is true that people with houses sometimes used them as ATMs, or recklessly traded up increasing their debt burden.
But people without houses took on greater debt as well.
Barbara Kiviat is guest blogging for Justin Fox at The Curious Capitalist and floats one possible explanation. It comes from Stuart Vyse, who in his new book "Going Broke" says that it is all about the ease with which we can make instant purchases in the modern world.
Obviously that is a fractional answer too. The Amazaon order may be "too quick" for our own good, but these houses and these 6 year auto loans take long enough for deliberation.
So I still see this as a wide cultural problem (perhaps stretching to Europe) of indecent debt love.
Justin was on a similar vibe in his post five horrendous ideas for spending borrowed money
Posted by: odograph at Feb 15, 2008 7:05:47 AM
Of course, combine indecent debt-love with a business cycle, and what do you get?
Posted by: odograph at Feb 15, 2008 7:08:17 AM
And to go a step further, do the regulations that seek to limit new construction ensure that the supply of homes in London will remain well short of demand for them. London is, after all, the original home of the green belt.
Posted by: Ironman at Feb 15, 2008 8:11:27 AM
I have a quote from the Telegraph to support my contention that this is not uniquely a housing issue:
What does a glamour model have in common with a man who works in a coleslaw factory? The answer is, the same thing that links a racehorse owner to a member of the ambulance service - a destructive addiction to debt.These credit junkies are not fictional characters. They are real people, case studies in my documentary - Repossession, Repossession, Repossession - broadcast tonight on ITV1 at 10.35pm.
Our interviewees are a cross-section of modern Britain, where millions of people have been lulled into a false sense of prosperity by the soporific sound of easy money, credit on tap.
This is a DEBT issue and should harken back to those MR discussions we had about "credit snobs" (and their flip side, "debt pimps").
I think our hosts were part of a community applauding debt expansion, even among the poor, as a path to the American (or British?) dream.
Why the heck wasn't savings the path?
Posted by: odograph at Feb 15, 2008 8:27:28 AM
Andy,
It's not just the FED. The FED has tried to tighten but wound up facing a flattening yield curve. This was "Greenspan's conundrum"; low real rates despite massive debt and low U.S. savings. It turns out it was the result of the shadow banking system that Wall Street and the big banks cooked up to offload lending to foreign investors. Now, however, the shadow banking system has imploded but the FED was long ago castrated by financial engineering.
Posted by: ideogenetic at Feb 15, 2008 9:50:15 AM
re: stagnant incomes
Maybe someone can clarify this issue for me. We hear over and over that incomes are stagnant - is this really true? I know that, in real dollars, the median household income has only risen slightly, and the median individual income has risen not at all. (the household rise being due to more two earner families) That much is clear from the regular census reports.
But shouldn't we be talking about wage mobility, rather than median income? In addition to the information above, its also clear that incomes among the top portions of the pyramid are indeed growing. It also seems that, through immigration, a fairly hefty number of people are being inserted at the bottom of the pyramid. So my question is, when income stagnation is discussed, by measuring the income of the central cohort of earners and its change over time, does anyone address the issue of the actual people who make up that cohort changing? Is this worth considering? If not, why not?
Posted by: RMH at Feb 15, 2008 9:58:55 AM
ideogenetic: Sure, the money supply was expanded by the commercial entities as well. However: what do you think would have happened, if the Fed simply stopped expanding the money supply - let's say in 2002? Do you think that the mortgage firms would be able to get resources to provide these loans?
Posted by: andy at Feb 15, 2008 10:03:15 AM
But people's incomes weren't stagnant at all. Tracked on an individual basis, they've been rising pretty rapidly. Most never expected real estate prices to actually drop, meaning saving via house ownership seemed like a very viable and sound decision. For a lot of the people I know, it still is. Excluding those who bought recently, its worked well.
I don't see how savings in similar assets vs. equities or dollars is any different to the consumer? If everyone cashes out of an asset quickly, its value drops. If everyone cashes out of a money market fund at once, the bank fails.
Maybe I'm way off the mark, but to me the issue never seemed that complicated. Extremely low interest rates (and steadily dropping long-term rates) increased the demand for loans and gave banks large incentives to lend out a lot of money. Because this increase in demand was not spurred by the actual accumulation of wealth (i.e., savings), the loans tended to increase demand in the areas of the economy they were spent on without drops in spending in other areas. This meant that prices that arose were unsustainable, and the income to pay back those loans might not exist in the rest of the economy. Because of certain pieces of legislation and the securitization of mortgages, a lot of the new loans went into real estate. The tremendous demand for mortgages (and therefore MBSs) meant that the raters of these securities had large incentives to commit fraud. These badly-rated mortgages kept people from seeing the extent of the problem until they started defaulting like flies.
