Wednesday, April 02, 2008

Yves responds to Brad elaborating on why he thinks having taxpayers prop up bad banks and bad mortgages can avoid a serious financial meltdown. Essentially, Yves asks "what part of bubble can you still not understand?" The model Brad offers where we begin with a "good" equilibrium and then move to a "bad" equilibrium does not have room for an asset price bubble, for an equilibrium that is good from a short-term employment perspective, but bad from a short-term efficiency, and medium-term employment perspective (since the employment was being created by bogus jobs in a false, bubble economy).

As the issue of asset price bubbles is central to thinking through how to deal with the mortgage crises. It's worth looking again at just how out of alignment prices got with incomes:Prices have a seriously long way to fall until they realign with rents and incomes.

I thought the questions were 1) how fast would this happen, and 2) would it happen in real or nominal terms, while Brad seems to think we can avoid it altogether. He is not alone in this. Here is the Economist arguing that
Mr Samuelson's other concern is equally misguided. Let the market collapse, he says, and homes will then be affordable. Moreover, lenders will have no fear that they're putting money up on inflated properties. But Mr Samuelson has no idea to what extent fundamentals played a role in the recent run-up in housing prices. Neither does he seem to recognise that prices may well overshoot on the way down, just as they did on the way up.

But the fundamental error is that he fails to see how a collapsing market might deter new entrants, no matter how low prices go. If banks believe that price declines will continue to fuel defaults and defaults will continue to fuel price declines, they will not lend. If they do not lend, willing buyers cannot buy. Even the cheapest homes aren't "affordable" if no one can borrow to purchase them. In both the financial sector and housing markets, moral hazard concerns are important to consider. But right now, in this crisis, a bad equilibrium has been reached that harms good and bad homeowners alike. Now is no time for the government to sit on its hands.
I struggle to understand where the Economist is coming from. I think we have a pretty good idea to what extent fundamentals played in the recent run-up: none. Pick your ratio, it's clear that the run-up deviated from every historical norm. And also, while I appreciate their concern over prices overshooting on the way down, I find it a tad premature given that they are currently 50% higher than they should be. The Economist also seems to think that the US mortgage market has seized up, which is simply not true. If you look at transaction volumes, they are lower than they were in the past, but people are still buying and selling houses, just not as much as they used to. Certain kinds of mortgages are no longer available, but good riddance to them. The problem with housing in the US remains affordability, not cheap financing.

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