Friday, June 9, 2017

Housing: Part 235 - Tight Money caused the Great Recession which caused the Housing Bust

This will probably be a long post.  And I may be totally out to left field here.  This is sort of a stream of consciousness post.  I apologize in advance if it is hard to follow.  I've been editing to try to be readable for the book.  I feel like just puking out some ideas on the blog for a change.

First, let me preface this by saying, I am not talking about whether the Fed was hitting their targets or meeting their mandates, as measured, our whether NGDP growth was above or below some threshold.  I am trying to get at something more subtle that maybe is only clear in hindsight.  This isn't a post about second guessing what was done as much as it is a post about what some of the subtle effects of Closed Access could be, and how they might undermine our basic methods for recognizing economic cycles.

Some observers believe that the Great Recession was more a product of tight monetary policy decisions from late 2007 and 2008 than it was a product of the housing bust.  I agree.  But, I tend to push that tight money problem back to early 2007 or even 2006, and I would suggest that the mortgage bust, as we have come to know it, was really a product of the Great Recession.

First, clearly there was a panic that began around August 2007 which destroyed the cash-like character of trillions of dollars worth of securities.  Regardless of one's opinion about Fed policy up to that point, this was a massive dislocation in the market for near-cash securities (Gary Gorton has written about this) which the Fed never countered, at least until the QEs kicked into gear in 2009 and after.  This was followed by policies in late 2008 which were explicitly contractionary, both during and after the crisis events at Lehman Brothers, the GSEs, and other institutions.

Now, considering this, what do we consider to be the defining characteristic of the housing bust?  Defaults?  Defaults overwhelmingly happened after 2007 - even after 2008.  If we define the housing bust by defaults, then clearly tight monetary policy caused the housing bust.  There really is no question about this.  Many anecdotes about defaults filled the papers of 2006 and 2007, but in terms of scale, defaults were overwhelmingly caused by the economic dislocations in late 2008 and 2009.  (Like so many issues regarding the housing boom and bust, the scale is alarming.  This is mountains and mole hills.  Defaults in 2006 and 2007, which were blamed on bad underwriting and supposedly triggered the collapse are a mole hill next to the mountain of defaults that happened when unemployment shot up and NGDP growth collapsed.)  Defaults accelerated after the August 2007 event and accelerated again after the September 2008 event.  More than 90% of the excess foreclosures happened after August 2007, more than 80% after September 2008.

(Even if you believe that prices had to collapse and that monetary and credit policies before September 2008 were appropriate, then, still, an economy full of homeowners with negative equity creates an even more important need for stability of employment and purchasing power.  So, really, even when it comes to the 2007 collapse in private securitizations, monetary and credit policy is endogenous, because those AAA securities broke below face value because of expectations of future defaults.  And those future defaults were bad enough to justify that collapse in valuations only because we explicitly chose public policies that allowed them to happen.  There is little controversy about whether we could have stabilized the economy and the mortgage market more.  The controversy is whether we should have.  The idea that the private securitization collapse caused the Great Recession is circular.  If it did, it is because we chose to allow it.)

How about prices.  Is the housing bust defined by collapsing home prices?  At the national level, the collapse clearly kicks into gear after August 2007.  Prices had been flat from the end of 2005 to August 2007, moving within a 2% range for that entire period.  The national price collapse happened after the August 2007 panic.  The private securitization market had completely collapsed, banks were defensive, and pressure was being applied to the GSEs to pull back.  The only mortgage conduit capable of filling the gap was the FHA/VA conduit.  Funding for homebuyers collapsed, and prices collapsed with it.

GDP growth began its steady decline around then (NGDP growth began to decline in mid-2006, but the decline accelerated in 2007.), the recession officially began in December 2007, unemployment started to shift up, etc.  Except for some commodity inflation, signs are pretty clear that monetary policy was too tight at this point.  So, if we either identify the housing bust by defaults or by prices, in either case, the housing bust happened after monetary policy became contractionary.  As with defaults, the price collapse accelerated after August 2007 and again after September 2008.

