...against fictions and other tall tales

Sunday, 29 January 2012

Interest rates and the housing bubble

In a recent post, Prof. Krugman seems to suggest that the Fed's low interest rates were to blame for the bubble in housing. I side with Robert Shiller on this issue:
The interest rate cuts cannot explain the general nine-year upward trend that we have seen in the housing market. The housing boom period was three times as long as the period of low interest rates, and the housing boom was accelerating when the Fed was increasing interest rates in 1999. Moreover, long-term interest rates, which determine the rates for fixed-rate conventional mortgages, did not respond in any substantial way to these rate cuts until the late stages of the boom. (2008:49)
Visually, this is what Shiller is pointing to (click to enlarge):

Source: Federal Reserve

Now, you can blame the regulators (and their political leaders) for having failed to stem the flow of toxic mortgages by setting prudent mortgage-lending standards, as I did in an earlier column. But to suggest that the Fed's low interest rates created the bubble is not right. On this point, the Financial Crisis Commission made it very clear: excess liquidity did not cause the bubble; rather, it was the failures in financial regulation and supervision that are to blame, including the "failure to effectively rein in the excesses in the mortgage and financial markets". (2011:xxvi)


National Commission on the Causes of the Financial and Economic Crisis in the US, The Financial Crisis Inquiry Report, Public Affairs: New York, 2011

Shiller, R., The Subprime Solution, Princeton Press: Princeton and Oxford, 2008


  1. Nod! circuit. You did what Schiller didn't do-challenge the critic on the premise. In any case, the critic should have checked Schiller's work before tabling the thesis, and go to the secondary reference FCIR for backup.

  2. Shiller knows what he's talking about. I'm not sure what the critic has to gain in saying the Fed caused all this. In my mind, that's like giving a free pass to those who were really at fault. Speaking of whom, this reminds me of something I read not long ago on the Bank of Canada site. I consider it the first law of banking:

    "Prudence on the part of individuals and financial institutions is the first line of defence against this risk. Households need to ensure that, in the future, they will be able to service the debts they take on today. For their part, financial institutions are responsible for appropriately assessing risk, as well as the ability of clients to service their debts." Household debt backgrounder

    The last sentence is the kicker, in my view.