Tag Archives: housing

What Super-neutrality Really Isn’t

Our friend Nick Rowe pays homage to Milton Friedman in one of his latest posts on what monetary policy cannot do. Indeed, Friedman’s speech to the AEA in 1967 should be required reading for any who wish to learn about monetary policy (it is indeed required reading for my Money and Banking students). The purpose of this homage is to absolve monetary policy of any wrong-doing in the current recession and preceding housing boom. Specifically, he argues:

It was in that paper that Friedman introduced the concept of the natural rate of unemployment. Prior to Friedman, most economists thought there was a downward-sloping Phillips curve, and that monetary policy could keep unemployment low provided we were willing to accept higher inflation. Friedman argued that this was true in the short run only, and that in the long run, when expected inflation equaled actual inflation, the Phillips curve was vertical. Monetary policy could target any rate of inflation, but the result would be the same long run equilibrium rate of unemployment.

Friedman needed a name for that long run equilibrium rate of unemployment, and he chose to call it the “natural rate of unemployment”. He chose that name to draw a parallel to Wicksell’s concept of the natural rate of interest.


There is nothing special about unemployment or interest rates in Friedman’s argument. Everything he says about them applies equally well to any real variable. Just as there is a natural rate of unemployment, and natural rate of interest, so there is a natural rate of output, employment, real wages, relative price of houses, or relative price of sardines. The underlying vision is one of the long-run super-neutrality of money.

Monetary policy has real effects in the short run, because it takes time for prices and expectations to adjust to a change in monetary policy. But if we compare alternative worlds where prices and expectations have adjusted to alternative monetary policies with different average money growth rates and average inflation rates, real variables should not be affected. They are pinned down at their natural rates by real, not monetary forces.

I am in agreement with Nick on nearly every point of this argument. Nevertheless, I am puzzled regarding his conclusion about relative prices. When discussing long-run superneutrality of money, he is referencing the idea that a change in money growth will only cause a change in the rate of inflation in the long run and thus have no effect on real variables. However, even accepting long run money neutrality, isn’t it possible (and in all likelihood probable) that relative prices have changed? In fact, this was Hayek’s main point in extending Wicksell’s idea of a natural rate of interest. In Prices and Production, for example, he writes:

. . . it seems obvious as soon as one once begins to think about it that almost any change in the amount of money, whether it does influence the price level or not, must always influence relative prices. And, as there can be no doubt that it is relative prices which determine the amount and the direction of production, almost any change in the amount of money must necessarily also influence production.

The appropriate question is thus whether superneutrality of money not only implies that the change in the rate of inflation is proportionate to the change in the rate of money growth, but also that individual price changes are equiproportional. Nick seems to believe that it is the case, whereas I find this conclusion wanting.

There is no greater illustration of our opposing views than the idea of inflation targeting. Nick argues that monetary policy did not play a role in the Canadian housing boom:

Did a change in monetary policy cause the house price bubble? In Canada, absolutely not. There was no change in monetary policy in Canada. As I argued in my previous post, The Bank of Canada hit its inflation target almost exactly on average over the period when Canadian house prices were rising. With actual CPI inflation at the 2% target, and expected CPI inflation presumably at the same 2% target, there was no sign of the unexpected inflation that is the signature of the short run effects of a change in monetary policy.

The inflation target was 2% and actual inflation was 2%. Nick views as suggesting that monetary policy could not possibly be to blame for rising house prices. I do not find this evidence convincing in the least. What an inflation target does is establish transparency and accountability for the central bank. If the central bank hits its target, all this tells us is that they have hit their goal. It does not tell us about the desirability of the outcome.

It is entirely possible (if not probable) that monetary policy has an influence on relative prices and the allocation of resources without the aggregate level (growth) of money having an effect on the aggregate level (growth) of output. Indeed, the fact that housing prices rose 85% in Canada while the inflation rate was 2% poses interesting questions. Does the price index targeted by the Bank of Canada underweight housing? Is housing measured properly in the price indices? Doesn’t the rise in housing prices suggest that relative prices have changed (in real terms)?

I think that this is the fundamental point surrounding inflation targeting. If one focuses exclusively on the overall rate of inflation and monetary policy affects relative prices, then monetary policy directed in this manner has the potential to create asset price bubbles, resource misallocations (or simply reallocations), and boom-bust scenarios — even if super-neutrality holds.

