Thursday, October 9, 2008

The Federal Reserve's Role in the Housing Crisis

As is usually the case in discussing economic policy, public debate rarely focuses around facts or theory and usually devolves into overly simplistic notions based in jealousy and frustration. The current housing crisis is no different. Both major presidential candidates, in an attempt to appeal to populous sentiment have chalked up our entire problem to be nothing more then the "greed" of Wall Street and therefore come to the conclusion that the "free market failed." The remedy is then by default more "regulation" which is never defined or explained by those advocating for it.

The reality is that there were a number of factors that have contributed to the housing bubble, the mortgage market collapse and the associated economic downturn. I therefore plan on starting a series of posts that will try to address some of these issues. This first one looks at the role the Federal Reserve had in creating, or at least contributing to, the housing bubble's rise and eventual popping. I bring your attention to the chart below:

The blue line is the ratio of the average price of a home based on an index to total GDP. It was scaled so that 1992 =1. The green line is the Federal Funds rate, the interest rate that the Federal Reserve manipulates when it is reported that interest rates have been "cut" or "raised." This is the rate at which banks lend to each other. The red line is a weighted average of mortgage interest rates.
Normally, house prices only grow as fast on average as GDP does, which correlates with the average incomes of buyers. This makes sense; as incomes rise, there is more demand for housing, and prices rise.
However, you can see how this proportional relationship of the two in the 1990's, shown by a relatively level line, began to change around midway through 2000. This is by no coincidence around the same time that the Fed cut the Fed Funds rate to a very low rate and kept it there for a very long time, particularly relative to the previous recession in 1991-1992. This had the effect of lowering mortgage rates to historically very low levels as seen in the red line. Around 2000, when mortgage rates started falling, home prices started rising as the cost of a mortgage payments went down and therefore the quantity of housing demanded went up. Likewise, the bubble was "popped" around 2006, right when the FED had now raised its rates and mortgage rates started to rise.

Essentially, it was not the "free market" or "greed" that caused this bubble, or at least not in of itself. The Fed, a non-free market institution had a very important role in creating or at least exacerbating the bubble and therefore ultimately our housing and economic woes. This chart (current through June) shows that in order to come back into equilibrium, prices have to fall a good amount further.

For a more detailed explanation, one good example can be read here.



Well, I must confess that, originally, I was one of those calling for the end of the "free market." My belief was that investor greed and market inefficiencies were entirely to blame for the collapse. Clearly, as you have eloquently stated, they were not. You even have a chart which lends itself nicely to your point...and I cannot argue against a chart. Believe me, I have tried...typically the argument ends with me yelling at it and the chart just sitting there...mocking me in its silence.

However, a few quick points. The chart and the statistics that it represents could never be understood by a vast majority of voters. If Obama or McCain were to drag an easel onto the stage and unveil this chart, I can guarantee that their poll numbers would drop.

I also think it would be a mistake to condemn the government entirely. The State's goals were amicable. I think we can all agree that increasing the amount of homeownership, especially among lower income families is a good thing. However, clearly the Fed messed up in choosing what means to follow in order to reach that end.

Furthermore, it would be misguided to ignore the important part that greed did play in the crisis - and I do not mean to suggest that EJ ignores this factor, he simply hasn't gotten to that part of his analysis yet. But to preempt him a little, at the height of the sub-prime mortgage crisis, there was absolutely no way that investors could claim that they did not see a crisis on the horizon. Everyone, including the CEO and CFO of Fannie Mae, recognized that the securitizing of these high-risk loans, coupled with the creation of negative externalities on the part of such organizations as Fannie, was a recipe for future disaster.

The candidates would do well to elaborate on their definition of "regulation," because, clearly, regulation is not the antidote. The important distinction between "oversight" and "regulation" is getting lost in the fracas. Congress, the SEC and the Treasury did not fail in its ability to "regulate" but actually failed to adequately oversee the market. Increasing the SEC's ability to oversee trading of this kind would be a perfectly reasonable response to the crisis...but it would not involve strengthening mandatory disclosure provisions or any other sort of harsh government regulation.

I agree with you that this is too complex for candidates to bring up, but more analysis could be done, or in particular why isn't the media in its endless opinion shows talking about this kind of stuff? I know I for one had a special place in my heart for those charts Ross Perrot used to always bring up to the stage with him. :)
One thing with the Fed and affordable housing though - there were and still are many government polices that were created to increase home ownership and your right that I will get to those in the future, but the Fed had little to do with that by design. The Fed kept rates so low not to increase home ownership, but because they were worried about deflation at the time and wanted to aggressively inflate the money supply. They overdid it though. And it isn't necessarily Greenspan's fault either, but is is because the Fed suffers from the shortcomings of any central economic planning attempt that has been tried. Mainly, it is impossible for anyone to have enough accurate information at their disposal to be able to manage or manipulate an extrmely complex organism as a national economy correctly. There are always unintended consequences of intervention.