What About the Recalculation Into Housing?

The standard view is that the Fed pursued an excessively easy money policy in 2002-03, which drove interest rates down to 1% and blew up the sub-prime housing bubble.  Everything about this view is wrong.  The Fed’s policy wasn’t excessively easy, it did not cause the low rates, and the low rates did not blow up the sub-prime housing bubble.

Sometimes it is necessary to go back to the basics of classical economics.  Imagine a production possibilities frontier for two goods, business investment and residential investment.  Now imagine that there was massive over-investment in some types of business investment during 1996-2000.  In 2001 it becomes apparent that over-investment in tech and communications has occurred, the floor drops out of the business investment sector, and business investment falls sharply.  What happens to the economy?  In the classical model a well-functioning economy should reallocate resources into other sectors, like housing construction.  This will happen automatically, without any government help.   All that is required is that monetary policy be stabilizing, that it keep NGDP growing at a fairly steady rate.

Is there any way to prevent reallocation into housing?  Sure, the Fed could adopt a very tight monetary policy (as in 2008 or 1930) and NGDP would fall, reducing output in almost all sectors.  But why would they want to do that?  And if they did do that then nominal interest rates would not rise, they would fall close to zero, just as in the 1930s, or as in Japan in the 1990s, or the US in 2009.

Or the Fed could run a more stable monetary policy, keeping NGDP growth up near 5%, and the economy would avoid a recession.  There would merely be a period of economic sluggishness as resources got reallocated from business investment to residential investment.  Interest rates would be slightly below normal, due to the weak business investment sector.

In fact the Fed did something in between these two extremes.  Easy enough money to keep NGDP growing a bit in 2001-02, but not easy enough to maintain 5% NGDP growth.  So we had a very mild recession, and interest rates fell, but not all the way to zero.  If money had been much tighter, rates would have fallen to zero.  If money had been much easier, rates would have been higher, as in the 1970s.  Indeed money was much easier by 2006, and rates were much higher.

So a reallocation from business investment into housing was entirely appropriate in the early 2000s if we were to avoid a depression.  Fed policy worked pretty well.  So what went wrong?  The problem was not growth, we need the economy to grow; the problem was foolish sub-prime loans.

But isn’t that a failure of the free market?  Not entirely.  Housing is not a free market.  The money being loaned out was essentially government funds (due to FDIC insurance), and thus the government needed to regulate the use of those funds to insure that banks were not taking excessive risks.  When I bought my house in 1991 you needed to put 20% down or else buy mortgage insurance.  I believe that requirement was phased out during the 1990s.  That was the cause of the sub-prime bubble, not easy money.  Money wasn’t easy.  The job of monetary policymakers is to keep NGDP growing at a low and steady rate.  The job of regulators is to correct for market failures, which includes other government policies that distort economic decision-making.  The regulators failed in the early 2000s, not the Fed.  (Of course the Fed is one of the regulators, so they are partly to blame.  When I refer to ‘the Fed’ I mean the monetary policy unit within the Fed.)

PS.  Real rates were also pretty low in the early 2000s, but the Fed has very limited control over real rates.  The low real rates reflected some combination of low business investment (post-tech bubble), or high savings rates (in Asia?)  I don’t have a theory as to what caused the low real interest rates, other than that it definitely wasn’t the Fed.  A better term would be ‘easy credit,’ not easy money.

PPS.  If it is hard to visualize how low rates might not be easy money, consider this counter-factual.  Instead of cutting rates to 1%, the Fed only cut them to 3%.  The economy does much worse, and then the Fed reacts to that much weaker economy by eventually cutting rates to near 0%.  A mere hypothetical?  No, I’ve pretty much described the 4 years after 1929, which is why the 2000 tech stock crash was not followed by a Great Depression.

PPPS.  If someone has pneumonia, and is running a fever of 102, I don’t deny that putting them in a freezer will lower the fever.  And if business investment is tanking, and resources are flowing into housing, I don’t deny that really tight money will prevent a housing boom.  I simply question the wisdom of that policy.

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