Fundamentals, Not Accelerators

Professor DeLong made a list of types of factors that determine asset prices.  He went through the list one by one, purporting to show that most of them are negligible when applied to 2008, and then by default assigns causation to the remaining.  The risk of his exercise is that it might miss something fundamental, and thereby assign too much to the residual “financial accelerator.”

We live a world large enough that something fundamental might happen that is not immediately obvious from my desk in Chicago, or even from Professor DeLong’s desk in Berkeley.  But I am surprised that Professor DeLong neglected the role of new capital goods prices and their effect on the quantity and price of capital assets.  After all, Professor DeLong has written one of the most cited papers on this subject.

Just to remind readers of the theory — a higher price for new capital goods raises the price of existing capital assets and reduces the quantity of new investment.  A lower price for new capital goods reduces the price of existing capital assets and increases the quantity of new investment.  This theory has nothing to do with “financial accelerators.”

It seems obvious that new capital goods (esp. new structures) became expensive during the housing boom, or at least slowed down the rate at which they had been getting cheaper over time.  Nonresidential investment had to compete with housing for resources, so in theory this competition reduced nonresidential investment and increased the market value of existing nonresidential capital (e.g., the S&P 500).  In theory, this process reversed itself when housing crashed.  Specifically, in 2007-8, resources were released from housing construction, which reduced new capital goods prices, encouraged nonresidential investment, and reduced the market value of existing nonresidential capital (eg., reduced the S&P 500).

Luke Threinen and I wrote a paper about this in October.  The figures below are from that paper, and from some of my blog entries on the subject.

[Click on figures below to see larger versions.]

The first one shows BEA investment in residential and nonresidential structures, each measured as an index.  The second shows detrended construction spending, each measure as year 2000 dollars deviated from trend.  Clearly the effect I’m talking about is first-order.  Thanks to the end of the housing boom, nonresidential investment can boom again.  This doesn’t happen because the managers of nonresidential businesses are general equilibrium thinkers, but merely because new capital goods are cheap.

The third figure is a time series index for nonresidential investment prices (including structures, equipment, and software).  Economists have watched this series head downward for decades (e.g., see Gordon, 1990); Figure 3 shows how the housing boom may have interrupted that trend.  Because our economic logic is that housing prices affect residential investment which then impacts the price of non-residential capital, it is important to note that nonresidential investment prices peak in the third quarter of 2006.  By this measure, the price of non-residential capital falls by 4 percent from its peak, although less relative to trend.  Given the continued reduction in housing construction, investment goods prices probably have fallen more in recent quarters (we made this figure when 2008 Q2 was the most recent national accounting data) and still have more to fall; an update of this figure could show investment goods prices down five or six percent.

The market value of existing capital can be measured in financial markets by the sum of the market value of debt and equity.  Equity is the residual claimant (that is, stockholders have a leveraged claim on the business assets), so each percentage point change in the market value of capital creates more than a percentage point change in equity values.  So the figure is easily consistent with a 10 percentage point change in equity values.

Professor DeLong knows better than I that true investment goods prices fluctuate more than the measured ones, especially in the short term, in part because of unmeasured price discounts offered by investment goods manufacturers, and in part because waiting times need to be included in the full price of an investment good.  Thus, the true price of new investment goods probably fell more than five percent and the corresponding reduction in the market value of equity should have been more than 10 percent.

In fact, equity prices fell 40 or 50 percent (I will not attempt to provide a precise percentage, because that may change significantly during the time it takes me to type this sentence).  The price of new investment goods cannot explain everything; it is obvious that a changing preference for safety and liquidity has a lot to do with asset price changes and volatility in 2008.  But we have hard evidence that Professor DeLong exaggerated the role of financial accelerators, evidence that was quickly found without moving from my desk in Chicago.  Is it possible that evidence of further exaggeration might lie elsewhere on this Earth?  I expect so.

Also from this issue

Lead Essay

  • In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages — even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud — and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests — especially about the aggregate wealth effects of the boom and bust — would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story — focusing on the money supply and government policy to encourage bad home loans — cannot be the right one.