Maybe it was Jackson Hole or the August slowdown, but academics are in a reflective mood these days.
And some of them are especially interested in answering one specific question that continues to linger — just what caused the damn housing bubble? A description of three attempts from the past week follows.
First up is the foursome of Charlie Bean, Matthias Paustian, Adrian Penalver, and Tim Taylor, whose paper at Jackson Hole investigated the lessons of the crisis for monetary policy.
With respect to housing, the authors find that the accommodative monetary policy following the post-tech bubble recession played only a modest role in price inflation. They first argue that the housing bubble took place simultaneously across countries whose monetary policy varied in its laxity:
Chart 1 shows that both UK and euro‐area policy rates were less noticeably out of line with their respective Taylor benchmarks. That too is striking. Indeed, in the United Kingdom, they were actually above the benchmark for much of the relevant period, even though the United Kingdom saw one of the larger run‐ups in debt and house prices during this period. And, in the euro area, countries such as Spain experienced substantial house price booms, while countries such as Germany did not.
But in addition to this analysis, which is familiar to anyone who has read the excuses analysis of Ben Bernanke, the authors also construct their own models to include other “shocks” potentially responsible for the increase in credit and the rise of asset prices during the bubble period.
They then set about finding just how much of the rise in leverage and asset prices could be put down to Fed policy (emphasis ours):
In the United States, the monetary policy shocks are associated with, on average, an extra 0.6 percentage points on annual real credit growth and an extra 1.5 percentage points on annual real house price inflation. That is to be compared with average actual annual real credit growth over the period of 5.6 per cent and average annual real house price inflation of 5.8 per cent.
Not nothing, but neither is it the whole story.
Curiously, the authors also find that monetary policy may have been too good throughout the so-called Great Moderation, in the sense that it led people and organizations to take on greater risks than during normal, more-volatile times.
In particular, over the period 2002‐5, macroeconomic volatility accounts for, on average, an extra 0.7 percentage points on US annual real credit growth and 0.5 percentage points on US annual real house price growth. In the United Kingdom, the corresponding effects are even larger: 2.1 percentage points on annual real credit growth and 2.0 percentage points on annual real house price inflation. A reduction in volatility also confers a sizeable “growth dividend”, suggesting that the stability of the Great Moderation period boosted the sustainable rate of growth, while the current period of high volatility has had the opposite effect …
Of course, this creates something of a dilemma:
Moreover, to the extent that better policy accounted for the Great Moderation, it provides a second, indirect, channel whereby policy may have contributed to creating the conditions conducive to a subsequent financial bust. But it would clearly be a mistake to conclude that policy should aim to induce fluctuations in the macro‐economy in order to prevent financial market participants becoming too confident about the outlook!
Still, this leaves quite a bit of house price inflation during the bubble that remains unexplained by these two factors. And the authors write that one of the biggest causes is, simply, “house price shocks”, which are defined as “movements in house prices attributable to factors not elsewhere accounted for”.
You can see a shock breakdown for the US in this chart:
These findings related to monetary policy and volatility are interesting, but given the rather vague description of “house price shocks”, this remains a mystery.
Which is similar to the conclusion of Edward Glaeser, Joshua Gottlieb, and Joseph Gyourko, who write at VoxEU that credit conditions — i.e. the low interest rate environment created not just by loose monetary policy but also by global imbalances — have a weaker relationship with home price movements than people think.
The authors give two reasons to question interest rates as the critical factor in explaining house price swings.
The first concerns homeowners’ expectations for the future (emphasis ours):
If people expect to move in the future, low interest rates today will not lead them to bid up prices so much now because they realise they might have to sell later at a lower price when rates are higher. The option to prepay also weakens the link between current interest rates and house prices for the same reason. …
Finally, if people are credit-constrained, lower rates today need not lead to higher prices. After all, if the marginal buyer cannot take advantage of those lower rates, they should not affect the buyer’s valuation of a home. Taken together, we show that these factors can reduce the predicted impact of interest rates on home prices by about two-thirds, bringing it down to 6% or 8% from previous conclusions of around 20%.
Second, the authors simply look back at the last thirty years of data and find a weaker relationship between interest rates and house prices than what would have been necessary to drive the price inflation during the bubble years.
The authors essentially throw their hands in the air and say that although interest rates were unlikely to have been the major force in driving up house prices, they have no alternative explanations. Mass psychology or the extension of credit to less reliable borrowers are possibilities, but they don’t know.
From the abstract (emphasis ours):
There is little consensus as to the cause of the housing bubble that precipitated the financial crisis of 2008. Numerous explanations exist: misguided monetary policy; government policies encouraging affordable homeownership; irrational consumer expectations of rising housing prices; inelastic housing supply. None of these explanations, however, is capable of fully explaining the housing bubble, much less the parallel commercial real estate bubble.
This Article posits a new explanation for the housing bubble. It demonstrates that the bubble was a supply-side phenomenon, attributable to an excess of mispriced mortgage finance: mortgage finance spreads declined and volume increased, even as risk increased, a confluence attributable only to an oversupply of mortgage finance.
The mortgage finance supply glut occurred because markets failed to price risk correctly due to the complexity and heterogeneity of the private-label mortgage-backed securities (MBS) that began to dominate the market in 2004. The rise of private-label MBS exacerbated informational asymmetries between the financial institutions that intermediate mortgage finance and MBS investors. The result was overinvestment in MBS that boosted the financial intermediaries’ profits and enabled borrowers to bid up housing prices.
The explanation has to do with the information asymmetries that exist in every step of the securitisation chain, both in the market for mortgage loans and the market for MBS. These asymetries exist between mortgage borrower and broker, broker and lender, lender and securitiser, securitiser and investor.
And here is the inevitable result:
The combination of information asymmetries on both sides of the housing finance market meant that borrowers were mispricing risk and entering into overly leveraged purchases, while investors were making the leverage available too cheaply. The result was the growth of an unsustainable housing price bubble as artificially cheap credit from investors’ mispricing increased mortgage demand, and increased mortgage quantity pushed up prices. Housing price appreciation concealed the risk in the lending by temporarily preventing defaults and inflating LTV ratios, which made PLS look like safer investments, fueling the cycle.
This certainly sounds plausible, but the authors perhaps give short shrift to the other explanations, which they do discuss. Their argument is that although some of the other factors may have contributed, it was the financing over-supply that was critical to enabling the crisis.
That’s fair, though still no reason to exclude the kind of multifaceted explanation that a subject this complicated probably requires.
Whatever the case, if the past week is any indication, academic interest in the topic is here to stay.
Missing the Housing Bubble 101 – FT Alphaville
Do information asymmetries explain the housing bubble – Felix Salmon