Interest Rates and the Housing Bubble
Suppose that John Taylor is right: that prudent macroeconomic policy would have had the Federal Reserve begin to raise interest rates not in the middle of 2004 but in the middle of 2003, and raise them back to boom-time levels not in two years but in one year, like so[1]:
What would have been the direct effect of such an alternative short-term interest rate path on housing prices?
Well, in 2006 interest rates in the counterfactual would have averaged 1/2 of a percentage point more than they did in reality; in 2005 interest rates would have averaged 3 percentage points more than they did in reality; and in 2004 interest rates would have averaged 2 1/2 percentage points more than they did in reality. If you had bought a house at the start of 2004 planning to sell it sometime in 2007, your carrying costs as of 2007 would have been 6% higher in the counterfactual than they were in reality--you would have been able to pay 6% more for the house at the start of 2004 and still make the same profit as in the counterfactual world in which interest-rate policy was much more aggressive. If you had expected the Federal Reserve to raise interest rates faster, then your estimate of the warranted price of housing at the start of 2004 would have been lower--a Case-Shiller index of 150, say, rather than 160.
Maybe a Federal Reserve that trumpeted at the end of 2003 that it was about to raise interest rates far and fast and thus pushed the Case-Shiller index down from 160 to 150 would have then and there stopped the housing bubble in its tracks.
I don't think so.
But the Economist does:
Economics focus: THE desire to rescue a damaged reputation is a powerful motivator. That is one conclusion to draw from a new 48-page paper written for the Brookings Institution by Alan Greenspan.... The crisis, he argues, stemmed from a “classic euphoric bubble” whose roots lay in the sharp global decline in nominal and real long-term interest rates in the early part of the 2000s.... Thanks to this euphoria, banks misread the risks embedded in complex new financial instruments. Mr Greenspan reckons the best remedy is to improve the system’s capacity to absorb losses by raising banks’ capital and liquidity ratios and increasing collateral requirements for traded financial products.... But the biggest gap between Mr Greenspan and conventional wisdom lies in the role of monetary policy in causing the crisis. In Mr Greenspan’s telling, central banks were innocent and impotent bystanders... deny that monetary policy in the early 2000s was excessively loose by traditional central-bank rules of thumb... there is no evidence that low short-term rates drove house prices upward... the global nature of the house-price boom as proof that monetary policy was not to blame... the looseness of monetary policy in different countries was not correlated with changes in house prices....
Monetary policy may be a blunt tool to deal with asset bubbles. But that does not mean it is irrelevant...
[1] It would, I think, have been distinctly odd to do so. Unemployment was definitely not at boom-time levels in 2003 and 2004--so returning short-term interest rates to boom-time levels would have been a somewhat strange thing to do:
