On Friday I joined fellow blogger Mark Thoma (and a good many other economists) at a very interesting conference on financial markets held at the Federal Reserve Bank of San Francisco. Here I share some ideas I expressed at the conference about the directions I feel this research ought to go.
The theme of the conference, and indeed the topic of a great number of academic papers now being written, is to try to describe what happens when capital markets have trouble efficiently bringing borrowers and lenders together. The motivation for this interest is the correct observation that interbank and other key lending froze up in the fall of 2008, with devastating consequences for the world economy. The objection that I have to many of these papers is that they focus too much on the effects of these disruptions and not enough on the causes. Many models take the view that credit markets were functioning more or less normally up until the fall of 2008, with the object of study taken to be understanding the consequences of how financial disruptions in 2008:Q4 were propagated to the rest of the economy.
Taken literally, this view would imply that the huge run-up in debt over the last decade was largely benign, and that the core problem is that banks stopped lending in 2008. If that’s your perspective, then it’s very good news that the rapid growth of debt didn’t end just because banks stopped lending.
My view is that the gross deterioration of underwriting standards suggests that it was the run-up in mortgage debt between 2001 and 2007, and not the failure of mortgage debt to expand further in 2008, that indicates a pathology in credit markets.
Here’s another variable that I think played an important role in what we’ve observed. Robert Shiller’s data imply that real home prices in the United States were remarkably stable for over a century. They began an unprecedented climb in the last decade, only to reverse course in equally dramatic fashion in 2006. One of the papers from the conference on which I was asked to comment took the perspective that credit markets were functioning essentially normally in 2008:Q3, with the goal of the research being to quantify the consequences of the disruptions that occurred in 2008:Q4. But surely those disruptions had a great deal to do with the decline in house prices that had been underway for several years at that point, and just as surely that decline in house prices had a great deal to do with the run-up in house prices that preceded the bust.
Shiller’s real home price index, 1890-2009. Source: Irrational Exuberance, Princeton, 2005, by Robert Shiller.
I presume that everyone would agree that the dislocations of 2008:Q4 did not arise in a vacuum. But some might nevertheless defend modeling those disruptions as exogenous events, if the primary purpose is to try to understand how those events affected the rest of the economy. However, I worry that this is more than just a detail of what one chooses to model, but has the danger of becoming a prevailing paradigm of some in policy circles, who may interpret the core problem as the financial events in the fall of 2008, rather than viewing the core problem as the conditions that precipitated those financial events.
Understanding those precipitating conditions strikes me as a higher priority for this kind of research. Is our goal to know how policy should respond to these disruptions, or how to prevent them in the first place? In terms of the narrow objective of evaluating Federal Reserve policy over this period, should we ignore the potential contribution of the low interest rates and lax regulatory regime that accompanied the preceding real-estate price run-up? It is all well and good for the fire-fighters to ask us aren’t we glad they have such a high-powered hose with which to douse the raging conflagration. I suppose that a reasonable response might be yes, but where were you four years ago, and who started this fire anyway?
My suggestion for the many researchers interested in adding to our understanding of credit market imperfections would be to focus not so much on 2008 as on 2004-2006. Any economists or policy-makers who believe that the goal of policy is to restore the economy to the conditions of 2005 may be missing the core lesson here.