by Mario Rizzo
To argue successfully that a low Fed interest rate policy was the fundamental cause of the housing boom-bubble is not a slam dunk. A relatively small reduction in the mortgage rates available at the time should not alone have a generated so much of a boom.
Casey Mulligan has a very interesting post at his blog, supply and demand (in that order). [I must say I have never liked the neo-Ricardian implication of the title: supply – real factors – is more important than demand. But let that pass. I like his blog anyway.] The immediately relevant posts are here and here.
In true Beckerian fashion, Mulligan asks the question: How is housing (the ultimate good) supplied? It is supplied not only by the physical inputs but also by all of the financial services that go along with it.
A mortgage contract has a certain “put option.” The owner can give up the house and walk away owing nothing. (Yes, there are costs involved.) Now the put option is worth something. It is worth more in expected value when there is an increased likelihood of a price crash. Now as prices in the housing market go up, the probability of the fall increases. Suppose the put option is not subsidized. In that cases, mortgage rates or some other cost of buying the house will rise.
Now suppose the put option is subsidized, say by the explicit and implicit guarantees of government sponsored agencies or by the fear of systemic risk problems (“they can’t let all this fail”). Then this valuable option becomes increasingly valuable as the boom goes on. However, because of the subsidy the new homeowners do have to pay more by the amount of this increased value.
(The reader should note that there is an asymmetry here. The subsidy does not turn into a tax when the probability that housing prices will rise increases.)
Therefore when we see the mortgage rate only somewhat below the normal mortgage rate we are not making the correct comparison. The effective mortgage rate should have been higher than the normal rate. This means that the relevant price of houses was actually going lower even as the observed mortgage rate did not move much.
This makes sense to me. Nevertheless, I should add that I do not rule out other factors playing a role too (and neither does Professor Mulligan).