Revisiting the housing bubble

Timothy Lee has a good post on the revisionist history of the mid-2000s housing bubble in the US. I find the basic premise interesting and pretty compelling: what looked like a housing bubble might have just been prices responding to a mismatch between supply and demand. Lee further says this analytical error—seeing a bubble where there wasn’t one—had huge policy consequences:

This mistake had profound consequences because the perceived size of the housing bubble influenced decision-making by the Federal Reserve. The Fed started raising its benchmark interest rate in 2004, reaching a peak of 5.25 percent in mid-2006. Part of the Fed’s goal was to raise mortgage rates and thereby cool a housing market it viewed as overheated… If the Fed had understood this at the time and acted accordingly, it could have averted a lot of human misery. Home prices would not have fallen so much, and fewer people would have lost their jobs. That, in turn, would have limited the losses of banks that bet on the mortgage market, and might have prevented the 2008 financial crisis.

That’s all fine as far as it goes. But as we reevaluate the housing bubble it’s essential to remember what really caused the crisis in the late 2000s—and led to such an unusually severe recession—and that was the financial complexity and opacity that was built on top of the housing market.

So while this reassessment is important, it’s hard for me to see a counterfactual where things turned out well. The key cause of the Great Recession was a financial panic caused by derivatives, the risk of which were poorly understood. Financial institutions took on more housing-related risk than they realized, and their counterparties did, too—and at key moments in the panic they couldn’t tell just how exposed their counterparties were to the housing market. Housing prices and the Fed’s response are key elements of this story, but they’re the tip of the iceberg.

(Though it’s been years since I have read it and even longer since it was published, Alan Blinder’s After the Music Stopped remains my key reference on this subject.)

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