The bubble theorists have had a lengthy stay in the spotlight the last few years. While I try to avoid their version of events leading up to the financial crisis of 2008, it is virtually impossible to avoid it completely. While I disagree with their take of events prior to the crisis, which I will explain here, I thought it best to at least step through the logic just to see if there might be other explanations for the observed phenomena.
One of the elements of the story about how bubbles form according to some of the most outspoken is “artificially” low interest rates that create a form of monetary stimulus, people gorge on credit because it’s cheap and easy, and subsequently make all sorts of investments that eventually go bad, cause massive losses and crash the economy. This may be an overly simplified version of the theory, and if I am misunderstanding it, I would hope that a bubble expert would so graciously intervene and correct me in the comments section.
The first problem with the theory as it has been explained is the missing link between “artificially” low interest rates and the concentration of bad investments into any given one. One would hope that the bar for accepting that bubbles exist because of monetary policy would be set as such to require an identification of what sort of thing occurs that concentrates the majority of bad investments into any given type across a nation of 100 million potential investors. Is it herd mentality?
I don’t have a definitive answer to that question. But if we’re assuming that misallocation of capital took place, and I do not deny it, it would be helpful to check the logical consistency of conclusions that can be reached about whom might have been misallocating capital and then step into how and why. The possibilities might be surprising.
It seems plausible that under conditions where potential investments compete for investment funds that if this sort of frenzy investment behavior took place, it would end up spread over cross -sections of the economy; or at least across a handful of sectors, rather than concentrated in just one type- a particular version of just one – subprime mortgages.
What if, instead of a investment-crazed herd of average people gorging on credit under conditions of “artificially” low interest rates, we had a centralization of investment management services as such that allowed just a handful of financial institutions to create the largest pools of consolidated capital ever known to man out of the multitudes of pension plans, 401(k), and like retirement savings programs, and make investment choices on behalf of the owners of the funds? If this were the case, would it necessarily matter the stance of monetary policy to the formation of a “bubble?” Perhaps it wouldn’t matter within a certain degree; and I don’t believe “easy money” would be a necessary condition to bring about the sort of behavior in the mortgage market observed in the last decade.
Market Monetarists do not all agree on whether low interest rates had a distortive effect on the subprime market or so called housing bubble. I find myself on the side of the spectrum of Market Monetarists who do not believe the effect was significant. I take to heart what Milton Friedman said about low interest rates – a sign that money has been tight; and the duration which the FF rate was comparatively low in the last decade was lengthy. If I look at NGDP growth over the time period from 2000 to 2005, I see that it was varying degrees below trend and did not rise to trend until 2006; leading to a conclusion that monetary policy could in no way be described as “easy” during the first half of the decade in which the “bubble” was supposedly being formed, consistent with Friedman’s take on the meaning of low interest rates. Therefore, I disagree that the stance of monetary policy had a substantial role in the creation of the subprime/housing “bubble.”
My disagreement with the premise that monetary policy created the housing bubble does not constitute a denial that there was a distortion in the housing market, however. I believe there was a distortion. But there could be many different contributing factors that are more structural in nature, one of which I have already mentioned here and discussed in another post.
Marcus Nunes has also pointed out other possibilities, particularly in this post where he documents changes in land-use regulation noting similarities in changes in states that experienced the most dramatic rise and drop of home prices during the last decade.
One other thing about the nuances around bubble theory that bothers me, and this isn’t a logical bone I am picking here, but rather a philosophical one, is the inference that average people are nothing more than mindless sheep who couldn’t possibly make sound choices about how to use their monetary resources and need some external signals in order to coordinate. I wonder if the Internet Austrians understand the philosophical contradictions inherent in their explanation of the housing and subprime market distortions. I can understand the big government conservatives latching on to this narrative, as it would serve their purposes nicely; but it seems well beyond the bounds of what might be written in the annals of libertarian philosophy that elevates individuals and the pursuit of their own best interests over interests of the collective.
PS: Sarbanes-Oxley is a very bad law and needs to be repealed.