Real theories of the financial crisis

by on April 13, 2010 at 5:19 am in Economics | Permalink

I don't agree with the emphasis on energy bottlenecks (although in the author's defense read this new paper), but there is much of interest in this rumination:

I was working backwards above but the whole crisis makes perfect sense if you start with lack of high ROE investment opportunities in the world as a whole, with local markets struggling to incorporate this information appropriately. To institutional investors, ranging from pension funds to insurance companies, fixed income investments appear disproportionately attractive in this environment, driving long-term interest rates low. Consequently, mortgage rates drop, making equity investment in housing attractive for homeowners. Even in the absence of a well-functional mortgage market (common in other countries that also had a significant housing boom) equity investment in housing appears to have the characteristics of a fixed-income investment, which again appears attractive in the absence of high ROE investments elsewhere. All of this boosts housing prices significantly above cost, which creates apparent arbitrage opportunities for the homebuilding industry and related industries (mortgage, finance, materials, machinery, etc). This temporarily cushions the blow to the economy of not having high ROE investment opportunities, by becoming the high ROE investment opportunity itself. But since the demand for housing is driven by miscalculation to start with (lower long-term interest rates driven by lower expected economic growth should not lead to an increase in real estate prices, except to the extent that the underlying real estate itself represents a bottleneck to growth), those high ROE investment opportunities turn out to have been illusory and cause significant losses for whoever in the supply chain is stuck with the excess inventory. The growth in supply of housing uncovers the illusion and the resulting price volatility causes a credit crisis and a severe economic downturn, as the economy faces both the temporary shock of price volatility and the long term shock of lack of high ROE investment opportunities.

And what explains the lack of high ROE investment opportunities in the first place? There are many places to look, but the biggest is the supply bottleneck in energy. While the growth in information technology has been impressive, as is the consequent potential for increase in productivity, none of this can increase return on capital against the backdrop of energy supply bottleneck. This is hard to explain, though my posts in the following thread effectively discuss the logic behind why energy scarcity will lead to low long term interest rates and low growth, not high energy prices:

http://forumserver.twoplustwo.com/11…regime-397397/

I don't know who wrote that, but I thank a loyal MR reader for pointing it out to me.  Here is related data on MPK.

not_scottbot April 13, 2010 at 5:50 am

Someone discussing energy in the context financial crisis? Why can’t we just postulate a can opener, and continue imagining that growth solves everything?

Andrew April 13, 2010 at 7:20 am

“demand should shift away from things that are energy intensive to those that are not”

I think that’s what he said.

Andrew April 13, 2010 at 8:03 am

prove = provide

Bill April 13, 2010 at 8:45 am

Actually, what you may want to do is link your previous threads on conspicuous consumption, asset liquidity, add to it a discussion of tax policy that favors housing—and what do you get, an unsustainable bubble in real estate.

To the point: your wife watches the Home and Garden Channel, with programs showing how you can make money by improving your house; you see the nominal asking prices for housesincrease in your neighborhood (failing to deduct real estate commissions and forgeting that asking price is not transaction price), mentally you revalue the price of your house (assisted by the local property tax assessor who is eager to increase value to increase taxes–but, what the heck, I’m wealthier so who cares), your broker says, Gee, you ought to take out an equity loan on your house and have that asset work for you, and, you know,the interest is deductable (no thanks); you look at your neighbor, a real estate agent who just moved into that house she owned and rented to students; now that she moves in and lives there, fixes up the place, and resells it for more, all of the gain is NOT Taxed (you wonder, such a life) as she moves on to the next house; one of your law partners talks about the tax deduction he gets on his second residence in the South, the hedge fund guy you advise tells you that property on this spit of land in Florida can only go up because they can’t make more land and this is the time he is going to invest in a condo, a firm you work with gets acquired and the general counsel and his wife begin to flip houses in Florida and Arizona as their new living; energy prices start to increase, consumer discretionary income begins to decline, houses start piling up…wonder if there is a bubble like people have been saying for a while…crash, boom bang.

Houses are tax favored assets (I won’t call them investments). We talk about borrowing from China, but fail to consider that a person that buys a $1-2 million house borrows that money from someone (aka, China), and deducts the interest from tax returns. If there is a later gain, it is not taxed.

If you are serious about crowding out in the capital market, we should look at putting a cap on interest rate deductions on house borrowing costs. Give everyone a $75k interest deduction limit per year. Place a limit on the deductability of interest on home equity loans.

Houses are very illiquid investments. We are tax favoring “investments” in a non-productive, illiquid “investment”, and then are surprised that there are bubbles and housing illiquidity. Then, when there is a crash, we subsidize the poor fools who made bad decisions.

This is not a sustainable program. Fix the tax code which is incentivising bad decision making.

Chris April 13, 2010 at 10:45 am

As an aside: twoplustwo is among the ‘smartest’ forums on the internet.

Lord April 13, 2010 at 12:20 pm

Stagnation instead of stagflation. While returns to energy alternatives may increase, it may not compensate for the losses due to higher costs in the first place as the alternatives are mostly more expensive to begin with. Did anything really get us out of the stagflation of the 70s other than the collapse in oil prices in the 80s? Will there be anything now if they don’t collapse again?

TGGP April 14, 2010 at 1:04 am

The strange thing about the recession is how much productivity has increased, and output has now recovered as well, while employment stayed low. As Garrett Jones noted in his EconTalk podcast, this is at odds with the “Real Business Cycle” story which fit previous recessions (characterized by lowered productivity). This energy supply bottleneck theory sounds more like those old recessions (particularly the “supply shock” of the oil embargo/price control 70s). Tyler Cowen and Casey Mulligan have both chosen to ask what’s going on with labor in this recession (even if one disagrees with their answers to that question).

JonF April 17, 2010 at 11:33 am

Let’s remember that there was also a huge speculative bubble in oil more or less concurrent with the housing bubble, and it too popped shortly after housing defalted. Also, while oil remains high, coal is not and natural gas is scraping bottom.

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