Did Tight Money Cause the 2006 Housing Bubble?

According to a very interesting post by Kevin Erdmann, the answer may well be yes.  Here is a comment he left, which summarizes his argument:

The housing boom was caused by TIGHT money!

What I realized was that there were many parallels between the 1970′s and the 2000′s, and that both periods saw similar demographic trends and low or negative real interest rates. Relative home prices rose in both time periods, but the reason they didn’t rise so much in the 1970′s is because the Fed was actually loose in the 1970s. Since home finance is treated as consumption financing, high inflation in the 1970′s kept home prices down. (Banks approve mortgages based on current income compared to the monthly payment, not based on something like a long term cash flow analysis of real estate versus a risk free bond investment.) Since the Fed was tight in the 2000′s, real and nominal interest rates were low. This meant that, unlike in the 1970′s, the size of the monthly payment was not a limiting factor. Homes were a reasonable investment in both periods of time. In the 1970′s, they were a killer investment if you could afford the monthly payment. The financial engineering used in the 2000′s to lower equity and down payments in exchange for higher monthly payments was simply a reasonable way to make this investment available to more people. Those methods were not relevant in the 1970′s because the monthly payment was already the limiting factor, because of high nominal rates.

I go into the details a little more here.

This is going to be really fun, so let’s back up a bit.  I don’t want you to miss any details, so you can blow people away at the water cooler tomorrow morning.

I’ve frequently commented on the puzzling fact that so-called “bubbles” seemed to occur more often during periods of relatively slow NGDP growth (1929, 2000, 2006), not periods of relatively high NGDP growth (1964-81).  Because periods of slow NGDP growth represent periods of relatively tight money, I always tended to discount arguments connecting easy money with bubbles.

But I never actually reversed the argument.  After all, why should tight money lead to bubbles?  Wouldn’t you expect more real estate bubbles during periods when inflation is pushing house prices higher at a rapid rate?  Perhaps, but as Kevin points out it’s real house prices that matter.  Even so, perhaps real house prices might be expected to go up during periods of high inflation, as houses are a sort of inflation hedge.

But Kevin noticed a powerful force pushing the other way.  In America mortgage debt is commonly structured so that monthly payments stay constant over 30 years.  This means that during periods of high NGDP growth, when nominal interest rates are also high, monthly payments will start very high in real terms, and then fall rapidly in real terms.  But your ability to qualify for a house depends on how large the initial nominal monthly payment is, relative to your current income.

This means that average people will have much more difficult time qualifying for a mortgage when both nominal GDP growth and nominal interest rates are relatively high. As a result, real estate “bubbles” are more likely to occur during periods when nominal interest rates are relatively low and average people find it easier to qualify for mortgage loans. I initially missed this point because I focused too much on the Fisher effect and not enough on the strange practice in America of structuring mortgage payments in nominal terms.

In this blog I frequently focused on two types of money illusion, downward wage rigidity and nominal debt. Sticky wages lead to unemployment when nominal GDP falls. Nominal debt leads to debt crises when nominal GDP falls. And now we have a third, monthly mortgage payments that are stable in nominal terms lead to real estate booms when nominal interest rates are relatively low. And of course nominal interest rates are relatively low when nominal GDP is relatively low. And of course slow nominal GDP growth is an indication of tight money.

I feel like I’ve hit the trifecta. The title of my blog now has three important implications. Money illusion contributes to business cycles, debt crises, and so-called “housing bubbles.”

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