From a macro point of view, there were mainly 2 macroeconomic causes that contributed to the creation of the housing bubble.
- Loose Monetary Policy – 2000-2007
A possible hypothesis that has emerged claims that the creation of the housing bubble was due to loose monetary policy after the dotcom bubble burst in 2001. Following the 2001 recession, a result of the burst of the technology bubble, the target fed funds rate(effectively interest rates) fell from 6.5% in December 2000 to 1.75% in December 2001 and 1% in June 2003. As seen from the graph below, these rates have not been seen since the 1950s and it was only reverted back to normal range towards 2006.
The Taylor Rule was popularized by Noble Economist, John Taylor, as an interest rate forecasting model that acts as a ‘recommendation’ for how central banks should set their federal fund rates to stabilize the economy in the short-term while maintaining long-term economic growth.
It can be seen quite broadly that using the Taylor Rule(Blue Line) as a general guide, fund rates were consistently lower than recommended rates from 2001 to 2006. Loose monetary policy increases incentive for asset managers in financial institutions to search for higher yield investment products thus increasing risk taking. Moreover, low interest rates fuel increase lending, especially in investment, which contributed to the credit expansion of the housing bubble as more liquidity flowed into unrealistic expectations.
- ‘Persistent’ Global Imbalances
From 1970s to 2008, emerging Asia and many of the oil-exporting countries managed to achieve large current account surpluses due to their successful export-orientated strategy. Such a trend should have predicted a general rise in their exchange-rates.(Demand for currency is a derived demand for goods) or a breaking down of the USD due to capital flight that would have triggered a confidence,currency and financial crisis(reminiscent of the 1997 Asian Financial Crisis). The surplus countries delayed such a disaster by reinvesting the surplus funds back into the US which further expanded the monetary base, encouraging excessive consumption and risky investment. The financial crisis indeed manifested but not envisioned by experts, it came in the form of the implosion of the real estate bubble as excess liquidity resulted in unrealistic asset prices.
The imbalances were a result of the following factors:
- The US current account deficit can be identified as a result of excessive consumption, low household savings, accomodative monetary policy(as previously mentioned) and a gradual lost of export competitiveness in certain sectors of the economy. Moreover, the US is the world’s reserve currency which entitles it an ‘exorbitant privilege’. As previously mentioned in an older article(Check out the ARTICLE), the US is able to issue out government securities indefinitely due to the importance of its role in global trade and financial sector.
- On the other hand, the surplus countries especially China are disposed to assume the role of creditor as a result of domestic economic conditions.
- Export Orientated Growth(High X-M)
- Undeveloped financial sector results in a lack of viable local investment opportunities(Investment dearth). It thus leads to excessive savings in financial institutions that aid state-own enterprises but hurt SMEs and the rest of the population(low returns since supply of funds is big)
- Weak social security nets encourages precautionary savings
- Cultural reasons
- Under-valued exchange rates sustained the export-orientated economic boom among many of the developing countries.
- To build up large foreign-exchange reserves(US Dollar) in response to the painful experience of the Asian Financial Crisis in 1997
The result was a global savings glut that was contrasted with a investment boom centralized in US. The excess liquidity result in the inflation of asset prices, significantly contributing to the creation of the financial bubble. Many of these financial products were also sold to investors from emerging economies as they entered the US market for investment opportunities. The global savings glut resulted in the gradual fall in long-term interest rates which further fueled credit expansion. The financial crisis was thus a result of ‘mutual cooperation’ deemed to be unsustainable from the beginning.
Questions to ponder about:
- Is there a justification to burst potential credit bubbles with monetary policy?
- Have there been an improvement in the persistent global imbalances after the crisis?
Check out Part 3…..