How about housing starts?  Housing starts and residential investment began to collapse at the beginning of 2006.  This is a little more subtle.  Before I get into this, though, I would point out that I think defaults and declining prices would be the most common characteristics associated with the housing bust, and that generally those things happened later, relative to the general economic decline, than is generally appreciated.  This is mostly because the small rise in delinquencies and defaults in 2007 was reported on with much more intensity than the many, many defaults that happened later.  The housing bust, as a proposed cause of the recession, is rarely described in terms of housing starts.  So, nothing that is commonly associated with the housing bust was really happening before August 2007.

As I have argued before, I think this early phase of the bust, where contraction was mainly manifest in declining investment, is actually the first sign of economic contraction, it was a development that was generally encouraged because of the mistaken idea that there were too many houses.  Fed members generally saw this as a positive development.  Mortgage growth continued through 2007.  I think this is generally because the rate of new first time homebuyers is more stable than other segments of the market, and these tend to be more leveraged buyers, so there is a natural stickiness to mortgage growth.  But, mortgage growth rates kinked down at the beginning of 2006, just like investment, housing starts, and home equity levels did.  It just took a little longer to adjust down.

This is the period where equity as a percentage of real estate values really started to collapse.  Prices were still relatively stable, but mortgages outstanding continued to rise, thus the rise in aggregate leverage.  Homeownership was falling by then.  I have argued that much of this shift was due to an exodus of capital out of home equity, much of it in the form of owners selling and not repurchasing new homes.  By 2006, first time homebuyers were in decline and exiting owners were increasing at the same time.  In addition to that shift, there was a shift of households out of the Closed Access cities.

Data from American Community Survey
During the boom, these were households selling out of the high priced cities and repurchasing in lower priced cities.  During the boom, some of those homes were purchased by households who were moving into the Closed Access cities, but most of them were purchased from existing Closed Access households who had been renters.  In both cases, this was a shift in ownership from lightly encumbered households (because they generally had significant capital gains) to more leveraged households.

This is where the interpretation is a bit subtle.  Generally, the housing bubble idea is based on the idea that the unsustainable supply of credit led to capital gains which would inevitably be lost, and that households were spending those capital gains on consumption.  But, what if prices reflected reasonable valuations of future rents, and credit supply was simply facilitating the purchase of what were really economic rents from exclusionary local political policies regarding housing?  Then, that consumption wasn't unsustainable.  It certainly wasn't unsustainable for those Closed Access outmigrants who realized their capital gains.  And, the new homeowners that purchased those homes weren't using those mortgages to fund non-housing consumption.  They were using the mortgages to fund the purchase of those expensive homes, and they were, in fact, probably crimping their other non-housing consumption as a result.

We can really think of other homeowners the same way.  Even if a household retained their home and got access to their gains by taking out home equity loans instead of selling their property, they were still accessing economic rents, just like the households that sold or moved.  The value of the homes were just as permanent.  They just chose to continue to hold those homes as unrealized gains instead of selling them and realizing those gains. and Sufi estimate that during the boom these home equity extractions amounted to at least 2.8% of GDP.  We can see this simply by comparing residential investment with mortgage growth.  Generally mortgage growth runs slightly below residential investment, but during the boom, mortgages outstanding were growing by about 2% more annually than residential investment was (as a % of GDP).

The Fed, trying to maintain low inflation, was countering this by reducing currency growth.  I'm not saying they were targeting currency growth.  I'm just saying, if mortgage growth was leading to increased bank deposits that were related to rising consumption, a central bank targeting inflation will naturally limit currency growth.  We can see that PCE core inflation was generally at target during this time, even though currency growth was very low.

Note, by the end of 2006, much of the excess mortgage growth was gone.  Since then, households have had to fund residential investment from other sources.  But, currency growth continued to fall until the summer of 2008.

Now, a reasonable response to this is that, while the Fed might have been a little tardy in reacting to the collapse in mortgage growth in 2007 and 2008, it was perfectly reasonable for them to counter the inflationary pressures of mortgage growth before then.  In terms of viewing monetary policy through the Fed's stated targets and mandate, this is certainly true.  Even in terms of NGDP growth, in late 2006 and early 2007, nominal GDP growth was sort of on the cusp of growth rates that would normally be considered recessionary, and it was subsiding, but it wasn't at a rate that is undeniably recessionary.

