On Steven Gordon's blog, Nick Rowe of Carleton University offers his thoughts on what caused the financial crisis/es along with the economics behind his thinking:
Some thoughts on the bubble/s and financial crisis/es, by Stephen Gordon: Nick Rowe provides us with some talking points on how we all got into this mess:
I am taking part in a roundtable on the financial crisis next week at Carleton (Wednesday 8 October 5.30-7.00 in 360 Tory, just in case anyone is interested in attending). The audience and other panel members will be mostly political scientists. I only get 10 minutes. This is what I am currently planning to say:
Opening Salvo: Could better regulation have prevented the financial crisis? Yes; restricting mortgages to less than 70% of the value of the home could have prevented the house price bubble and prevented the crisis. No; because that regulation could only have passed, in a democracy, if a majority of people had been convinced that disaster would happen if people borrowed more; and if a majority had been convinced of that, a bubble would never have happened anyway, and so regulation would not have been needed.
Politics: The left blames Bush, the Republicans, and deregulation. The right blames Obama, the Democrats, and the Community Reinvestment Act. Both sides sound convincing. But both sides are obviously wrong. The housing bubble is global; the financial crisis is global. Russia has a financial crisis, but the Republicans do not regulate Russian financial markets. England had a housing bubble, but does not have a CRA. The US bubble burst first, but other countries are following closely. Canadians watch too much US news. This is a global phenomenon, and needs a global explanation.
What is a bubble? Everybody talks about the house price bubble, but nobody defines what it means. Let me define it:
The amount you should rationally pay for a house, if you sell it one year later is:
1. P = Annual Rent + [P one year later]/(1+r)
And if you (or the people you sell it to) sell it infinity years later, it is:
2. P = Present Value of Rents to infinity + [P infinity years later]/[(1+r)∞]
The second term on the right hand side is the bubble. If everybody expects, and expects future buyers to expect, that future prices will stay finite, the bubble term is zero, and they will not rationally pay bubble prices.
So why do bubbles happen, and why in so many countries at once?
Irrational herd instinct maybe? I don’t know, but I can say something about when they are more likely to happen:
If rents and house prices are growing at rate g, and g<r, then:
3. P = Rent/(r-g) + P[(1+g)/(1+r)]∞
If g gets close to r, very small changes in any of the terms have very big consequences for the price you should rationally pay for a house. The ratio between today’s prices and today’s rents becomes very fragile, and very sensitive to expectations about the future. It gets very hard to distinguish between prices that are high because of a bubble, and prices that are high because other people expect slightly higher growth rates. Maybe other people are right? Maybe houses really are worth that much? (And if g ever exceeds r, we enter the financial twilight zone of pure bubbles, where chain letters are stable, and Ponzi schemes really can make everybody rich.)
So why did bubbles happen in so many countries at about the same time? First, because world interest rates were low. And world interest rates were low not because Greenspan set them low (central banks cannot set interest rates below the natural rate without causing accelerating inflation), but because world savings were high. And world savings were high because the world’s population is getting older, and when people get older they save more for their retirement (note China). And second, because world GDP growth was high (note China and India), Ricardian rents on inelastically supplied land (for houses or oil) had a high growth rate too. So g was close to r. Which made it easier for bubbles to form, in many countries.
So why did bursting bubbles cause a global financial crisis? Why are financial markets so fragile? Because financial markets try to do the impossible. Ultimate savers/lenders want financial assets to be Short, Safe, and Simple. Ultimate investors/borrowers have projects which are Long, Risky, and Complex. Financial markets and financial institutions try to give both sides what they want. In normal times the magic works. Without that magic, people would only save gold or canned food, and there would be no investment, and we would still be in the Stone Age. But the price of that magic is an inherent instability. Each individual can liquidate his savings at any time, but we can’t all liquidate at once. Beliefs become self-fulfilling, and we can also get a second, bad equilibrium, with a bank run or stock market crash. Most people can hold safe assets, if uncorrelated risks are pooled, but some people must always hold the remaining, correlated risks. And if those people go bankrupt, the safe assets too become risky. Many people can hold simple assets, provided some other people do the complicated research. But if their research turns out to be wrong, the simple assets become complicated too.
Efficient financial markets give both sides what they want, but are inherently fragile. There is an inherent trade-off between efficiency and stability. Changes in regulation can move you along that trade-off. Good regulation might improve the trade-off. But it cannot be eliminated. Government bailouts are just the government acting as one more financial institution. Governments too can become illiquid, or insolvent, or get their research wrong.
What should Canada do? Our housing bubble is perhaps smaller than in other countries, and our financial institutions are perhaps more stable. But nevertheless this is a global crisis, and we ought to share in the global rescue. The Canadian government should borrow several hundred billion dollars, and use it to buy risky assets at fire-sale prices. Swap T-bills for toxic waste. We might also make a profit!
Hmmm. I don’t know if I can say all that in 10 minutes.
Comments? Criticisms? Useful advice? What did I get wrong?