Thursday, May 25, 2017

Housing: Part 232 - Credit supply, housing supply, and financial crises.

Credit causes financial crises.  How do we know?  Because that is our set of possible outcomes.  Mian, Sufi, and Verner have a new paper out, titled, "Household Debt and Business Cycles Worldwide". (HT: John Wake)
We group theories explaining the rise in household debt into two broad categories: models based on credit demand shocks and models based on credit supply shocks.
They find that when household debt rises, this is associated with a temporary rise in consumption that is followed by a drop in GDP growth.

They dismiss a rational expectations credit demand shock cause because this would mean that higher debt levels are based on optimism about future economic growth, and that doesn't jibe with the predictable decline in GDP growth that happens after household debt grows and the low interest rates that tend to coincide with these periods of rising debt.

What if we expand the set of possible causes to include supply constraints?  Supply constraints lead to rising home prices in cities with productive employment.  The debt is a result of households buying access to constrained future production.  This is why rising household debt is related to low interest rates, rising home prices, and subsequent declining growth rates.

The bidders on restricted housing do have rational expectations for their own rising incomes.  Incomes are rising in those cities.  It is their countrymen who are denied access to those local economies who have stagnant incomes.

Since the credit demand shock story fails this test, MS&V can attribute these results to credit supply shocks, which they attribute to behavioral biases among lenders.

They also note that the relationship is non-linear.  Higher debt/GDP ratios lead to falling GDP growth but lower debt/GDP ratios don't lead to rising GDP growth.  This, again, comports with a housing supply cause.  Elastic housing supply simply allows housing to continue to expand at the cost of construction.  There is a floor on home prices in a functional economy.  Inelastic housing supply where potential incomes are high causes prices and debt to rise and crimps economic opportunity and growth.

It is odd that the supply issue is so invisible in these academic discussions, because, first, it is such an obvious problem right now.  This is not an unknown issue.  And, second, it is generally accepted that for home prices to rise excessively, supply needs to be inelastic.  Even these credit shock models can only cause these results when housing supply is inelastic.  The supply problem is built into the models, at some level.  It's really a sort of rhetorical issue that it isn't allowed to be causal.

Of course, as is the norm on these papers, amid extensive discussions of the role of price expectations in borrower behavior, rent is simply not mentioned as a determining factor in home prices or expected future home prices.  A text search for rent comes up empty.

This leads to a fundamental difference in thinking as the business cycle proceeds.  If we think of the debt as a product of a credit supply shock and overly optimistic lenders and speculators, then their optimism is the source of the problem.  In the Great Recession, this reached outrageous levels by September 2008 when the Fed was still bracing against inflation after home prices had dropped by more than 20% and were still falling by about 1% monthly, nationwide, and the public was beside itself because we were "bailing out" the ones that did this to us.  But, the key period is really back in the 2006-2007 period.

The sharp decline in housing starts and residential investment was welcomed, because obviously the lenders and speculators were overfunding new building.  The initial declines in GDP growth were accepted because, obviously, all that credit had led to overconsumption which needed to calm down.  And, eventually the collapse of the private securitization market - a massive hit to nominal growth - was seen as medicine well-taken, and the GSEs were castigated for attempting to make up for it - just more greedy lenders, and weren't they the problem to begin with?

Long term interest rates which remained very low throughout that series of events, because there was already a flight to safety, and already home equity was not considered safe.  Since we are so strongly led to see credit as causal, this looked like a credit supply phenomenon, and those low rates were interpreted to be stimulative.  It's the central bank and our collective notion of acceptable public policy that has a behavioral bias.  Those low rates were shouting that bad things were on the horizon.  Some will find this unbelievable, but I think that if the Fed had lowered rates in late 2005, and kept the Fed Funds rate at, say, 4%, long term rates would have moved higher, residential investment would have stabilized, buyers would have returned to the housing market, and the CDO boom would never have occurred.  The CDO boom was a product of the flight to safety, both by investors and by home owners fleeing the housing market.  A credit supply shock view meant that we saw a flight from the housing market as a positive - a correction.  But, a negative housing supply shock view would have properly led us to notice that was a sign of severe dislocation.

It seems to me that, in practice, behavioral finance is simply collective attribution error.  We were convinced that there were these massive forces of irrational actors in the marketplace, and given any support, they would re-enter the housing market and push everything out of whack.  MS&V attribute the end of the boom to changing sentiment.  Surely this is true.  The difference in interpretation here is whether we encourage that change in sentiment to disastrous ends or work to counter it and stabilize it.  At that point, monetary and credit policy become endogenous, and our interpretations of these cycles become self-fulfilling prophecies.  They note, by the way, that these crises tend to be worse in economies with constrained monetary policy.  Yet, since the cause of the crises is determined to be excess credit, this interpretation of the cycle leads us to put self-imposed limits on monetary and credit policy.  With that interpretation, it would seem like madness to try to provide stability if that is only going to encourage more borrowing.