Unemployment was also stable, although I would argue that employment growth was actually beginning to weaken substantially, and that the first phase of contraction led to a reversal of the Closed Access out-migration surge, which was a buffer against rising unemployment.  This caused the early signs of cyclical dislocation to be hidden, so that by the time unemployment became a signal of contraction, there had been many months of internal stresses within the economy.  Even having said this, though, the rise in unemployment in the US predates the rise in other countries.  Something unusual was happening here by early 2007.

Setting Fed mandates and targets aside, though, what does this mean simply with regard to stability itself.  What if much of that new housing wealth was the capture of economic rents?  These were largely future potential economic rents, which will eventually be earned through excessively high rental rates on those properties.  Those future rents are capitalized in today's home prices.  This added consumption wasn't being financed by using unsustainable capital gains to borrow from financiers.  It was financed by those future economic rents.

This was basically consumption smoothing by rentiers.  The rentiers were consuming today out of their capitalized future economic rents.  And, on net, we would expect non-rentiers to lower consumption as they suffer from the losing side of the surge in rentier incomes.  Rentiers explain the increase in borrowing.  Non-rentiers explain the increase in low risk investments, such as AAA securities.

Current consumption was being claimed by non-producers.  That isn't controversial.  My tweak to the story is just that this consumption wasn't unsustainable.  So, this means that there would be inflationary pressures.  This means that the rentiers were claiming current consumption from the non-rentiers - they were outbidding them.

What if those gains were sustainable?  Then we have an economy composed of rentiers and non-rentiers.  According to Zillow, from 1998 to 2006, total value of Closed Access residential real estate increased from $2.9 trillion to $7.4 trillion - most of that after 2002.  Even in real terms, this was an increase of about $4 trillion.  Mian & Sufi estimate extracted home equity, nationally, from 2002 to 2006 at $1.45 trillion.  If that is a transfer from non-rentiers to rentiers, that is a major economic dislocation.

Mian & Sufi's 2.8% represents all borrowing through this channel, so consumption would only be a portion of that.  On the other hand, this measure does not include capital gains captured by households either selling homes into the boom or selling high priced Closed Access homes to move to lower priced cities.  Adding all of these sources of current consumption together, it seems that this transfer of rents accounted for much of the growth in personal consumption during the boom.

Real GDP growth per capita was significantly higher in the Closed Access cities during the boom than it was elsewhere, by the way.

Taking all of this together - the low level of currency growth, the significant rise of credit fueled spending, and the moderate levels of total spending and of inflation - suggests that there was a shift in consumption toward households who were harvesting capital gains from housing.  All else equal, without that shift, inflation would have been negligible and nominal GDP growth would have been very low.

Again, I don't think I really need to assert anything here.  This is not controversial.  The idea that debt was fueling consumption is universally accepted.  But, the difference between irrational, unsustainable capital gains and harvesting of permanent economic rents is pivotal here.  What would happen if the source of consumption was from the harvesting of permanent economic rents?  Imports would rise.  Savings would increase.*  Debt would rise.  Everything that happened would happen.  And, if the central bank didn't counter all of this, then inflation would rise, too.  But, the central bank did counter it.

We are an open economy, so when the central bank countered the inflationary effects of this consumption smoothing, at first, it didn't create a problem.  We purchased imports - which, again, were seen as unsustainable overconsumption from debt, but really were consumption smoothing from the owners of our increasingly exclusive asset base.  Inflation is basically a product of monetary policy, and as long as it isn't disruptively high or low, it shouldn't matter that much.  Eventually it mattered because policy became disruptively tight - first leading to extremely sour expectations in real estate markets, then a breakdown in mortgage markets, then finally a sharp downturn in consumer inflation and NGDP growth.

