Monetary Policy and the Housing Crisis

8 October 2008 at 12:36 pm 5 comments

| 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.”

Entry filed under: - Langlois -, Austrian Economics, Papers, Public Policy / Political Economy.

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5 Comments Add your own

  • 1. Michael F. Martin  |  8 October 2008 at 2:04 pm

    Hayek and Schumpeter will be as influential in the 21st century as Keynes was in the 20th. Hayek’s intertemporal coordination theory prognosticated the present credit crisis.

  • 2. Paul Cox  |  8 October 2008 at 8:05 pm

    Contrary to your opening comment, I think Organizations & Markets needs to be in the front seat of the financial crisis.

    With Information Technology (IT) taking an advanced role in defining and supporting our organizations and markets, how will the necessary changes in our organizations come about? Can we continue to rely on “spontaneous order” to see us through rebuilding our organizations.

    I believe this financial crisis is the equivalent to what the Soviet Union experienced in the past 2 decades. Our organizations, the bureaucracies, are too slow and inefficiently efficient to deal with the demands of them in this fast paced world.

    This leaves us with few alternatives. Either we keep the old organizations and accept a lower standard of living, regress to manual systems, or enable IT to take the lead role in remaking our more prosperous future.

    We must define what the future organizations are. It is the people who write this blog that have, I think, the responsibility to make these points known and ensure the appropriate actions are taken. Your work in transaction costs, defining the boundaries of the firm, and defining a greater division of labor are the tools that society needs to see us through this mess.

  • 3. Steve Phelan  |  9 October 2008 at 2:59 pm

    There seems to be a consensus that lending standards were lowered. The question is then why?

    Liebowitz argues that it was because of political pressure to loosen standards around CRA and minority lending (although he admits that speculators were the ones taking ARMs with high default rates).

    Taylor argues that the low foreclosure data in a rising market masked the real risk.

    I would argue it was because of agency problems throughout the mortgage distribution chain.

    Liar loans are the classic example (where was see at least one case of a $14,000 a year worker getting a $700.000 mortgage). Who had an incentive to

    Not the buyer, who wanted a bigger house
    Not the broker, who received a commission for originating loans
    Not the bank, who onsold the mortgage to investment banks
    Not the investment banker, who packaged the mortgage as a security and onsold to mutual funds and pension funds
    Not ratings agencies, who are paid by investment banks
    Not fund managers, who are paid a % of funds under management and could earn higher returns on AAA rated bonds.

    I contend it was the incentive structure that super-charged the housing boom by encouraging relaxed lending standards that made more money for everyone in the system – the proverbial ‘free lunch’ that turned out not to be free.

  • 4. rlanglois  |  16 October 2008 at 4:10 pm

    Here is a CNN Press conference from right after the bailout that sheds some light on these issues:

  • 5. Dick Langlois  |  21 October 2008 at 11:53 am

    More seriously, here is a new IMF working paper whose results are very much in the vein of what we have been discussion in this post. This financial crisis, the authors say, shares “characteristics often associated with aggregate boombust credit cycles, such as financial innovation (in the form of securitization), changes in market structure, fast rising house prices, and ample aggregate liquidity. We find evidence that all these factors were associated with the decline in lending standards. Denial rates declined more in areas with a larger number of competitors and were further affected by the entry into local markets of large financial institutions. The increasing recourse to loan sales and asset securitization appears to have affected lender behavior, with lending standards deteriorating more in areas where lenders sold a larger proportion of originated loans. Lending standards also declined more in areas with more pronounced housing booms. Finally, easy monetary conditions also played an amplifying role. These effects were more pronounced in the subprime mortgage market than in the prime mortgage market, where loan
    denial decisions were more closely related to economic fundamentals.”

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