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Blogging from the Hoover Institution:

Blogging will be light for me over the next few days, as I am in Palo Alto at the Hoover Institution for a meeting of the Hoover Task Force on National Security and Law. We will workshop some papers over the next day and a half.

But I will also add that this is the institution that just recently published economist John Taylor's Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis. It's a short, barely 90 pages essay focused mostly on the monetary issues in the financial crisis. It is also one of the handful of books crucial to understanding the financial crisis and how it came about - I can't recommend it highly enough. I got it and read it in a single late night sitting, then read it again, this time going carefully through the numbers, which tell a remarkable story.

I'll be back to a more regular schedule when I'm done here. By the way, when academics die and go to heaven, it looks like the Hoover Institution. Really great place, and I am very grateful to have its support.

Ricardo (mail):
I haven't read John Taylor's book but based on the reviews in the link above, it seems he is repeating an argument he first made in the Wall Street Journal. Alan Greenspan's response to that argument is here and is worth reading.

Greenspan's argument is backed by the basic observation that long-term government bond yields and long-term mortgage rates barely moved while the Fed raised rates substantially after 2003. You can see this in the yield curves from that period of time here.
6.11.2009 2:09am
A. Zarkov (mail):
The US was not the only country to experience rapidly escalating residential real estate prices. For example Spain had a big bubble-- did the US Federal Reserve cause that too? Spain didn't have the Community Reinvestment Act, Alan Greenspan, subprime mortgages, Fannie and Freddie etc. But it still had a bubble. Perhaps it did have all that stuff too in a home brew form, but I doubt it.

Is this another book that tries to reverse engineer the crisis and explain everything by looking backward? Did John Taylor predict the crash in 2007-2008? Did he predict anything? Was he telling people to get out of the market in early 2008?

If you don't want to lose money investing then, with a few important exceptions stay away from academic economists. Not that it proves anything, but in 1999 I was arguing with a colleague (who has a PhD in economics from Stanford) about Dow 36,000. At that time it was just an article in the Atlantic Monthly. I couldn't convince him the theory was wrong, no matter how many equations I wrote on the board.
6.11.2009 3:39am
Bill Poser (mail) (www):

when academics die and go to heaven, it looks like the Hoover Institution.


I assume you're talking about the working environment. I find the Hoover Tower quite ugly. And much of it is windowless - I can't imagine working in those parts would be pleasant.
6.11.2009 6:00am
Arkady:
Maybe this fixes it:


when [rightwing] academics die and go to heaven, it looks like the Hoover Institution.


I would imagine the leftwing version is something like


when [leftwing] academics die and to to heaven, it looks like Harvard (Yale, Princeton,...) with palm trees.
6.11.2009 7:18am
Zywicki (mail):
I agree that is an excellent book. I read it and just never got around to recommending it here.

Zarkov: Taylor argues that he did predict it based on monetary theory. He also argues that the other countries you identify followed the Fed in their monetary policy--essentially that Europe became over time an echo chamber for Fed monetary policy. I don't know enough about the underlying facts to know for sure but his argument seemed plausible based on the data he presents.

Ricardo: I think that Taylor is basically right and Greenspan is basically wrong. I argued in my WSJ piece commenting on the two of them that Greenspan's argument fails to account for changes in consumer behavior switching over to ARMs and that the fundamental problem turned out to be an ARM problem.

If I am correct, then my argument provides the proximate mechanism that supplements Taylor's thesis of showing why changes in short-term interest rates could provide the underpinning of the crisis.

If Taylor is correct about Europe, then I suspect that something similar can explain at least some of what happened in Europe as most mortgages there are ARMs.
6.11.2009 9:29am
/:
Perhaps it did have all that stuff too in a home brew form, but I doubt it.


Yeah, it's not like Europe is full of socialists denying property rights and perpetuating the welfare state by making employment government's business or anything.
6.11.2009 9:47am
Tracy Johnson (www):
Does this mean you'll be a qualified Hoover Sales Rep when you leave?
6.11.2009 9:56am
rosetta's stones:

"...Greenspan's argument fails to account for changes in consumer behavior switching over to ARMs and that the fundamental problem turned out to be an ARM problem."


Makes sense to me, intuitively. The long term mortgage rates may not have been moving, but those ARM rates can be considered a "movement", especially if coupled with teaser rates. If ARMs were pulled in sufficient quantity, they would have an effect, which might not be described by simple analysis of long term mortgage rates alone.

