Tuesday, October 27, 2015

Winterspeak — The Housing Bubble involved banks

Where Amir Sufi and Atif Mian go wrong in their explanation of the different economic consequences of the dot-com bubble and the housing bubble,
In general, economics treats money as an "illusion" in that it facilitates the trade and exchange of real goods and services, but fundamentally does not impact or distort that exchange (at least to no great degree). A rose is a rose is a rose, and therefore a good is a good is a good regardless of whether it's prices in dollars or shekels. Therefore, money in general and banks in particular do not play a central role in macro monetary models, which instead focus on things like time preference, consumer expectations, etc. 
In reality, money, or more particularly credit, plays a central role in the economy because of how bank lending works. When banks lend, they lever up their balance sheet, and therefore create money out of "thin air", constrained only by capital requirements on the supply side, and the number of qualified borrowers on the demand side.…
These two $6T are not comparable. In the dot-com bubble, the loss wiped out venture accounts and household wealth in brokerage accounts, but neither was enabling additional lending (and therefore money supply). In the housing bust, $6T of bank capital (which collateralized the loans) was propping up an additional $120T or so (at a 5% capital requirements ratio) of money supply, so the impact on the economy was over an order of magnitude greater.…
The Housing Bubble involved banks


Andrew said...

How so?

Random said...

Lending to buy houses. This pushed up land prices and led to collateral-debt spiral. Banks didn't really care if borrower repaid as they seized the house and took capital gains.
Until they didn't.

Ralph Musgrave said...

I agree with Random: there's certainly such a thing as the collateral-debt spiral.

A silly aspect of the existing system is that if people switch resources to speculating in houses from other forms of spending (which is what happened prior to 2007), aggregate demand doesn't necessarily rise, so inflation (house prices apart) seems OK. Thus central banks don't raise interest rates.

That's stupid because if there's increased demand for something (e.g. funds to buy houses) then the price of borrowed money should rise, just like the price of apples rises if demand for applies rises.

In contrast, under full reserve banking, private banks cannot just print money and lend it out: no one can borrow unless someone else is willing to lend. Thus if demand for borrowed funds rises, interest rates would rise. That doubtless wouldn't put an end to all house price fluctuations, but the problem should be moderated.