Just What We “Need”

November 27, 2009

by Mario Rizzo

Investors’ eagerness to invest in mortgage debt helped drive mortgage rates to all-time lows this week, Freddie Mac said.

The average rate on 30-year fixed-rate mortgages was 4.78%, the agency said Wednesday, matching a record low set in April. That was down from 4.83% from the previous week and 5.97% a year ago

I am amazed that aggregate-demand economists can look at the housing market and simply wonder how to bring it back to normalcy. Today the Wall Street Journal reports that investors are flocking to invest in mortgage-backed securities now that the Fed has been buying them. Freddie and Fannie are too big to fail, and so forth. The risk premium relative to Treasuries has fallen to the narrowest point this year.

From the investor’s perspective these are relatively safe problem-free investments. On the other hand, from the social perspective these investments delay the necessary adjustment of resources out of housing — remember: the over-expanded bubble sector?

Our aggregate-demanders (aka “Keynesians”) do not need to worry because during recessions the allocation of resources is not important. All that matters is propping up spending and restoring “confidence” in something called “the economy.”

UPDATE: A New York Times editorial argues that the housing stimulus is not working. What is their standard of “working”? It is hard to tell precisely. The complaints are that new housing construction has fallen, prices of houses are expected to fall still further and that more homeowners have negative equity. So presumably a policy that “worked” would have increased housing construction, propped up prices, and prevented the spread of negative equity. No readjustment in their play book! What is more disturbing, but predictable, is that the drumbeat for reconsidering the Fed’s plan to begin exiting the housing market has begun:

And the Federal Reserve, whose interventions have sustained the housing market over the past year, must show flexibility. The Fed has made it clear that it would prefer to begin withdrawing support for the market in the months ahead. But without other strong and successful fiscal measures in place, that could do more harm than good.

Stay tuned.

6 Responses to “Just What We “Need””


  1. Policymakers are not distinguishing between cyclical and permanent changes. If home prices have permanently fallen, then policies to “stimulate” housing must fail.

    To return the nominal value of homes to their pre-crisis level would require a great inflation. That would still not restore the real value of homes to their pre-crisis level.

    Policymakers are trying to contrive a solution where one already exists. Homeowners who are hopelessly underwater have an existing remedy: bankruptcy.

  2. Bill Woolsey Says:

    I hope no one is so crazy as to believe that real residential investment, much less home prices everywhere, should rise to past peak levels.

    Surely, the Fed is targeting credit into housing because they believe there has been some kind of overshooting (or undershooting, I suppose.)

    I don’t favor having the Fed determine what asset prices (including houses) should be, much less trying to target output of some particular sector of the ecomomy. I think they are doing this because they see their role as fixing failures in credit markets rather than simply maintaining aggregate demand. I think the criticism that they are solely focused on aggregate demand and don’t see a need to reallocate resources is 100% wrong. It is rather that they think the market is misallocated credit and resources–too little housing. Not relative to the peak levels, but compared to where it would be if the market was left alone to allocate credit.

  3. Mario Rizzo Says:

    Bill,

    How does the Fed know what overshooting (the adjustment) is if they did not know that there was a bubble previously? See my post “Retrospect..”

    https://thinkmarkets.wordpress.com/2009/11/28/retrospect-is-prospect/

    There is a macroeconomic knowledge problem.

    https://thinkmarkets.wordpress.com/2009/01/21/the-macroeconomic-knowledge-problem/

  4. von Pepe Says:

    Prof. Woolsley,

    I hope no one is so crazy as to believe that real residential investment, much less home prices everywhere, should rise?

    Too Little housing? So, are you saying based on potential AD housing quantity is too low? Isn’t the FED then targeting output in some particular sector?

    I have tried for 9 months to follow you and Scott Sumner and I admit it is very seductive…but it always kinda comes back to old-fashioned macro-management of just pulling levers and poof, we are back to potential output (do we ever consider potential output being targeted is wrong for amongst many reasons we pulled future consumption into the 2002-2007 period – so, we are even wrong on that aggregate statistic?)


  5. The best guess is the Fed is trying to stabilize the value of the MBSs held by banks, so there need be no further write downs. But the Fed is prone to repeat past errors, as chronicled by Allan Melzter in his history of the Fed. Acccording to Meltzer, the Fed have repeatedly mistaken permanent changes for cyclical disturbances.

  6. Mario Rizzo Says:

    Jerry’s comment is interesting because it shows the interrelation between the financial sector (stabilizing the value of MBSs) and the real sector (prices, construction activity in housing). The aggregate demand economists seem to concentrate on the impact of the value of MBSs on the solvency of banks and the total availability of credit. But the total availability of credit is also the specific availability to, in this case, the housing sector. So von Pepe has a good point too.


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