Bob Cropf

Origins of the economic crisis

In economics on January 29, 2009 at 11:30 AM
Jeff Frankel's Weblog Dec 5, 2008

Source: Jeff Frankel's Weblog Dec 5, 2008

  1. I like the “Economic Crisis for Dummies” approach but I think there are a few problems:
    (1) Easy money monetary policy should be much bigger and more central;
    (2) There is nothing in there about policy — where is the “LACK OF FEDERAL OVERSIGHT” for (a) lending, (b) investing, and (c) securities and where is the bubble for federal policies that doesn’t encourage households to save???
    (3) Isn’t is pretty optimistic to have 2008-2009 in the Recession bubble? Of course, I hope that it is right, but the new Q4 numbers are out and once you take out inventory, the GDP growth rate was -5.4%.

    Delong has an interesting post about stimulus skeptics. It is quite amusing to watch this… except as Neil Sinhabababu notes that is quite scary that the Nobel Prize winners don’t agree on such fundamentals.

  2. Thanks for the insights, Kathleen. I have some questions of my own:

    Why do you assert that monetary policy played a major role in the crisis? Can you point to any events that back up your assertion?

    Do you mean lack of federal oversight or lax enforcement?

  3. The easy money policy that started in the 1990s and continued into the 2000s was much more central to the problem for two reasons:

    (1) It made it really easy for people to rack up all sort of debt which was used to fuel consumption and growth, particularly in the housing sector. The increase in demand caused by the ease of accessing credit — it was cheaper to buy than to rent in a certain sense — lead to an increase in price which in turn lead to an increase in supply, but supply in housing has a decent lag time (~18mo). The increased price lead to more “investors” to enter the market, which further boosted prices, contributing to further increases in supply (keeping in mind the lag in supply).

    (2) The low interests rates from the Fed also made investments in things like t-bills too conservative, so additional investment dollars (and euros and krona) were looking for something a little “hotter”. Real estate development and the mortgage markets were booming and these are “safe” investments because of lending requirement and sercuritization, so money flocked there – they were getting excellent returns. This drove up the prices of these securities, so there was pressure to increase supply, which in turn put pressure on lending institutions to lower their lending requirements, which made them less safe.

    At this point (1) and (2) converge. People reached their limit on debt and started defaulting, particularly on mortgages, which called into question the value of the securities, so the price fell, which meant that lending institutions could no longer find buyers for their mortgages which meant they had no money to loan which meant that people applying for new mortgages and other loans could not get them, which cause the bottom to fall out of the housing prices. Among other things.

    Thus, if interest rates had been raised following the “recovery” from the 2001 recession, we may have avoided the housing bubble. We also may have delayed the financial market trouble, but the housing bubble was merely the *excuse*, if not the housing bubble it would have been another bubble (energy possibly?). The housing bubble is just particularly problematic because it is so central to not just the economy but society (where people live is where they go to school, shop, etc.) and it is so big. Plus, because of the lag time, houses finished this year were planned back in the height of the market, 2005. Much of this surplus is real surplus (there just is not an owner for each of these houses) not surplus based on market price – it was built not to meet the demand created would-be homeowners but demand created by “investors”. Most are ill suited to the real needs of the communities they were built in (i.e. these are not affordable housing units built close to public transportation lines, but McMansions that are not only $$ to buy they are $$ to live in) and have become a real problem for many communities as their vacancy is further depressing home values.

    As far as federal oversight, I meant both. There was obviously lax enforcement (Bernie Madoff being a prime example) but there was also insufficient ability to regulate the financial markets, particularly after Phil Gramm’s Commodity Futures Modernization Act left the SEC unable to regulate credit default swaps, as well as unable to regulate Enron.

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