The return of Hayek?

Except his name is John Taylor:

Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.

Here is the paper.  A Hyman Minsky fan, however, might challenge whether this data really supports Hayek’s theory.  An alternative theory is that markets are bubble-prone and that easy monetary policy was simply a trigger that set off an irrational speculative excess.  The Austrian story is that "the government distorted price signals to the market."  Are those two accounts really so different?  Do we need metaphysics to resolve that question?  Take the classic "thin skull" case in the law.  Austrians won’t describe it this way, but they are postulating a very thin skull for markets and then blaming government for the disaster which results from government’s glancing blow to that skull.

Keep in mind that no entrepreneur looks at price signals exclusively, rather they interpret prices in the context of the real economy and other bits of knowledge  Was it so hard for investors to say to themselves?: "I see that one price (short-term rates) has changed in favor of greater housing investment.  But other parts of my brain tell me that real estate prices won’t go up forever, levered positions are dangerous, and that I should be cautious."

Let’s say that the government subsidized the price of bananas, you bought so many bananas, put them on your roof, and then the roof collapsed.  Is that government failure or market failure?  The price was distorted, but I still say this is mostly market failure.  No one made you put so many bananas on your roof.

If Minsky and Hayek are running in a race for interpreting the last two years of the U.S. macroeconomy, Hayek has something to offer but so far Minsky is in the lead.


Would the Austrians not argue that the skull is thin due to past interventions. Woudln't people learn from smaller more frequent, more local bubles?

But many people started to ignore the price of the house and only looked at the monthly payment, as long as the monthly payment seemed OK the price of the house was ignored. If you have a fixed rate loan and you don't plan to move, you are still doing OK. You have a large house with an affordable fixed payment. But if you took a risk on your loan, or who looked to flip your house, you are in trouble. (As are those who must relocate or sell for some reason.)

The market knew that the Fed action was temporary and many felt that they had to act quickly to exploit the opportunity. But the Fed action had the largest impact on adjustable rates. Overly optimistic views of the future of housing prices led to many buyers taking greater risks then they should. Markets like Chicago saw a temporary shortage in housing, which led to prices increasing much quicker then incomes. Many buyers were willing to take on greater risk, to buy into a hot market, out of fear that the shortages would continue into the future.

I was shocked at parents telling young adult children that they should stretch to buy a home because the children would never see such low interest rates again. These parents remembered the high interest rates of the seventies. So prudent debt levels were ignored and many house buyers became monthly payment buyers.

Still the vast majority of buyers are not defaulting. Ohio and Michigan are having troubles but the cause is a weak local economy not a housing bubble. Florida and California are having trouble, in part do to excess speculation in housing. But the history of Florida is filled with such housing bubbles - as is California. Some fraud occurred as people tried to exploit a heated market. Some people made terrible choices. Some lenders played hot potato with loans.

Did low short term rates cause a bubble? Yes, to the degree that people were willing to ignore traditional affordability guidelines and take on greater risk. Yes, because it increased short term speculation in housing markets.

I agree with DanC. The non-organic growth in housing prices was caused not directly by the low interest rates available, but by the ability for buyers to purchase "more home" with the same (initial) monthly payment, thanks to the spike in non-traditional mortgages. This quickly shifted from being able to purchase a larger or nicer home to being able to bid more for a smaller home to ensure that you get it in a frenzied market. This, in turn, fed the myth that housing is more than a safe investment, that it is a guaranteed goldmine. This, in turn fed the frenzy more, and the market spiraled upwards in bidding wars that never would have been able to occur in a world of only fixed mortgages. Add speculators to the mix and the bubble is complete.

The three things I fault the government with in relation to the bubble are:

1. Allowing too much rampant "creativity" in the mortgage market. I know that some people will argue that the government forced lenders to make loans to people of less means, but I am not referring to predatory practices here. I think most people knew the loans were risky but were wildly overoptimisitc about their investments, such as someone buying Internet stocks on margin in 2000. These types of mortgages should not be banned, but when the market first began to become so clearly distorted (~2005), something should have been done to curb these types of mortgages and the price spiral they encourage. Alternately, the fed could have raised rates to curb the bidding war, but I do not attribute the low rates as the direct cause. Why hurt everyone just to curb housing? Attack the source.

2. Continuing to be a cheerleader throughout the boom. MSNBC, Fox, and all the major nows outlets prefer optimism in business news (rightfully so). But when there is clearly something unprecedented going on in a market they tend to overplay the optimism card, having a panel of 4 bulls and 1 bear (if that)! Serious debate winds up being minimized and overpowered by rationalizations that we are in a new paradigm (tech stocks in 2000, housing prices in 2006). The Fed and the government should have taken a more sober look at what was going on. Instead they lended yet more force to the arguments of the cheerleaders.

