How Do We Explain Housing-Boom Optimism?

If I understand him rightly, I don’t much disagree with Professor Mulligan.  We agree that Federal Reserve policy acted to promote the housing price boom by lowering real interest rates.  The difficult question is:  what share of the boom can we attribute to monetary policy, and what share to other independent sources?  Applying Professor Mulligan’s way of computing the impact of lower real interest rates alone on the present discounted values of houses, correct anticipation in 2002 of real T-bill rates — which were about to go 200 basis points lower for the next three years — can account for only around a six percent rise in house prices.  Thus the milder-discounting effect by itself accounts for only a fraction of the actual run-up in prices observed, assuming correct anticipations.  The present-value calculation is straightforward.

We can get a bit more impact out of lower interest rates by noting that the lowering of mortgage lending standards implied an even larger drop in risk-adjusted mortgage rates than in risk-free Treasury rates.  Market participants did not have any clear basis in historical time series for anticipating that this drop would reverse itself soon.

Still, I agree that the joint hypothesis “real interest rate anticipations were correct and they alone fully explain the rise in house prices” is untenable.  Of course, we already knew that anticipations of house prices could not have been correct, given that nobody would pay $300,000 for a house in 2006 that he knew would be worth only $200,000 two years later. 

Professor Mulligan reasonably proposes to attribute the bulk of the rise in house prices to some kind of ex-post-mistaken (but not necessarily irrationally exuberant) anticipations, offering the hypothesis that “it was optimism that raised housing prices, not much of anything tangible during the boom.  Whether it was optimism about future interest rates, future tastes, or future technology is more of a quibble.”  Optimism about “tastes” here includes optimism about the future growth of demand in particular local housing markets.  Something like that would seem to be required to explain why the house price boom was so highly concentrated in a few states.  We can’t explain such concentration by appealing only to optimism about technology or national economic policy variables.

An appeal to optimism, of course, doesn’t really explain events but simply gives us a reframed question:  how do we explain an increase in optimism?  I suggest that optimism (regarding whatever) during this period was not independent of the rising rate of aggregate nominal income growth that was being fueled by Fed policy.  Expansionary monetary policy may have (at least cyclically) effects on relative prices and real variables, like the real demand for houses, through income channels, not only through its effect on the real interest rate.  I anticipate, and agree, with Professor Mulligan’s likely response that more needs to be done to quantify these other effects.

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.