The Government, Housing, and The Crisis

It is time to weigh in on some important topics with respect to the current financial crisis. First, I think it needs to be noted that the crisis has already had many stages, each of which likely need to be discussed individually. They can loosely be classified as follows:

1.) The housing bubble (or “How we got here…”)

2.) The bursting of the housing bubble, the increased perception of risk, the fall of Bear Stearns, and the expansion of Federal Reserve power (sorry I couldn’t make this pithy).

3.) Financial market mayhem.

4.) The Hank Paulson Variety Show. (My thoughts here and here.)

Over at Cato Unbound the crisis is being debated by the likes of Lawrence White, Brad DeLong, and Casey Mulligan. Each makes particularly intriguing points, but the main point that I would like to address is in regards to the stages of the crisis. We seem to have gotten to the point where everyone is talking past one another because each is talking about a separate stage of the crisis. For example, White’s essay clearly outlines the incentives put forth by the government that contributed to the housing boom. DeLong, however, counters that White is not addressing the important issue and that he even gets the one he is discussing wrong. I think that there are elements of each of their essays that are correct, but I do not agree with DeLong that they are mutually exclusive.

White is largely concerned with stage 1 listed above. His essay (helps) explain the cause of the housing bubble, but is quite vague on the impact of the economic shock created by its collapse. DeLong is primarily concerned with stages 2 and 3, or in other words the impact of the economic shock. Further, he asserts that government intervention and monetary policy explain little about the shock.

Let’s take this point-by-point. First with regard to monetary policy. DeLong asks:

Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans?

This is somewhat misleading. As our friend David Beckworth points out,

The absolute dollar size of the [open market purchase], however, is not important. What is important is whether these increases in liquidity were excessive relative to the demand for them. One only needs to look at the negative real federal funds rate that persisted over this period to see that these injections were excessive.

I think that Beckworth hits the nail on the head here. These injections were clearly excessive as is evident from White’s chart in his Cato policy paper, in which he compares the actual federal funds rate to that which would be predicted by the Taylor Rule. Further, recent research has shown that low interest rates cause banks to lower their lending standards. These would seem to suggest that monetary policy played in important role in causing the economic shock.

This brings us to the second point in this discussion: did government intervention cause the housing bubble? I believe that the answer is both yes and no. I am on record in saying that Fannie and Freddie (see here and here) did not cause the crisis. In fact, if you read Stephen Cecchetti’s excellent discussion of the early part of the crisis, you will notice that private securitization of mortgage debt was growing much faster than that of the GSEs in the early part of this decade. Nonetheless, I believe that government policy did play a minor role in creating the housing boom (as I will discuss below).

As previously mentioned, monetary policy seems to have played a crucial role in the financial crisis. However, the fact that monetary policy stoked the fire says little about why all of this money flowed into housing. I think that there are two main culprits: (A) Securitization, and (B) Government policy; the former being a necessary condition for the latter to have a meaningful impact. Allow me to explain.

In private conversations with our friend Barry Ritholtz about these matters, he has challenged me to explain why the Community Reinvestment Act (CRA) did not create a boom (or crisis) from 1977 to 2002. This is a fair point and one that I think few (if any) have failed to address. What changed in recent years is that (i) the CRA received some teeth in 1995, (ii) the Federal Reserve lowered interest rates to historic lows for an extended period of time, and (iii) the increased use of private securitization. Ultimately, I think that (ii) and (iii) are the most important both in creating the economic shock and that (i) played a minor role in that the other two factors facilitated the compliance with government policy.

When government regulation is created, there is an immediate incentive to circumvent the regulation. However, the use of securitization essentially made it easier for banks to comply with CRA (by buying securitized mortgages that complied or by issuing the mortgages themselves and selling them off as part of an ABS in the future). Thus far all we have is lower bound estimates of the impact of the CRA on subprime loans, but this lower bound is decidedly not zero. As the link above indicates, a recent Fed study indicated that only about 8% of subprime loans can be correctly tied to the CRA. Nevertheless, as Lawrence White points out in that post, this ignores potential “demonstration” effects. In other words, once banks who are not required to comply with the CRA discover that other banks are making these loans somewhat successfully, they might be more inclined to enter the market to compete directly with these firms (this might explain why 75% of troubled mortgages originate from firms that are not required to comply with the CRA). In any event, however, it is unlikely that the percentage of subprime that originated directly as a result of CRA exceeds 20% and therefore must be deemed a relatively small factor.

To summarize, I believe that monetary policy and the increased use of securitization are to blame for the creation of the economic shock and the subsequent chaos in its aftermath. Nonetheless, I think that government policy does play a minor role in explaining the creation of the shock.

Housing and Monetary Policy

John Taylor looks at housing and monetary policy:

Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.

Here is a non-gated version of the paper.