MS&V note that GDP forecasts tend to be too optimistic going into the bust, in that they don't reflect what MS&V find to be predictable declines after the boom in household debt.  To the point above, it seems that forecasts which did shade lower would also become endogenous, because this would encourage more growth oriented monetary and credit policies.  I wonder if forecasts in 2006 had been lower, would we have accepted looser monetary policy?  I'm not sure we would have.  The drop in growth comes from this paradigm that views credit as a disease and stability as dangerous.  The drop in growth was a choice, even if it was a choice we didn't admit or understand we were making.

It is telling that the howls of protest in late 2008 weren't complaints that stabilizing monetary policy had been tardy.  The complaints were that policy should have been tighter in 2004 or 2006 or 2008.  And the chorus of ad hoc inflation phobia that claimed inflation was actually high in 2004 and 2005 if you counted home prices as part of the basket of consumer prices suddenly turned to silence when home prices were dropping by double digits.  To do anything about that "deflation" would be a "bail out" don't ya know?  And it would only encourage that dangerous credit supply that leads to crises.  The credit supply thesis has an endogeneity problem.

Maybe you could say the housing supply thesis has an endogeneity problem too, and that Canada, Australia, etc. are just kicking the debt can down the road.  At least their result has option value.

3 comments:

  1. "It is odd that the supply issue is so invisible in these academic discussions, because, first, it is such an obvious problem right now. This is not an unknown issue. And, second, it is generally accepted that for home prices to rise excessively, supply needs to be inelastic. Even these credit shock models can only cause these results when housing supply is inelastic. The supply problem is built into the models, at some level. It's really a sort of rhetorical issue that it isn't allowed to be causal.

    Of course, as is the norm on these papers, amid extensive discussions of the role of price expectations in borrower behavior, rent is simply not mentioned as a determining factor in home prices or expected future home prices. A text search for rent comes up empty."--KE

    Amen, brother, amen.

    For whatever reason (and a cynical observer might suggest rather overt class bias) property zoning is not a topic in macroeconomic or libertarian or right-wing circles.

    Egads, every day there are posts against the minimum wage or for international "free trade."

    Even more exasperating, there are op-eds making long faces about the evils of rent control, which never even broach the topic of property zoning.

    And only weirdo-losers care about the routine criminalization of push-cart, motorcycle sidecar or truck-vending. (Tyler Cowen is crying about restrictions on side-walk food vending…in Bangkok. Not in Los Angeles or Virginia).

    Marxist medicine is poison. Vulgar Marxist analysis…sometimes has its merits.

    Sheesh, one could build a case that property zoning is the key macroeconomic issue of the day. Certainly it is for tens of millions of Americans.



    ReplyDelete
    Replies
    1. I think it's more of a silo thing happening. I see a lot of action happening on local supply - Moretti, Richard Florida, the YIMBY movement. I am happy with the direction of the discourse. I think you risk turning people off with a cynical attitude.

      I think the bias comes from a tendency, at the macro level, to treat finance as a scapegoat. As I say in the post - several countries have this cost problem. Every one has a different banking system, a different mortgage funding system, a different tax regime, different sorts of demand-side programs. Every country that has this cost problem has a local supply problem that makes a few cities more expensive than the others, which can only come from supply constraints. But, pundits in every country blame foreigners, speculators, and lenders. This bias is so strong, that the complaints from NIMBY marchers in San Francisco or Manhattan are basically entirely about rent, and by the time the issue gets up to the Ivory Tower, the topic of rent is entirely gone, because finance is such a universally satisfying explanation.

      I think there is a lot of commotion happening about zoning and supply. It's just that the supply people and the macro people never talk to each other, and they are all happy to blame lenders and speculators, so there is no motivation for them to question the consensus.

      Delete
  2. I may have sent you this link before, but it is a story of a land development company paying $3 billion for parking garage in Hong Kong, upon which they have the right to build a 465,000 sf structure. That's about $6,450 for permitted square foot of building.

    http://www.scmp.com/property/hong-kong-china/article/2094553/henderson-buys-worlds-costliest-commercial-land-plot-murray

    No doubt the buyers will borrow money to complete the transaction.

    Property zoning is perhaps the macroeconomic issue of the day. The Hong Kong Monetary Authority is talking about curbing excess etc.

    ReplyDelete