IMO, of course.
Posted by: Grant at Feb 15, 2008 10:04:07 AM
It is echoing to places like student loans too, for the same reasons Grant lists above. Cheap money made a big business, encouraged fraud and low-quality loans.
(Are the government guarantees on low quality student loans a shoe waiting to drop?)
Posted by: odograph at Feb 15, 2008 10:24:35 AM
1) Median wage growth has been essentially nil since 1980. Mobility is also lower than it was in 1980, not higher. See the recent NBER paper by Meyer and Sullivan, for instance. (Indeed, had the distribution of income remained at its 1980 level, the median full-time individual would have made $70,000 last year, since the labor share of GDP has not changed and real GDP has risen about 130% since 1980).
2) I don't know how we can blame Greenspan when the housing bubble was also seen in the UK, Eastern Europe, South Africa, China, etc.
3) Yes, housing prices will fall. The median house price-income ratio is a fairly constant number across the last century. I see no reason for it to have changed since 2000.
Posted by: cure at Feb 15, 2008 10:44:03 AM
"No one made homeowners treat rising asset values to be the same in value as accumulated monetary savings."
No one held a gun to their heads but abnormally low interest rates and lax (or is that "lack of") oversight in the lending markets certainly added fuel to the fire.
Posted by: martin at Feb 15, 2008 10:46:41 AM
In an interview (I think it was 60-minutes), Alan Greenspan was asked why he didn't do more when he saw there was a problem in the mortgage sector. He answered that it was like pulling off on the side of the road knowing something is amiss from the noise and smoke coming from under the hood, opening the hood and not recognizing anything you see!
It's anathema to say here in this corner of the web, but the FED's greatest sin was lax oversight and regulation. It allowed its authority to be usurped by Wall Street and now its power over the economy is also compromised.
Posted by: ideogenetic at Feb 15, 2008 10:46:48 AM
One of the typical stories about the causes of the great depression was that people should have known something was wrong when bellhops and shoeshine boys were talking about buying stocks on margin.
Perhaps the modern version of that story is all the people who wanted to flip houses and others stretching to buy houses, beyond prudent traditional limits.
Still this doesn't look much worse then the S&L crisis. Problems are concentrated in about ten communities. Hispanics may have done worse then most groups. But employment is rather steady. If we avoid the collapse of a poorly managed Bank of America ( or another large financial institution ) markets will clear. Detroit will still have the problems it had. Miami will have cheaper retirement condos for baby boomers. Life goes on.
Posted by: DanC at Feb 15, 2008 11:07:47 AM
cure,
I think you missed RMH's point about median incomes (its different people), -median- incomes move very slowly despite the fact that real incomes are going up: why? Because its different people. Include immigrants etc and this makes a huge difference.
Add to that the ridiculous nature of the CPI (how many iPods and cellphones could you buy with $500 in the 1970s?) and you have got yourself some pretty bad stats. As to mobility, relative mobility has not gone up (and may have gone down, though its debatable) but real income mobility over a lifetime is much higher in the US than in Europe and hasn't slipped at all.
It has gone up in dollar terms. That means that those who start out poor (immigrants, the young etc) end up farther ahead in real terms after a given period here and now than in 1970s or in Europe.
Posted by: liberty at Feb 15, 2008 11:35:48 AM
Once again, Tyler, you raise an issue to diss Austrian theory. (The last time, by my account, was on Jan. 3.) But surely you are aware that Greenspan in fact encouraged this kind of activity earlier this decade as a way to speed recovery (unless Gramlich not yet appeared on your "What I've Been Reading" list). Why don't you accept that all of the monetary inflation that occurred under Greenspan (see the MZM figures) can result in sector-specific bubbles notwithstanding a relatively low official inflation rate? When not explaining things like when we should fire our dentists, you are otherwise a dependable defender of the establishment. That is the only way I can understand your dismissals on Ron Paul, Austrian business cycle theory, and any other forms heterodox thinking that might threaten it.