But thinking about inflation in this way, the question arises: how exactly was monetary policy to blame for the housing bubble?  And, how was tightening it supposed to be the cure?  Even in the conventional telling, that this was all reckless and unsustainable debt fueled spending, how was lowering the inflation rate supposed to help?  I mean, if housing debt was allowing households to claim an extra 2% of current consumption, why would that be any different if inflation was 5% or 0%?  Those households were using access to nominal spending power, but they were claiming real output.  Why would a change in inflation change that?

The only way monetary policy could change that is by lowering expectations so much that it induced a crisis of confidence in the housing market by causing home price expectations to collapse - to fall into negative territory.  And, this is clearly what had happened, in a pretty extreme way, by no later than mid 2007.  The Fed's response to these collapsing expectations was to say "the housing correction is ongoing", and to continue to use that term - "correction" - through the end of the year, even after the collapse of private securitizations.

To this day, this is explicitly and widely supported.  The problem, the story goes, with the economy in 2006 was that all those starry-eyed speculators thought that home prices never go down, and that if there was any mistake about how we handled it, it was that we didn't set up markets for those prices to fall earlier.  I am making a damning accusation about the policies that were widely demanded and enacted in this country at that time.  This is awkward, because it should require some contentious claim about what was being demanded.  It's awkward, because the claim itself is not contentious at all.  The explicit demands to create negative expectations in the housing market were broad and loud then, and they are still broad and loud.

Data from Zillow
The reason my criticism is so damning is because the premise was wrong.  The reason my criticism is so damning is a boring little scatterplot which shows that the capital gains funding that consumption were from permanent economic rents.  While the country was fretting about how home prices were becoming unmoored from rational value, rent was becoming a more and more important factor.  It still is.

Notice in the graph how most metro areas basically fall on a line that intersects the origin.  In other words, prices and rents were fairly proportional.  (In 2007, the Contagion cities were causing a bit of a bulge at the top end of the mass of less constrained MSAs, pulling it slightly above the proportional line.)  But, in the Closed Access cities, and generally only the Closed Access cities, the relationship is not proportional because the price also reflects future rent expectations - a cash flow growth premium.  By 2015, even with a basic, linear, unweighted regression between median rent and home prices among MSAs, r^2 is above .85.

Notice one thing that nobody ever expected.  Nobody expected the rents in those high priced metropolitan areas to decline.  We aren't about to see a correction there, even though that is where the correction is needed.  This would require a resurgence in housing - at least in terms of building and lending.

This realization should create a wholesale shift in how we view monetary policy at the time.  Monetary policy was countering this housing-fueled consumption.  But, this wasn't coming from a widespread dissemination of debt to marginal households.  This was coming from a minority of households who had become quite wealthy by obstructing access to opportunity through repressive housing policies.

This seems like the classic problem of a non-optimal monetary regime.  There were two distinct types of Americans - those who were consuming gains from economic rents and those who were not.  The first set didn't need monetary accommodation.  The second set did.

But, in the end, this problem is dwarfed, I think, by two more important factors.
  1. The consumption fueled by housing gains had nothing to do with monetary policy, except that before 2007 we were within a range that allowed the economy to function.  And a functioning economy that contained these pockets of Closed Access was bound to have high home prices.  When we left that range in 2007 and 2008, that source of consumption was undercut.  But, of course, this catastrophe was applauded, not derided.  "If only we had done it sooner."
  2. The effect of the expectations channel overwhelmed any negative effects of the more conventional damage tight monetary policy might have caused for the have-nots.  As I review the data, even the decline in migration out of the Closed Access cities that began to happen in 2006 was mostly due to the decline in migration among homeowners.  The disruptions were targeted to recent homebuyers in Closed Access and Contagion markets.  When those disruptions took hold, the Fed didn't discontinue its tight policy, and since policymakers thought working class borrowers were the source of that extra consumption (They weren't.), they severely clamped down on lending to those markets in 2008 and after.  And, it was late - in 2009 and 2010 - that those households were hit.  But, even there, the hit was largely through housing, as working class neighborhoods really took a beating as a result of those late policy choices.
But, even though this was related to expectations specific to housing, it is still intertwined with monetary policy and the problem of rentier and non-rentier needs.  Some neighborhoods in places like Dallas started to see slow price declines in 2006 and 2007, accelerating in 2008.  Dallas was non-rentier territory.  An extra 5% of inflation over that period might have done wonders for sentiment in places like Dallas where home prices were never particularly high.

