I have been trying to make sense of the FCIC report released yesterday. I am apparently the only person who finds both the majority conclusion and the dissenting view unsatisfying and thus believes that we continue to misunderstand this crisis.
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Friday, January 28, 2011
Posted by Thomas Oatley at 8:32 AM . Friday, January 28, 2011
For those not paying attention, the FCIC majority view (six Democrats on the Commission) found that the crisis was avoidable and a result largely of excessive risk taking by financial institutions and regulatory failure by government agencies. The main dissent (there are 2) argues that these factors were clearly part of the story, but assign greater weight to "broad forces" such as the global savings glut.
I find both views unsatisfying because neither rests on any clearly identifiable macroeconomic model. The majority view seems to dispense with macroeconomic reasoning altogether. For them, the crisis is simply a matter of individual behavior; they seem willful in their refusal to embed this behavior in any macroeconomic context. The minority view seems to adhere to a model in which foreign savings generates a demand for safe assets which are available in greatest supply in the US. They don’t embed global financial markets in any broader macroeconomic model.
Because neither viewpoint offers a broader macroeconomic model, neither offers a satisfying answer to either of the two dimensions of the central question: why did the US experience a housing bubble? The majority view doesn’t address the “why US” question at all (a point nicely highlighted by the dissenting view). Nor does it answer the housing bubble question: between 2000 and 2006, residential investment in the US increased from 25 percent to 36 percent of total fixed investment while total investment didn’t increase as a share of GDP (get the data here). Deregulation, which affected the financial sector generally, doesn't explain this sectoral reallocation of investment. Hence, the majority viewpoint doesn't answer the second dimension of the question--why real estate?—either.
The dissenting view can't explain why foreign demand for risk-free assets caused by the savings glut sparked a housing bubble in the United States. This specific allocation of foreign savings (in terms of asset class and country) is hardly a deterministic (or even highly probable) consequence of a sudden increase in savings in the rest of the world. Indeed, the last time a set of countries emerged as major global creditors almost overnight (OPEC in the 1970s) excessive global credit financed sovereign debt (of the commercial bank variety) in Latin America. The financing of over-priced houses in Las Vegas was in no sense a necessary consequence of East Asian savings.
I think that answering these two questions requires one to embed the global savings glut and financial markets in a dependent-economy approach to open economy macroeconomics. The dependent-economy model, also known as the Australian model after the nationality of the key contributors (Salter, Swan, Corden), allows us to consider the impact of a current account deficit on the real exchange rate and the impact of the real exchange rate on the allocation of investment activity between traded and non-traded activities (or between manufacturing and housing if you wish to simplify).
The simple story is the following: a current account deficit causes real currency appreciation. Real appreciation raises non-tradable prices relative to tradable prices. This relative price switch encourages investment to shift away from traded to non-traded activities. More simply, with the dollar over-valued, domestic manufactured goods are less competitive with equivalent foreign goods. So, people invest in activities that don’t compete against foreign goods—e.g., building houses.
This simple mechanism explains one dimension of the crisis: given the US current account deficit, the dollar will strengthen and cause investment to shift into real estate. One would imagine that investment would also flow to sectors that support real estate (i.e., mortgage lending) as well as other areas sheltered from international competition. Hence, a reasonable hypothesis is that the reallocation of investment into real estate and away from other activities resulted from a real appreciation of the dollar caused by the current account deficit.
This leaves the second dimension of the question: why the United States? That is, what caused the US to have a current account deficit? Two mechanisms seem relevant. The first is the mechanism the dissenting viewpoint highlights—the current account deficit was a result of foreign demand for US assets. The second mechanism makes no appearance in the FCIC report—fiscal policy. A decrease in government revenue (2001 tax cut) and an increase in government expenditure (War on Terror) produce a federal budget deficit that reduces national savings. All else equal, the fiscal deficit increases the current account deficit.
As I said, we need not choose between the two mechanisms but we might want to think about their relative priority and importance. One might suggest that foreign enthusiasm for the dot-com bubble of the late 1990s generated a current account deficit and dollar appreciation. The popping of this bubble in 2000 should have seen adjustment, but the re-emergent fiscal deficit widened the current account deficit and kept the dollar strong. On top of this, the foreign quest for relatively safe assets reinforced the impact of the fiscal imbalance on the current account. A self-reinforcing element (mania-induced bubble) emerged as real estate prices began to rise. To that we could consider the consumption boom that resulted from HELOCs as home prices rose in value
In short, viewed through the lens of a dependent-economy model, the crisis was caused by the relative price consequences of a macroeconomic imbalance (the current account deficit). At least part of the blame for this macroeconomic imbalance lies with those who make fiscal policy (a group who seem to be the only government agents entirely absent from the report). There are other implications, but this post is already too long. More to follow.