Posted by: john at Feb 15, 2008 1:59:11 PM
Marc Faber has had an outstanding record over several decades of using an Austrian-informed macro perspective to inform investment strategy. Although a contrarian and heterodox his thinking is v influential in the hedge fund and investment community.
Here is a link to a debate between him and Gavekal
http://www.weedenco.com/welling/Downloads/2006/0802_GP_Faber.pdf
The Bank Credit Analyst and BIS have also applied the Austrian perspective to relate asset prices, credit growth and the business cycle. So perhaps, Tyler, it is only in academe where '[t]his idea has played a surprisingly small role in business cycle thinking'... People who actually have to make money in macro have been thinking rather differently from the academics.
Posted by: Hedgefundguy at Feb 15, 2008 3:23:27 PM
I think people should not borrow money not unless they can prove and have the money to pay the loan back and that's what we do at www.afsloansonline.com Personal Loan
Posted by: ek at Feb 15, 2008 4:01:05 PM
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.
The Fed's loose monetary policy encouraged homeowners to treat their homes as ATM machines, which is an empirical implication of ABCT. As Business Week points out today, "The Fed's Tense Ride," when the Fed raised rates in late 2005 and 2006, lenders, not wanting to lose customers, lowered their lending standards, which is also consistent with ABCT.
(The Economist's "Economic Focus" last week cast blame on securitisation, but that is like like blaming a gun for a gun-related murder, when the culprit is the criminal who pulled the trigger. In the case of the housing bubble [yes, Tyler, there was a housing bubble--look at the decline in homebuilder stocks after August 2005], housing downturn and mortgage forclosure mess, the Fed was the culprit. As I said before, Easy Al belongs in leg irons.)
Posted by: Bill Stepp at Feb 15, 2008 6:20:22 PM
I think I need a primer here.
If we are going to say that "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." I (for one) need an explanation of what's what.
I buy a house. The value rises / falls. My net worth rises / falls.
I guy GM stock. The value rises / falls. My net worth rises / falls.
I buy a 30 year Treasury bond. The value rises / falls. My net worth rises / falls. (Sure, I'll almost certainly get the money back in 30 years, but what will it buy?)
I buy gold. The value rises / falls. My net worth rises / falls.
I stuff my mattress with $20 bills. Inflation slowly erodes the value, so the value falls.
I inherit appreciated Zenith stock that my grandfather paid pennies for, but now is worth $$$ and pays a big dividend. But, I hold on too long, Zenith goes bust and all I get are capital losses.
So, when it is accumulated money and when it is rising asset values -- and why are they so different?
Posted by: ZBicyclist at Feb 16, 2008 3:07:19 PM
There's a few concurrent effects happening right now. I must admit, I'm more familiar with the credit market crunch than with the feared slow-down in consumer spending. However, I trace the whole mess back to rapidly rising home prices. Lenders dropped their standards because the prices of assets securing their loans were going up 20% each year. Even the stodgiest lenders had to drop their standards and prices if they wanted to make any loans in an aggressive competitive environment. I would guess that consumers were also tricked into making riskier than normal credit decisions because of the rapidly rising value of their homes. And sadly, I do trace back rapidly rising home prices to historically cheap credit in the early part of this decade. Yes, it is Greenspan's fault. I would love for someone to convince me otherwise, but be forewarned that I do not buy Krugman's "greedy banker" hypothesis.
Posted by: Jacob at Feb 18, 2008 11:28:50 AM
And I think all of this would have happened with or without HELOCs. To the extent that we were banking on homeowners to spend their newfound "wealth" to drive the economy, I think we could be in trouble. However, I am one of the odd people that think's it's OK to have a quarter of negative economic growth every once in a while, if there's a good reason for it. Restoring consumer spending to a sounder foundation sounds like a good reason to me.
Posted by: Jacob at Feb 18, 2008 11:33:42 AM
Can't moral hazard be avoided if the stockholders are wiped out?
And isn't there a chance that the government can later sell its stake and recover it's investment (as the U.S. Government did with Chrysler)?
And isn't the avoidance of panicky runs on the banks a public good?
Posted by: ZBicyclist at Feb 18, 2008 11:03:00 PM
Even if the real estate bubble bursts, the stringent limitations on building around large cities, such as London, will remain. This maintains high housing prices in the long run. The market would probably drop independantly of any bubble burst if the 1947 Town and Country Planning Act were removed.
Posted by: Stéphane at Feb 22, 2008 2:40:41 AM