It only got worse after early 2008.  Regarding working class homeowners, one might properly conclude that the housing collapse did cause the recession.  But, in that case, it was tight credit policies from the GSEs and Dodd-Frank, in 2008, 2009, and 2010, that caused dislocations in those communities.  Low tier home prices didn't collapse across the country in 2009 and 2010 because of bad underwriting or excess prices in 2005.  So, for those communities and neighborhoods, it was the credit-policy induced housing bust of 2009 and 2010 that exacerbated recessionary conditions in 2009 and after.

Because the exodus of homeowners that had been growing throughout the boom and accelerated in 2006 and 2007, home equity levels collapsed much more strongly than valuations, both the growth of mortgage financing and the harvesting of equity continued to boost consumption after expectations in the housing market had soured.  In addition, sanguine attitudes about the collapse in housing starts meant that there was no natural buffer for declining investment by the time of the first panic in August 2007 and by the time the recession officially began.  Housing starts were already at levels normally associated with the depths of a recession.  Prices began to collapse, in part, because the shift in quantity supplied that could come from changing rates of new building had already been mostly exhausted.  This was met with indifference because of the mistaken notion that we had too many homes.  Ben Bernanke still thought there were too many homes in 2011, and he was far from alone.

For many of these reasons, the collapse was felt first in changing expectations about home prices.  Obviously, negative expectations about values create a natural dislocation in ability to use an asset as collateral.

Here is where you might scold me and explain that it isn't the Fed's job to keep home prices from declining.  I certainly agree, with regard to idiosyncratic price movements.  But, these were nationwide.  As a start, we should have a strong presumption that broad changes in sentiment and price have a systematic or monetary source.  And, obviously my contention that prices are mostly capitalized economic rents from future political exclusion is important here.  But, even setting all that aside, let me suggest that all of our measures of monetary policy effectiveness - inflation, output, NGDP growth, etc. - are not the end goal of monetary policy.  They are proxies.  They are proxies in the service of stability in the business cycle.  In the end, regardless of what we think those proxies were signaling to us, they are only proxies.  If every tactical target the Fed has is on the nose, and an imminent collapse in housing sentiment is going to lead to a generation defining recession, then proxies be damned.  We shouldn't let tactics take the place of the mission.

I don't blame the Fed for looking at those proxies.  It's not their "fault" in that sense.  But, just because the proxies failed doesn't mean that the any of these series of developments were not, in some sense, monetary issues.

But, even saying that, the horrible truth is that we imposed three (really four) stages of collapse on ourselves.  (1) the housing exodus in 2006 and 2007 that coincided with collapsing investment and the retrenchment of migration that had been flowing away from the high cost cities, (2) the August 2007 securitization panic, (3) the wider panic of late 2008, and (4) the federal denial of credit and the late crash of working class housing markets from 2008 to 2011 (and really to this day).  The initial collapse in sentiment might not have even been catastrophic if we had stopped after #2.  Maybe a generous lending policy from the GSEs in 2008 would have been enough to stabilize the economy even with a very tight monetary policy.  Surely the lack of mortgage access had something to do with the sharp drop in low tier prices, and the sharp drop in low tier prices was the root of rising defaults, collapsing securities valuations, etc.

The counterfactual that would be interesting to know would be whether systematic support of generous conventional lending in 2007 and 2008 and after would have been enough to counter any cyclical effects of the repricing in the Closed Access and Contagion cities that might have come from the collapse in private securitizations.  That repricing had happened by the tragic late 2008 episode.  I don't think that most of that repricing was necessary, but in any case the credit repression that happened after that and is still happening - after monetary policy finally became more accommodative (over much public consternation) - was egregious and unnecessary by any measure.

* Much of the savings was from foreign sources.  And much of it was unmeasured because capital gains on those homes are not counted as savings, even though they really are savings if they are permanent, and they certainly are savings for the many households that sold and realized those gains.