3. Retaining mortgage interest expense as a tax write-off. This greatly distorts the rent-vs.-buy decision. Although in general it is a good thing to incentivize owning a home over renting, in this market it reinforced the myth of "you can never go wrong buying a house no matter what price you are paying." I held off purchasing my first home because I became convinced as of 2005 that we were due for a major correction. As a renter, therefore, I am frustrated by the distortion on my tax return!

If it is market failure, that term doesn't mean what most seems to think it means. When the roof full of bananas collapsed, it was either personal failure or engineering failure. That there are markets for bananas and structural engineering cannot mean that anytime a trader makes a bad deal in those markets the *market* has failed. The *market* succeeded at the moment of voluntary exchange.

The outcome of exchange is an individual assessment. The *market* wasn't trying to sell more bananas than a roof could hold, it was merely offering quantity at price. The abstract *market* is not aware of anyone's roof. Government, however, might have policy aimed at controlling quantity and/or price. The state is much, much more appropriately evaluated as if it were an individual sentience than any market. If government encouraged more bananas at a price, it could be seen to support individual failure. When the roof collapses, the government shares some responsibility, probably not through direct malice, but through the negligence of unintended consequences.

Two issues. First, did low interest rates create a housing bubble? Two, did low interest rates contribute to the sub prime mess?

Lower interest rates did increase demand for housing. But that is hardly a market failure. People could afford more homes and in markets with limited supplies prices escalated.

Housing markets are designed to extract the highest possible price from the highest demand buyer so a minority of buyers can temporarily distort the value of a market. Housing markets are illiquid by nature so in an up market transaction prices are higher then the "true" long term price and in a down market transaction prices are lower then "true" long term prices. Did the Fed help create noise about the true market price by increasing some demand at the margin? Yes. Is that a market failure? Not really, most people had started to shake their heads at the prices the market had reached. The winning bidder in an auction always bids a price that others at the auction think is too high.

The bigger problem is the sub prime market. Did the Fed contribute to the sub prime mess? The Fed increased demand for housing but they did not change the guidelines for loans. The ability of lenders to play hot potato with loan papers and a move away from community based lending encouraged lenders to take greater risks. The lenders should have known (did know) the housing prices were above long term levels (based on affordability) and that zero down loans were risky. Some lenders saw great opportunity in these risky loans, they perceived that the market was incorrectly pricing the value of these loans. They were able to convince others that these loans, as a group, were relatively safe. Is it the Feds fault that the market mis-priced the risk of these loans? No

I think the wrong question has been asked. Whether the current problem is a market failure or a government failure is not a meaningful question. Whether the country would have been better off with a gold standard or some other type of monetary policy is really the bottom line. If markets are indeed prone to bubbles, I certainly think they are, what types of policies help limit them?

I would assume Tyler understands atotbc very well, but based on how he describes it, I would think he either is under-explaining it to make his point or that his views on monetary policy have changed such that he doesn't give much weight anymore to the effects of interest rates on market forces.

I wonder what some of the defenders of high executive pay are saying now.

Clearly the source of the credit crunch is that a lot of highly paid financial experts paid way too much money in the secondary market for subprime mortgages. Some snake oil salemen convinced them with a lot of hand waving that these things were AAA investments. This encouraged the suppliers of these items to ramp up production.

Before the end, they were making 100% loans to people whose whole income would not cover the mortgage payment after first reset....let alone a more normal level of 30-50 % of income. And why not? If you are just going to resell the loan, what do you care if is obviously going to default.

... I think the failure is with the idiot who decided to put bananas all over his roof.

I mean call me crazy...

When you're wielding a baseball bat, everybody has a thin skull. Or when you're wielding a monopoly on the currency. In a competitive market the Fed would have driven itself out of business with such low rates. As it is, in the international market, which unlike the domestic currency market is competitive, its dollar is losing ground rapidly to the better managed euro.

BTW, for what the analogy is worth, in law the entire responsibility, including the payment of all damages and normal and abnormal, falls on the person who touched without consent the guy with the thin skull. When it comes to doing things to other people without their consent, traditional law demands that the actor be very risk averse. Because, as the thin skull example shows, the person with the right of consent usually knows far more about the situation than the actor does.

So, when the government seizes the very thing that makes the market so effective - price signals conveying dispersed, tacit information - and causes failure, thats a thin skull? Huh.

