Arnold Kling  

Regulatory Hindsight and the Housing Bubble

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Martin Wolf says,


When house prices are going to rise, or people expect them to rise, by 10 or 12 per cent a year, an additional 1 per cent on the interest rate is not going to stop people from buying houses. Of course, we could have said that to buy a house, no one may borrow more than three times their income and that everybody has to have a down-payment of at least 50 per cent of the property price. But I suspect that any government that tried to introduce regulations like that, or comparable regulations to stop bankers from doing deals, would have been swept from power.

Well put. Pointer from Mark Thoma.

UPDATE: see the first commenter below, who points to Wolf's remarks that the efficient markets hypothesis has taken a beating.

Fischer Black, a major figure in the efficient markets school, once shocked people by saying that he felt that prices were correct within a factor of 2. That seemed like an awfully wide range for someone who believes in efficient markets. But it seems fine to me. Maybe the range is even wider for something like oil, where there are so many unknowns.

I think it is possible to believe that financial markets can be subject to wild swings of sentiment and still believe that they should be left alone. If government had been given free rein in 2005 and 2006, who is to say that the political focus would not have been on making housing more "affordable" and throwing more gasoline on the fire, so to speak? In fact, that is more or less what Congress and regulators did.

There is a vast difference between saying that "In hindsight, government could have stopped bubble X," and saying "government officials can be counted on to distinguish better than speculators the difference between permanent trends and transitory shocks; moreover, government officials face few political constraints against acting on their superior information."

Here is where "Markets fail. Use markets" is a helpful bumper sticker.


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COMMENTS (4 to date)
Mark Seecof writes:

What do you think of Wolf's subsequent comments about the efficient market hypothesis (and the desirability of a new regulatory regime)?

WOLF: I believe that there is indeed something very problematic about the way that we have been thinking about free financial markets and how they are regulated. George’s basic point—that market deviations are natural and self-reinforcing and can, if not checked, turn into bubbles—is correct. The efficient market hypothesis—which emerged in its many variants in the 1970s—is not looking very convincing now. We have just had two of the biggest bubbles ever measured—the stock market bubble and the current credit-cum-housing bubble—in the most sophisticated economies in the world. This is not happening in Korea and you can’t blame it on crony capitalism in Thailand. This is in the US and Britain, and these events simply cannot be reconciled with any version of the efficient market hypothesis. Therefore the insights of somebody like George, or like Robert Schiller, who looks at this in terms of behavioural economics, or Hyman Minsky’s theories, seem to me a much better account of how financial markets actually work than the views of orthodox economists from ten or 15 years ago.
Tom Grey writes:

While I think the "efficient market" theory is pretty reasonable, financial innovation is like all new innovation -- not knowing the limits.

The leverage Soros talks about is also partly the increased globalized size, so when a limit is passed (stocks or US house assets; or maybe oil in the near future?), the size of the herd which is now wrong is much bigger.

I absolutely think all financial institutions which paid bonuses equal to or greater than 10 times the average annual salary, should have some 5 year clawback "wrongful profits" tax at decreasing 100, 80, 60, 40, 20% rates of those bonuses, whenever a bank/ financial institution goes bust.

Long Term Cap Mgmt meant the US (taxpayer/ consumer) was the insurer. There should probably be some "too big to fail" tax/ additional capital requirement on all financial firms that are too big.

The increasing USD devaluation is one way to save the banks from their nominal overvaluation errors, at a general cost to US society.

George S is most correct here:

"Regulators have to accept responsibility for preventing asset bubbles from getting out of hand. To do that, it isn’t enough to regulate the money supply; you also have to regulate the availability of credit. Markets are given to extremes of euphoria and panic, and therefore you need to use margin requirements and minimal reserve requirements more actively and vary them according to market conditions. That is the main lesson."

I'm not certain regulating credit is the only way, but stopping asset bubbles IS a gov't job -- given that sloppy managers of firms "too big to fail" WILL be bailed out.

For instance, only allowing 80% of the value of a home loan gone bad to be written off -- where the 80% value becomes a Federal Asset Regulator variable that goes down (to 75 or 70%?) in good times, but up (to 90 or 95%?) in bad times.

The bankers have learned to stop inflation with interest rates. Another rate is needed to stop asset bubbles -- tax write-off rates might be one, with quarterly/monthly adjustments.

Mark Seecof writes:

Prof. Kling, thank you for extending your remarks.

I think that very often the efficient market hypothesis fails to explain events precisely because the government often distorts markets severely. In the case of the housing bubble, the government restricted the supply of housing, then forced lenders to give money to unqualified buyers, then eliminated competition in ratings agencies, which empowered them to make corrupt bargains with issuers, then created and extended severe moral hazards ("too big to fail, etc.") by allowing financial industry firms to privatize gains and socialize losses (directly, by laying off losses onto GSE's, the Fed, etc., and indirectly through schemes based in corrupt tax policy).

The housing bubble could not have occurred without all of the home-buying suckers, the mini-speculators sure that supply of greater fools was inexhaustible, but equally it could not have occurred without the eager participation of all the industry players from the Mozilo/Countrywide, Cayne/Bear-Stearns level down to the lowliest boiler-room mortgage salesmen and "realtors." All of the industry types got rich from fees derived ultimately from selling hollow bonds with the connivance of government actors.

Mr. Econotarian writes:

The question is whether you more strongly believe in the "efficient market" or "efficient government" hypothesis...I know where I'd place my bets.

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