Saving rates look low throughout the Closed Access era because the capital gains are received as savings by the rentiers, but they are not recorded as savings.  Whether these are properly considered savings or not depends on if the gains are sustainable.  They are if they are capitalized rents.  They aren't if this was just an irrational credit-induced bubble.  This is the trouble with this topic.  Our interpretation of events affects the causal inputs.


  1. Well, I am going to have to read this one a few times, but on first reading I would say "this is the real story."


    The above post is much simpler (reflecting its author), but in its way complements your post.

    I will toss in my usual quibble: In all the words of the above post, you cannot edge the two that sum everything up? "Property zoning."

    At the core of problems in monetary policy, again and again, is zoned property.

    This is from Adair Turner, a really smart guy, even if I do not quite agree with his slant on this:

    "As a result, unless tightly constrained by public policy, banks make economies unstable. Newly created credit increases purchasing power. But if urban real estate is in scarce supply (which it is in many cases), the result is not new investment but asset price increases, which induce yet more credit demand and yet more credit supply. At the core of financial stability in modern economies, I would argue, lies the intersection between the infinite capacity of banks to create new credit, money, and purchasing power, and the scarce supply of irreproducible urban land. Self-reinforcing credit and asset price cycles of boom and bust are the inevitable result. Such cycles are inherent in leveraged banking system."

    Of course, urban land may be "irreproducible" but certainly high-rise condos and subways can do a lot to change the effective meaning of "irreproducible." (Push-cart vending too!)

    You (correctly, I think) say the increase in consumption from bank lending on property was in some ways justified, as the urban property was in fact more valuable, given property zoning. It wasn't poor people getting liquored up on second mortgages in Bakersfield.

    But I think there is some logic in Turner's comment too, that freshly-printed money in a modern developed economy pours into extant assets in real estate booms, fueling consumption of all kinds.

    Then, if a central bank wants to clamp down on inflation (ever a topic for a Richard Fisher), or if the central bank worries about financial instability from rising property values, it starts to cut the jets.

    Indeed, if central banks pull the rug out from real estate to fight inflation or rising real estate values, you can get a collapse in property values, as we saw.

    And banks are heavily exposed, and so they collapse.

    It may beyond the ken of your book, but Turner raises interesting questions about the role of debt, and the possibility that simple central bank helicopter drops might be a much better way to boost demand in an economy, rather than rising real estate values or the federal government borrowing more and more money.

    In sum, get rid of property zoning and send in the choppers.

    1. I think I have two main differences from that point of view.

      1) I view debt differently than others. I think there is a lot of "reasoning from a..." going on. Debt is treated mainly as a demand phenomenon, and I think rising debt is more often a result of rising supply - savings looking for low risk. These episodes do tend to be associated with low interest rates, after all. This gets explained away by attributing low rates to loose money, which you and I both would agree is not really correct. Or it is explained away as bankers becoming reckless and lowering their spreads, sort of flipping it back to a demand explanation, as the supply of credit fuels nominal spending. I think declining sentiment leading savers to demand low risk securities is a better explanation and flips the story upside down. It would call for accommodation instead of tightening.

      2) I think there is a monetary offset to credit expansion just as there is monetary offset to attempts at fiscal stimulus. This clearly was happening during the boom. This also gets misdiagnosed because low interest rates are blamed on loose money, so it is very hard to argue that money was tight when credit was expanding. But since there is monetary offset, it is more useful to think of this as a transfer of consumption from non-rentiers to rentiers rather than an increase in consumption across the board. One might say that there was an increase of consumption across the board, which led to rising imports. But those imports were funded by economic rents too. Rentiers have global income sources, and their consumption is global too. This is where the persistently positive US income on foreign investments is important. If credit supply alone was funding those imports, foreigners should be earning more income from us.

  2. Certainly, you are have lots of company in the "global capital glut," which includes me.

    I suspect extensive sovereign wealth funds, public pension funds, legally required insurance (premiums invested), rising global incomes allowing savings, and semi-forced Far East savings and probably some other factors lead to Niagaras of capital in a globalized economy.

