By Vernon L. Smith and Steven Gjerstad
Financial and economic collapses in 2007-2008 and 1929-1930 followed unprecedented residential mortgage credit expansions. Both generated household balance sheet crises that were transmitted to banks as asset prices collapsed against fixed debts. Industry suffered from declining expenditures on housing and durable goods, and income fell when production and employment declined. Irving Fisher (1933) described this spiral in “The debt-deflation theory of great depressions.”
These developments impacted major categories of US expenditures. The chart shows percentage changes in expenditures on consumer non-durables and services (C), GDP, consumer durables (D), non-residential fixed investment (I), and housing (H). The change for each category is computed relative to its level at the start of the recession in Q4 2007.
Housing expenditure turned steeply downward long before other major sectors; its decline before the recession began exceeded that of other categories during the entire recession. Housing expenditure peaked in Q4 2005, 51 per cent above its level when the recession began. The consumer durables expenditure peak in Q2 2005 was barely above its Q4 2007 level. The other series increased steadily during the 7 quarters preceding the recession, then declined, none falling so much as housing.
Expenditure patterns before and during the depression were strikingly similar to those in the current crisis. A major real estate downturn began in 1927; consumption, GNP, durables consumption and investment all grew until their 1929 peaks. These series declined in the same order during the depression and the current recession: housing fell most, followed by investment, consumer durables, GNP and finally consumption. (In “Housing Is the Business Cycle” Edward Leamer finds a similar pattern in eight of 10 previous post-world war two US recessions).
In both crises as house prices and homeowners’ equity fell, first consumption and then production and income declined, net borrowing turned negative, and monetary policy began “pushing on a string”. Banks reduced new lending to build reserves against losses. Although the monetary base has exploded in the current recession, its turnover rate – what economists call the velocity of money – shrank drastically. Keynesians call this the “liquidity trap,” failing to convey understanding of its origin in accumulated balance sheet deterioration.
The last chart shows annual average AAA bond rates and the corresponding velocity of the monetary base from 1919 to 1940 and 2001 to 2008 (with five year averages for 1941 to 2000 and quarterly averages for Q4 2008 through Q3 2009).
Monetary velocity collapsed as the depression developed from 1930 through 1932, stabilising in 1933. Comparable velocity declines starting in Q4 2008 parallel immense depression era movements. These are the only two US episodes of dramatic financial system de-leveraging in the past 91 years. During the depression velocity fell because nominal GNP declined by 46 per cent while the monetary base rose only 16 per cent, whereas during the current downturn GDP fell 3.8 per cent as the monetary base more than doubled.
In A Monetary History of the United States, Friedman and Schwartz roundly criticised the Fed for its failure to aggressively expand the money supply from 1930 to 1933. By contrast, many people have criticised the Fed for the scale of its current intervention. How did we reach conditions where the Fed felt compelled to choose between a limited response – which would risk a de-leveraging spiral and collapsing GDP – and a rapid expansion of the monetary base? In part it was because another lesson from the depression went unlearned. Just as in the current crisis, rapid mortgage credit expansion fueled a housing bubble. When house prices fell, mortgage debt weighed on household and bank balance sheets. The deterioration of household balance sheets led to suppressed housing and durable goods expenditures which in turn led to declines in production, employment and investment.
(Click on chart for full-size image)
Once the immensity of the current collapse became apparent, Fed Chairman Ben Bernanke applied depression policy lessons to the current crisis, but he was initially reluctant to go beyond traditional liquidity enhancement interventions. In an October 15 2007 speech, Bernanke reiterated the principle that “…it is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions,” adding the qualification, “but developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.” By September 2008, the qualification swamped the principle: before the end of 2008 the Fed had reserved a woefully under-collateralised financial system with $333bn in lending on commercial paper, $544bn in discount window loans, and more than $82bn of asset purchases from counterparties to AIG credit default swaps. Though the composition of the intervention has changed over the past year, its magnitude has fallen only slightly.
A blindsided Fed’s delayed alert came not from its econometric models, but from the fallout of the July 2007 collapse of CDS prices, which sent an unmistakable signal of widespread concern about residential mortgage-backed securities to credit markets. After BNP Paribas halted withdrawals from funds with deep exposure to the US residential mortgage market, the Fed suddenly realised the extent of credit market problems. Though derivatives were flawed as “insurance”, they did provide the first definite signal of mortgage market dysfunction, a warning instrument not available in 1929.
The lesson is not just that the Fed failed to anticipate the collapse in the bubble: it also didn’t foresee its devastating consequences. This is reflected in the candid comment last year by Fed Vice Chairman Donald Kohn (Cato Journal): “I and other observers underestimated the potential for house prices to decline substantially, the degree to which such a decline would create difficulties for homeowners, and, most important, the vulnerability of the broader financial system to these events.”
In his “Asset-price Bubbles and Monetary Policy” speech in October 2002 Bernanke noted “evidence for boom-bust cycles in residential property: busts followed 10 of 19 booms.” These are poor odds given the collateral damage nationwide residential price collapses can do to household and bank balance sheets.
Steven Gjerstad, Research Associate
Vernon L. Smith, 2002 Nobel Laureate in Economics and Argyros Professor at the Economic Science Institute at Chapman University
