Sunday, December 20, 2009

Was the Subprime Fiasco a Separate Issue from the Recession?

Scott Sumner recently wrote:
I consider the subprime fiasco of late 2007 to be a separate issue from the recession. If the Fed had targeted NGDP growth at 5% then the subprime crisis would not have caused a significant recession, nor would we have seen the subsequent huge losses in non-subprime mortgages, commercial loans, and industrial loans. The latter were mostly caused by tight money.
There's something to what Sumner writes, but only to a degree.

The subprime market imploded in part because of the structure of the subprime market that was securitized with faulty assumptions on default rates. The faulty default rate assumptions are a typical error that econometricians make. They look back a couple of years and project the data they have into the future.

In the subprime market, the econometricians assumed that default rates wouldn't change after securitizations, even though the originators of the subprime loans no longer were at risk upon default because they syndicated the mortgages (and the risk) out the door. Their total incentive, thanks to the econometricians, was based on originating mortgages, risk be damned. Naturally, some aggressive bankers took the econometric backed investment bankers up on this offer.

Thus, this error by econometricians could have occurred in a market where the Fed wasn't manipulating the money supply. And the subprime market did start to crash before the rest of the economy. However, the Fed easy money policy provided plenty of fuel for the subprime expansion. It's as though you gave an axe murderer a machine gun. If he only had an axe he would kill anyway, but with a machine gun he is going to do much more damage.

It was tight money supply, as Sumner points out, that caused the entire economy to go into recession. This also intensified the subprime problem on the downside, but didn't create it.

It should be noted, and Sumner doesn't go this far, but huge Fed money printing could have bailed the subprime market out, but it would have had to have been huge money printing and very price inflationary.

Huge Fed money printing would have further boosted the housing market and pushed prices higher. Thus, allowing those with short-term arms interest rates to flip their houses for a profit. This, of course, would have led to an even greater disaster down the road, but it was an option Bernanke chose not to take. Instead, he chose to bail out the connected Wall Street players and pretty much let everything else collapse.

1 comment:

  1. Sumner's analysis doesn't go as far as yours does because he doesn't understand money. He just thinks its a variable to tweak in his economic models. He really seems to think you can totally defeat the boom-bust cycle with no ill economic consequences and undue redistribution of wealth through scientifically intelligent and objective manipulation of the money supply.

    He's the monetary crank's monetary crank. Friedman was shooting airballs compared to the street game this player runs along the chain link fence and straight into the money hoop.