"I see that one price (short-term rates) has changed in favor of greater housing investment. But other parts of my brain tell me that real estate prices won't go up forever, levered positions are dangerous, and that I should be cautious."
Investors said that quite often; I even know a few people who said that on the board of a publicly-traded bank. However, Wall Street's quarterly-obsession and the fact that the harm from credit crunches are spread out over all actors meant that banks faced strong incentives to lend anyways. We gotta keep up with the Jones' Bank this quarter, ya know?

Do we think that the short-term obsession of many shareholders of public companies is something which is natural in a stock market, or is the product of heavy intervention and regulation? How far do the unintended consequences of the SEC go? Can we even know?

Blame the housing bubble on fraud and credit default swaps in the "off the books" shadow banking industry. Mortgage loan officers were paid well for originating loans (sub-prime, Alt-A and HELOCs) that had poor prospects of ever being repaid. Once the originator was paid, he wiped his hands of the loan and sent it to investment bankers or private equity funds that would securitize it through a network of insurers insuring insurers, until nothing was really indemnified. It became difficult to figure out who was responsible to the actual loan investor.

The boarded-up city of Cleveland, where the poorest home owners were encouraged to pour debt upon debt, stands as a monument to a system gone amuck. Massive Wall Street bonuses, paid by companies of dubius solvency to their financial engineering sociopaths, proved that crime did pay. The real estate values in Manhattan and Cleveland moved in opposite directions. As for government intervention, while most governments turned blind eyes to a rigged system, AG pimped adjustable mortgages (just as he was starting to raise rates).

"Do we need metaphysics to resolve that question? "

Oh, yes we do -- the Absolute, in postulating its own becoming, carries within it the seeds of ABCT.

Or, read another way, the above response is no less absurd than was Cowen's question.

Is this Minsky or is this Hayek? It's Hayek, and Tyler is once again misreporting Hayek's theory of the trade cycle:

The fact that [action by the Central Bank] is _NOT_ an inherent necessity of the monetary starting point is however shown by the undoubtedly endogenous nature of the various older trade cycle theories, such as that of Wicksell. But since this suffers from other deficiencies, which have already been indicated, the question of whether the exogenous character of modern theories is or is not an inherent necessity of their nature remains an open one. It seems to me that this classification of monetary trade cycle theory depends exclusively on the fact that a single especially striking case is treated as the normal, while in fact it is quite unnecessary to adduce interference on the part of the banks in order to bring about a situation of alternating boom and crisis. By disregarding those divergencies between the natural and money rate of interest that arise automatically in the course of economic development, and by emphasizing those caused by an artificial lowering of the money rate, the monetary theory of the trade cycle deprives itself of one of its strongest arguments; namely, the fact that the process it describes must always recur under the existing credit organization, and that it thus represents a tendency inherent in the economic system, and is in the fullest sense of the word an endogenous theory.

It is an apparently unimportant difference in exposition that leads one to this view that the monetary theory can lay claim to an endogenous position. The situation in which the money rate of interest is below the natural rate need not, by any means, originate in a deliberate lowering of the rate of interest by the banks. The same effect can be obviously produced by an improvement in the expectations of profit or by a diminution in the rate of saving, which may drive the "natural rate" (at which the demand for and the supply of savings are equal) above its previous level; while the banks refrain from raising their rate of interest to a proportionate extent, but continue to lend at the previous rate, and thus enable a greater demand for loans to be satisfied than would be possible by the exclusive use of the available supply of savings. The decisive significance of the case quoted is not, in my view, due to the fact that it is probably the commonest in practice, but to the fact that it must inevitably recur under the existing credit organization.

Just look at the education and health care sectors, sectors with rabid inflation, low real capital returns and riddled with companies that would be utterly ruined without government support.

All the Austrians are saying is that the government is trying to run the financial system like the public schools, and you shouldn't be shocked when the results are similar.

Here's a question re: the validity of the "thin skull" theory of the market being proposed by the author. Do you consider the Fed to be a "glancing" blow? Seems like a sledge hammer to me.

This is a pretty silly argument. First off, you characterize a system with legal tender laws, GSEs, CRA, a Central bank setting interest rates near zero and papering over the difference, legalized FRB, and other interventions as a "glancing blow". They you blame the victim for the attack?

Markets can't function without prices so of course if you use price controls (which is what fixing interest rates is) then you get bad results.

Do you go to the car dealership, go under the hood and yank some wires, and then argue "What kind of lemon are you trying to sell me?"

The interventions you are advocating are sufficient to wreck the only mechanism the system has for coordiating peoples plans. Of course those plans will be discoordinated.

Thanks for bringing this topic up, Tyler.

The paper is very interesting.

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