It also makes sense to me anecdotally. My sister-in-law pulled a mortgage similar to all of the above, and is in foreclosure now that the rate skyrocketed. The home value has plummeted, and I told her to let it go if she can get out of it clean somehow.
6.11.2009 10:05am
Pyrrho:
Yeah, it's not like Europe is full of socialists denying property rights and perpetuating the welfare state by making employment government's business or anything.
What do any of these things have to do with monetary policy, which is the specific focus of both this thread and the post you were responding to?
6.11.2009 12:21pm
A. Zarkov (mail):
Zywicki:

Good answer! We need to get facts. Did Spain have ARMs with low teaser rates that would qualify an applicant for a loan he couldn't afford to pay back?
6.11.2009 1:08pm
lance.cahill (mail):
I'm not sure if I find Prof. Taylor's arguments persuasive. I have yet to read his most recent book, but I have read his working papers and Wall Street Journal op-eds concerning the crisis. I would imagine his book is a lengthened form of that, wherein he may address some of my objections.

I'm afraid Prof. Taylor confuses nominal and real variables when analyzing the role of monetary policy in the crisis. Certainly, the Fed Funds rate was dramatically lowered in the wake of the dot.com bubble burst and the 9/11 terrorist attacks. Whether that increased the amount of money available to potential homeowners is another matter. For example, the Federal Reserve cut interest rates in the lead up to the Great Depression, yet failed to increase the money supply.

Monetary policy in the 90s reflected what many free-banking advocates say would happen if the Fed were abolished. As consumers shifted into stocks during the 90s, M2 velocity rose, but was offset by the rate at which M2 grew. Certainly, the blimp of a bump that occurred in total reserves during the 01-02' recession may have had a poorly understood role in the current crisis, but it hardly justifies the current economic conditions. The current economic conditions are more likely a symptom of the still hotly-contested business cycles. Financial innovation probably had more to do with the current crisis than monetary policy.

Also, if an excessive money supply was the cause of the run-up in housing prices, one would expect this trend to be substantiated if compared to other locations. If this is not true, there must be other factors. The UK had larger overvaluations in home prices, but had a tighter monetary policy. Now, Taylor may have pre-empted this with his argument that the world followed US monetary policy. In addition, I am unaware of whether England had ARMs.

As well, there's some papers out saying the decreased amplitude in the housing investment cycle is due to a tighter integration of capital markets and mortgage markets, decreasing banks dependency on the volume of credit (determined by the policy interest rate) for financing new construction and housing investment. The responsiveness of home investment to monetary policy changes has decreased since the 1980s, which weighs against the verdict that the boom in residential construction was the fault of the Fed.

Let's also remember that the rate of new home construction did not exceed normal rates until 2004. This exceeds the 6-18 months of long and variable lags of the effects of monetary policy.
6.11.2009 1:35pm
/:
What do any of these things have to do with monetary policy


'M' is only one factor of the equation.
6.11.2009 3:34pm
Ricardo (mail):
I don't have data on ARM originations handy right now but here is the data for subprime originations (almost all subprime loans are ARMs with teaser rates but, of course, many ARMs are not subprime or even Alt-A) in billions of dollars. And since subprime loans -- especially those made in the more recent years -- are responsible for so much of the troubles we are experiencing now, the data is very relevant:

2001 $190
2002 $231
2003 $335
2004 $540
2005 $625
2006 $600
[From Gary Gorton's "Panic of 2007" paper]

So subprime lending really started to take off after 2003 when the Fed was already raising the Fed funds rate. It's my impression that ARMs more generally also became much more popular in 2004 and after as a response to Fed tightening. If you are a bank and you think interest rates are going to increase, it is in your interest to off-load that risk onto your borrowers.

The evidence that interest rate cuts directly led to the bubble is weak as Richard Posner, quoting housing economist Edward Glaeser acknowledges* here:

Moreover, a leading housing economist, Edward Glaeser, has pointed out to me that, on the basis of studies of the responsiveness of housing prices to interest rates in other periods, it is unlikely that the fall in mortgage interest rates during the early 2000s accounted for more than 20 percent of the increase in housing prices.


If ARMs were more popular in the period of 2001 through 2003, short-term interest rates may have contributed more to the housing bubble but my impression is that ARMs became much more common only after the Fed had already loosened.

* Just so that no one says I am distorting Posner's argument, he argues that the bulk of the housing bubble was caused indirectly by low interest rates through rising asset prices -- particularly stock prices. I don't find this a plausible argument. Many of those taking out subprime mortgages, for instance, had no assets in the first place. The stock market market outlook was also very uncertain up until 2005 or 2006 -- and by that time the Fed was already ratcheting up interest rates. The timing doesn't work on these arguments.
6.12.2009 1:32am

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