The Housing Bubble
Matthew Martin 7/24/2012 11:21:00 AM
I'm rather puzzled by the argument that the interest rate was too low. First of all, there is actually a positive correlation between the interest rate and the growth in home prices, not the negative relationship that is typically assumed. Just look at any of the interest rate hikes in the graph: an interest rate hike has never reduced home prices relative to CPI anywhere in the available data, and in all but one case (in the mid 1990s) was actually associated with higher home prices. I'm not trying to argue causality here--I just don't think that an interest rate hike would have been effective at all in reducing or slowing the growth in home prices relative to inflation.
Now, the fact is that we have had very low inflation since 1997 when the current housing bubble appears to have begun. Inflation was even lower than it appears when you consider that housing also represents a significant chunk of the CPI index. My view is that if we had aimed for a higher overall inflation rate, we would have been able to devalue home prices relative to the overall price level, and thus have avoided the bubble. That is to say, I think that higher inflation would have increased wages faster than it increased home prices, so that the ratio of the two would never have grown to the proportions it did prior to the current recession.
As for the very low interest rates, it would be a mistake to cite these as a reason to believe that monetary policy was too loose. This fallacy comes from failing to fully understand how monetary policy influences interest rates: there are two effects, the liquidity effect and the inflation effect. The former is what people who associate low rates with loose money are thinking of--in the short run under tight enough monetary conditions, the primary effect of expanding the money supply is to lower interest rates due to the fact that lenders are more liquid, and therefore more willing to lend. But in the long run, and if monetary conditions are loose enough, the inflation effect dominates--the effect of expanding the money supply is simply an increase in the inflation rate, which in turn increases interest rates. Thus, "easy money" conditions should be characterized by a small liquidity effect and a relatively larger inflation effect--further expansion of the money supply increases interest rates, while "hard money" conditions should be characterized by a relatively long period of depressed interest rates following an increase in the money supply (note that in any conditions, the liquidity effect is temporary, in the long run printing money always raises interest rates).
So we can tell if monetary policy was tight or loose by looking at what happens to interest rates following an increase in monetary base: if there is a long period of low interest rates, then the liquidity effect dominates and money is tight; if there is an increase in interest rates not too long after the increase in base (maybe following a brief decline) then monetary policy is relatively loose.
I certainly do not think that making monetary conditions even tighter would have solved anything, and might actually have made the recession worse by forcing banks into even more precarious leverage ratios.