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Sep 26 2008

Monetarism and the Housing Bubble

For Becca, who asked why some of us fogeys were talking about the housing bubble crash as though it had implications beyond a bailout.

Monetarism is the basic economic principle the U.S. currently operates under. To simplify greatly, monetarism says that the health of our economy is directly dependent on the amount of money in it. It’s a top-down ideology that treats the economy as a monolith, with no regard for differences among industries or for non-monetary events, but it has some appeal in its simplicity.

Since the Carter administration, the heads of the Federal Reserve, all three of them, have been monetarists. The setting of the Fed Rate on a periodic basis is a monetarist policy decision, determining how much money is available in the economy in the form of loans. Lower interest rates make more money available. The broad acceptance of monetarism is seen in the way that investors eagerly await the Fed’s decisions on rates and the way the stock market can swing after a decision.

Alan Greenspan was the second monetarist Fed chairman. His reputation was made by his handling of the 1987 stock market crash. He was reappointed by Democrats and Republicans and was one of the most trusted people in government. Despite overseeing the economy during the dot com bubble, his reputation remained intact until the collapse of the housing bubble.

The housing bubble itself and the problems stemming from it may be Greenspan’s fault. The dot com bubble burst in early 2001. In September, America’s confidence was shattered. Markets fell further. The Fed responded by drastically dropping interest rates and flooding banks with cheap cash. Those rates stayed ridiculously low until rising gas prices triggered general inflation a couple of years ago.

The banks, with their “responsibility to shareholders” (see also this), had to do something with that money. Because the average consumer was already overextended with debt, because much of the production for our economy has shifted overseas, because there was no political will to invest in infrastructure, because confidence at the top doesn’t mean everyone is confident, the banks had to create a place to invest that money. There was nowhere real to put it, so we got a bubble instead.

This bubble is largely a failure of monetarism. It shows monetarism to be a myopic, overly simplistic theory. In addition, it’s a failure of laissez-faire capitalism, which has generally been sold to us right alongside monetarism, since monetarism was created and adopted first by libertarians. Anarchic markets and industry are not the answer. They’re the problem.

We all know (at least all of us who can think) that strict monetarism, if it wasn’t the answer last time, is not the answer this time. We’re just not sure what comes next.

2 comments

1 ping

  1. 1
    Mike Haubrich, FCD

    One of the problems of low-interest credit is that it screws up the reserves of banks. As Washington Mutual learned, banks can’t make a profit by offering short-spread revolving credit while at the same time paying higher than market rates on savings. Banks were almost forced to go with alternative securities by a low-credit policy. They shored up their reserves by going after lower-quality higher-potential-yielding and it cost them. Now they have been swallowed by what is starting to look like a massive consolidation in the banking industry. When rates are low like this, smaller banks just can’t compete with larger banks. Another problem that I see with low interest rates is that people see no reason to save their money in solid savings accounts which pay barely over 2% (even though it is compounding interest) we have become such a short-sighted economy that it makes no sense to have a savings account when we could be using our money instead to pay revolving debt. Live now, pay later.By continually lowering rates, the Fed may have doomed us.

  2. 2
    Stephanie Zvan

    Thanks, Mike. I knew the Fed Rates were below the CPI for several years. I didn’t think about what that meant to savers, though–basically that money in savings still loses value for that entire time.

  1. 3
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    [...] collapse. The excess of funding came from monetary policy instead of retirement savings, but the result was the same. The housing bubble itself and the problems stemming from it may be Greenspan’s fault. The dot [...]

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