Housing Bubbles and the Theory of the Second Best
For my modern economic perspectives class that I have talked about before, we are now reading through Joseph Stighlitz’s Freefall, which is a relatively thick book that deals exclusively with the financial crisis of 2008 in the U.S. and around the world. In the first chapter, Stiglitz makes two claims about the market that, he says, warrant government regulation: agency problems, and externalities. Essentially, the causes of the collapse can be traced back to those apparent market failures.
My goal at the moment isn’t to get into the nitty-gritty details of his arguments. I do not think he makes a very convincing case that the causes are market failures (at least he hasn’t in the first three chapters), but I think he does make a good case for regulation. How can that be?
Having read a fair number of books devoted solely to the financial crisis, I think I have a decent enough grasp of the overall picture. I do buy into the Austrian explanation that the root of the crisis lies in the Federal Reserve and its policy of keeping interest rates low from 2001-2006. That seems to me the most cogent explanation given the facts of the matter.
But that explanation really doesn’t tell the entire story, as any good commentator on the issue will be quick to explain. There were other culprits: Fannie and Freddie, the Community Reinvestment Act, and so forth. The truth of the matter is that the depth of the crisis we are suffering through today cannot be blamed solely on government intervention. There was, I believe, a serious lack of regulation and in that sense I am in total agreement with someone like Stiglitz.
Now, I’m pretty convinced that without the Federal Reserve there wouldn’t have been a bubble. In fact, Stiglitz agrees with me. He writes that
Lax regulation without cheap money might not have led to a bubble. [p. 9]
I think that much is pretty commonsense. Loose monetary policy is a leading culprit in fueling asset bubbles; everyone and their mother knows that. But in 2001 we did have a Federal Reserve and it did throw open the money spigots to stave off the dot-com recession. Now, that loose money wasn’t destined to go into housing. There weren’t any government officials purposely directing that money into mortgages, but it just so happens that is where the money found itself over the next couple of years.
And thus, home prices, fueled by cheap credit, began to skyrocket. We were not, however, the only country pursuing easy monetary policy around that time period. Most of the rest of the developed world were in the same boat. Some suffered more than others. Canada’s central bank, for example, pushed down interest rates to near the same levels we did. Canada also saw its housing prices rise but not nearly as fast as the U.S’s.
As research from the Cleveland Fed shows, the primary difference between the two country’s in the run up to the crash was regulation. The fact of the matter is that Canada simply did a superior job regulating the excesses and euphoria that often accompanies loose monetary policy. Unlike the U.S., Canada actually thought things through. It basically said, we have loose money floating around, so let’s make sure it can’t get out of hand. The Canadian government insisted on higher-lending standards, for example. Also, not having an equivalent Fannie and Freddie made the 30-year mortgage largely unavailable, which meant that borrowers were required to put up a larger down payment to get the mortgage.
All of the various regulations, in fact, ensured that Canada’s housing bubble remained more innocuous than ours. Stiglitz points out that a lot more could have been done in the U.S. to head off a rapidly inflating bubble:
They could have, for instance, pushed for higher down payments on homes or higher margin requirements for stock trading, both of which would have cooled down those overheated markets. [p. 8]
I think that’s exactly right. Unlike him, though, I’m not convinced that would have entirely solved the problem. The next page over Stiglitz makes the absurd argument that the Fed’s cheap money could have been directed towards new investment and the expansion of enterprises which would have allowed us to, presumably, ride along on a never-ending ride of cheap credit and strong economic growth. I think that’s a bit utopian; what boom led by cheap money has never, eventually, gone bust?
At any rate, the lesson I carry away from the first part of this book is that if you decide to go ahead and artificially lower the interest rate, at least have some regulation in place to minimize the damage. Regulation, like capital, is not homogeneous, and x regulation is not necessarily substitutable for y regulation. There are varying degrees of regulation, some worse than others.
Of course, the real solution is to rid the economy of the major cause of bubbles, so perhaps this post is nonsensical. But I still believe there is a theory of second best in regards to regulation and the economy. Some other countries got the picture, so why didn’t we? We had the worst of all possible worlds. We removed the market’s built-in system of checks and balances, and didn’t even attempt to replace them with government mechanisms for dealing with the mess that usually entails.
America: not always #1.