    People like to say, "Savers are entitled to a return," and they forget that savers are also "entitled to a loss." If the supply of capital exceeds the profitable investment options, you get losses.

    On the your second point I think you are right, but I am beginning to not trust international trade and capital flow stats. $32 trillion in offshore accounts, and Apple profits booked in Ireland, and $5000 in paper-cash in circulation for every US resident etc.

    In my pen-for-hire business, I am seeing more and more private JVs of foreign money teaming with US operators to buy and upgrade class B apartments. So, is this classed as a foreign purchase of land? Can the federal government track money anymore?

    John Cochrane had a convoluted diagram of offshore entities that owned Trump's personal helicopter and I got a headache just looking at it. A four-sided Rubik's cube is nothing.

    I agree with the NY Fed study (somewhat bolstered by your blog post on foreigners supplanting native-borns in closed-access US cities) that foreign money pours into US real estate, helping appreciation in residential values.

    But at the core of the problem is always property zoning.

    1. But where home prices are high, incomes are rising too and rents. How would foreign money driving up home prices cause rents and incomes to rise? The source of rising prices isn't foreign. It's the protected local labor market.

  3. Fantastic, comprehensive post. Almost every thought I had as I read, then got addressed. First caveat (hat tip to BC!), local authorties should have loosened property zoning.
    From the perspective of monetary policy, the Fed was in a tough, but not impossible situation. Their inflation targeting regime could not handle the situation. I think that the best the Fed could do from August 2007 would have been to target 5% NGDP growth (LT being even better) and that the result of that would have been two years with close to 5% inflation and almost no RGDP growth. But after that, the economy would have quickly returned to normal and unemployment would have never exceeded 6% or, at most, 7%.
    That said, at the time, this wasn't easy to see. In July of 2008, the Fed looked at last 12 month CPI and saw 5.5%. That's pretty high. They didn't realize that we are on a path to sharp negative inflation and really soon.

    1. Yes. And, I have to be careful. I put some of this on tight monetary policy, but I don't put this on Fed leaders. (Well, I say that, but some of their reasoning is baffling, like how interest on reserves was necessary in order for them to keep the Fed Funds Rate at 2%, which is basically saying interest on reserves enabled them to stick to a catastrophic policy. But they are in a tough position here.) As bad as it was, they were pulling us in as loose a direction as they probably could have. I mean, after the disastrous errors in September and October 2008, due to discretionary tightening, the overwhelming complaint was that they were bailing out Wall St. I blame monetary policy, to an extent, but the country as a whole is responsible for that, and in a way we were lucky to have the leadership we had. In the end, the blame lies with Closed Access policies, which are like a virus in the zeitgeist, so that stability and growth are equated with bail outs and inequity. Until we kill that virus, this is probably our lot.

  4. For some reason, my browser only showed the comments prior to mine after I posted. Oh well - I didn't add much to the discussion. :-(
    Semi-related thought to economic rents. Real estate investments can be volatile. Prices are more volatile than rents, at least in multifamily. But when setting a trend line for growth, many markets should track close to inflation over time. But rents in Closed Access markets will grow faster; perhaps at the rate of NGDP growth. As interest rates and cap rates have fallen over the last two decades, the impact of that additional rental growth has made the difference in cap rates bigger on a percentage basis (ie, 4% is to 6% is a much bigger number than 7% to 9%). So not only does rent grow faster over time in a Closed Access city, but the prices will be increasingly volatile.

  5. "But where home prices are high, incomes are rising too and rents. How would foreign money driving up home prices cause rents and incomes to rise?"--KE

    My position is not that only foreign buyers push up housing prices; it is that they contribute to the rise.

    However, I can imagine a scenario in which foreign inflows of money would cause incomes and rents to rise.

    For sake of argument, let us take Perth, Australia, perfect climate, 2 million pop., safe place, good government.

    Okay, so let's say some movie stars and celebrities move to Perth, and it becomes hip, and "put on the map." Perth becomes a Vail, or Monaco in the media.

    Okay, so foreign capital flows into Perth as hipsters buy houses, and new businesses open up, such as fancy restaurants, spas, $15 drink bars, boutiques.

