Organizations and Markets

Monetary Policy and the Housing Crisis

| Dick Langlois |

I know I’m swimming over my head in macro-infested waters, but I thought I would think out loud some more about the housing mess. In my previous post on the subject (and comments), I posed the question whether a politically influenced (exogenous) lowering of credit standards was more of a culprit than monetary policy (or other macro forces) in causing the housing bubble and subsequent collapse. So I looked at an NBER Working Paper by John Taylor at Stanford that’s been out for a few months. Taylor argues that it was indeed Fed policy that caused the run-up in housing prices. He rejects the alternative possibilities (A) that most of the liquidity fueling the boom was money rushing in to the U.S. from overseas or (B) that it was the increased liquidity that came from securitization and financial innovation. Most interestingly, he argues — as have others, though I can’t find a good reference — that a large part of the reduction in lending standards was endogenous. Foreclosure risk was (is) anticorrelated with an increase in housing prices; so in the run-up, risk of foreclosure was actually declining ceteris paribus. Partly because of the complex and often impenetrable structure of housing finance, lenders took these foreclosure rates as stable in the long term. Moreover, as others have pointed out, lenders were concerned less with default in the run-up than with the risk of early repayment as people refinanced the equity out of their houses (or sold quickly for speculation, as Liebowitz says). All of this meant that lenders considered it optimal to lower credit standards.

This story strikes me as having a Hayekian flavor to it, though I don’t know if Peter and his commentators would agree. It also has something of Leijonhufvud about it, as Taylor’s main message is that the Great Moderation was a matter of the Fed sticking to the program — staying within the “corridor” — and not deviating as it did in 2003-2006, presumably in an effort to stimulate the economy after the Internet crash. The deviation of 2003-06 was “comparable to the turbulent 1970s.”

8 October 2008 at 12:36 pm Dick Langlois 5 comments