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.