    These new businesses generate higher incomes for owners and employees, otherwise they would not displace existing thrift shops and stationary stores.

    The bartender at "$15-Drinks Bar" is making a lot.

    At first the inflow of capital is welcomed, but soon residents feel the character of their city is getting bulldozed, and their sons and daughters priced out of the housing market.

    So they start downzoning, or leaving already restrictive zoning in place, and start instituting rent control. Yes, exactly the wrong moves, but this is what always happens in the Anglosphere, no?

    Obviously, as foreign capital competes for the limited supply of housing, housing goes crazy, to an average of a million dollars for a shed. Maybe foreign buyers are not the bulk of buyers, but they are often the marginal buyer. So they play a large role in setting price.

    There you have it, incomes higher, rents higher, housing prices higher, from foreign capital inflows.

    Los Angeles may look something like this. I am trying to think what L.A. exports. Yes, Hollywood, but as a fraction of local employment, Hollywood is not much. The big industries left town (aerospace).

    What L.A. sells is land. It sells land and consumes imported goods.

    That is also the U.S. trade model to some extent.

    1. My imagination must not be as good as yours, because I don't see this as a very plausible scenario outside of small boutique cities. :-)

  6. Well….

    Would a city like Vancouver, Canada be defined as a economy known for exporting financial or tech services, or as a place wealthy people move to from around the globe?

    Orange County, CA? I can't think of any service they export. Ask people in OC what they do and they offer a blank stare and answer "real estate."

    Silicon Valley and NYC seem to fit the model of high-productivity regions that export services (and have tight property zoning).

    Los Angeles somewhat in the middle, probably. Huge amounts of foreign capital buying real estate, from what I have seen. Export industries left long ago, but maybe some serves are exporter, or Hollywood stuff.

    Your own blog show foreign-borns replacing or supplanting (depending on your point of view) native-borns in closed access cities. No doubt some of that is talented job seekers, but another component must be offshore investors buying land.

    Remember: Anyone on the planet who buys $1 million in property in the U.S. can get a EB-5 green card and become a resident.

    And then we have the NY Fed study that nations that run current account trade deficits have house price explosions.

    That makes sense---foreign capital seeks a low-risk home (no pun intended). But $1 of foreign capital can leverage up 5 to 1 through the U.S. banking system.

    Add that picture to tight property zoning….


    China has been clamping down on capital leaving the country.

    "The rise in China's foreign exchange reserves is bad news for global real estate"

    Business Insider

    Mar. 12, 2017, 8:05 PM

    "Now that the capital controls expressly prohibit real estate purchases, it’s kind of tricky for Chinese buyers to continue to drive the market. Actually, it’s likely pretty hard to even get the money to pay the mortgage on current purchases. Vancouver, Canada – a hotspot for Chinese buyers, saw a sales decline of 78% during this Chinese New Year, one of the most popular times to buy. Bloomberg also reported that Chinese real estate buyers were suddenly short on cash after the change in rules. February’s inflow of foreign exchange might be the first official data point to show that China’s buyers can’t continue to drive international real estate markets."

    We see this:

    Vancouver's Average House Price Drops By Nearly One-Fifth
    The Huffington Post Canada | By Daniel Tencer
    Posted: 02/15/2017 2:22 pm EST Updated: 02/15/2017 2:24 pm EST

    Foreign capital flows must play some sort of role in house prices, especially in global cities, such as NYC, Boston, SF, etc.

    Now prices have "stalled" in NYC

    "Developers Lure Buyers to Cities, Even as Prices Stall
    New York Times-Jun 6, 2560 BE
    Developers Lure Buyers to Cities, Even as Prices Stall ... commercial property, including large apartment buildings, in cities like New York…."

    Just a coincidence that NYC prices stall when China cuts capital outflows?

    1. It may not be a coincidence. Demand is an important factor in prices.

    2. If you made it difficult or illegal for American buyers to take out mortgages, prices would decline, too. And we did!

  8. The plot thickens..but becomes more muddy. My next hobby will something simple, like sub-particle physics...