The Role of the Federal Reserve and the Housing Bubble

We recently received the following excellent question about our post on the current mortgage crisis.

Question: One of the solutions we have seen to the economic recession we are now in is to push down interest rates for home loans to help out the housing market. If these loans are once again made with implicit or explicit government guarantees to home buyers with less than perfect credit are we setting ourselves up for another crash?

Great question! The short answer is yes, but I would wager that we not dig ourselves a bigger hole this time (largely because the financial steam shovel that dug it is decidedly out of commission). I neglected to mention the role played by the Federal Reserve in the earlier post because everything already appeared complicated enough. However, the Fed played a very important role, which definitely deserves its own post. In the previous post I mentioned how depositors leave money in banks, which is then lent out as mortgages, which are then sold to Freddie and Fannie, who then sell them to investors. Thus, the cycle is fed by both ends as money from investors works its way (via Freddie and Fannie) back to the banks where it mingles with more money from depositors and is leant out again to begin the cycle afresh. What I did not mention is that banks have a third source of funds—the Federal Reserve. Essentially, the Federal Reserve lends money to banks (either through buying bonds from them or direct lending). The money supplied by the Fed is the source of the nation’s money supply and is simply created electronically and dwarfs the amount of physical currency in circulation, which is determined by the rate at which people want their electronic dollars turned into tangible ones. The Federal Reserve began its current policy of lower interest rates in 1997. Part of this policy was due to the fear that the Asian Financial Crisis would trigger a credit crisis in this country, which did not materialize (although there was a mild credit crunch). A less well known reason for this policy was a quiet agreement between the Federal Reserve, President Clinton, and the Republican Congressional leadership. Concerned about government deficits, Alan Greenspan persuaded the government to rein in spending. Politicians, however, were concerned that less government spending would slow the economy, so Greenspan agreed to offset any economic pain caused by budget cuts with lower interest rates. The lower interest rates fueled an economic boom, which turned to bust in 2000-2001 and was made worse by the dot.com bubble and 9/11. The perceived need to stimulate the economy has kept interest rates very low since then, which, of course, added more fuel to the monstrous circle of lending and buying mortgages.

But will these lower interest rates create a new bubble? As mentioned above, they probably will. However, we must recognize that this time the vicious cycle discussed in the earlier post should not re-materialize or do so on a much smaller scale. For starters, banks are being careful of whom they loan to, and Freddie and Fannie are broke and can’t buy the mortgages off the banks. Furthermore, having been badly burned, investors won’t be buying the mortgaged-backed securities that poured cash into Freddie and Fannie, which then made its way into the banks and resulted in more poor lending. That being said, this does not mean we will not see a bubble. No matter how noble the intentions, the economic paradigm remains—when something is subsidized you get too much of it. This is true for everything from credit and housing to ethanol. It was true in the 19th century, when government subsidization led to a railroad bubble and in the 21st when cheap credit fueled the dot.com and housing bubbles. Anyway, hope this answers your question, and thank you very much for sending it. While we don’t get a lot of comments, several hundred people read this blog every day. While this is flattering in itself, we would feel even better if we got more questions.

Comments

[Is this necessary]

My take is that the several hundred people who are reading this blog daily do have some questions. Why not contact them and ask why they are not posting questions and comments?

It's probably the same reason few if any questions get asked during business update meetings.

[Bobby L]

I think the next bubble won't be houses, trains, or even ethanol per se - I think it will be a "Green bubble," and given all the legislation, and promises of millions of jobs, subsidies and mandates galore, etc., etc., that "we" really haven't learned anything from this past decade and it will be just as bad in about 8-10 years.

[Lucas Pillman]

Alastair Walling,

Thanks for the response, and yes, that did answer my question. I was actually a little (happily) shocked when I came back to see how you had so thoroughly answered my question.

I think both of your posts emphasize how much government intrusion into a market like the housing market always distort the market. The hard truth seems to be that there are too many resources located in the housing market right now, and that those who made the poor investment into these markets will have to suffer some form of loss. Will this fly politically? No. Government will continue to subsidize homes.

But investors might take note that government subsidies or insured investments like mortgage securities are not immune to the force of creative destruction moving resources to where they are valued most.

Alastair Walling, you graciously said you are interested in questions so maybe you can help me with what I am now scratching my head about. We have just discarded two government subsidy solutions to the housing market/bad loan mess we now have. Is there a politically viable alternative that conforms to free market principles? So far, free market ideas on how to deal with these toxic assets has been seriously lacking.