Posted by: Dirk | June 28, 2009

On Monetary Policy

Recently, I have been wondering how much the people running the financial system really knew about the system they created. Now that it is all uncovered it seems incredible that this system survived for so long. All this has affected macroeconomics down to the bone. Just one examle: monetary policy normally is assumed to work through housing starts. A fall in the interest rate will cause real estate investment to go up, thereby creating extra economic activity that should increase demand. So, did the low interest rate of the Fed cause the real estate bubble?

Let’s see. There are two players in this game, households and banks. When will households buy houses? Households are speculating that prices of real estate are growing fast by the growth rate g. They are willing to use debt-financing in order to buy such assets as long as the interest rate r offered by banks is lower than the growth rate g. So given that g>r they are buying. When are firms lending? In normal times banks make money by lending out for the long run and pocketing the difference between the interest rate at which they borrow themselves and the interest rate mortgage holders pay. Not so in the 21st century. Banks sell the loans off to international borrowers. They make money by collecting fees instead.

The banks profit is revenue minus costs, and revenue comes out of these fees. Every mortgage that is securitized brings a profit, and since it is subsequently sold of leaves the banks with no risk. Banks can start over again, without waiting for repayment of old mortgages before they do so. So, revenue is a function of mortgages sold m. Time to sum up: households will buy as long as p > r, banks will finance as long as they can sell the mortgages to somebody else.

The only connection between the Fed’s interest rate i and the mortgage market is the the interest rate charged by banks r. Since r does not affect the banks profits, they had all the right incentives to use teaser rates in order to lure more households into buying houses. But would it not be bad for households if this system would create a housing bubble with an unhappy end and prices falling? Many home owners can just walk away in case that happens, handing in the key to the banks and thereby also unloading their debt. Whoever holds the asset-backed mortgages ends up with the problem.

The interest rate set by the Fed does not play a big role in this game. It certainly helped that there was no threat of higher interest rates in the future, but once a bubble starts it is hard to prick it anyway. Especially if your transmission mechanism fails. Instead, easy money has led to private sector firms loading up with debt in order to defend themselves against highly indebted financial institutions which threatened to use cheap money to take over existing businesses. This is probably what then caused the debt-deflation later on. Macroeconomics is an interesting subject, but the way the economy works changes from time to time. For too long, the discipline has ignored these changes, blinded by the Great Moderation and other phony explanations why still everything would be perfectly fine.


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