Hummel, Henderson, the Fed, and the Housing Bubble

by Liberty and Power

My old friends Jeffrey Rogers Hummel and David R. Henderson continue to argue that the Fed had little or nothing to do with fueling the housing bubble during the first five or six years of the present decade. Their latest article along these lines appears in Forbes. This is the third rendition of their argument that I have read, and I am no more persuaded now than I was previously.

Hummel and Henderson base their argument mainly on the claim that the Fed was not an engine of inflation between 2001 and 2006 because the rate of growth of the monetary base and the rate of growth of various monetary aggregates were declining during that period. Indeed, they were declining. Computing the rates of growth for the December value relative to the preceding December value, I find the rates to be as follows for the monetary base: 2001, 8.7%; 2002, 7.5%; 2003, 5.8%; 2004, 5.0%; 2005, 3.6%, and 2006, 2.9%. The rates of growth of M2, computed on the same basis, were as follows: 2001, 10.3%; 2002, 6.3%; 2003, 5.0%; 2004, 5.7%; 2005, 4.0%; and 2006, 5.4%.

It does not follow, however, that simply because these (and other monetary) rates of growth were declining, the Fed bore no responsibility for fueling the housing bubble. If we begin at a high rate of growth, as indeed we did in 2001, then rates may fall and still be “inflationary” in their effect on certain asset markets. Consider, for example, that during the entire period from the fourth quarter of 2000 to the fourth quarter of 2006, real GDP rose by only 14.9%, whereas during the same period (December-to-December monthly figures being used) the monetary base increased by 38.3% and M2 by 42.7% — or, by 2.6 times and 2.9 times as much as real GDP, respectively.

In pondering the Hummel-Henderson thesis, I keep coming back to various analogies, such as this one: I walk onto the street and I’m hit by a car going 50 mph; the next day, I walk out and I’m hit by a car going 45 mph; and, being a slow learner, I walk out during the next three days and I’m hit in daily succession by cars going 40 mph, 35 mph, and 30 mph. After five days, I am pretty nastily banged up, but Hummel and Henderson come along to comfort me by informing me that my being hit repeatedly cannot actually have hurt me because each day the car that hit me was going slower than the one that hit me the day before.

Hummel and Henderson also continue to endorse Alan Greenspan’s story that the real culprit was a surge in foreign savings that was invested in large part in U.S. housing-related securities, such as Fannie and Freddie’s bonds. I confess that I have never understood this story. In order to invest in U.S. securities of any kind, foreigners need to acquire dollars. And all dollars ultimately come from the Fed, because every dollar consists of either a circulating Federal Reserve note or a dollar deposit account subject to a variety of Fed controls. Was the Fed really powerless to “sterilize” the inflow of foreign savings? Or did it simply not attempt to offset this inflow, which it might have done by, for example, selling securities on the open market or by increasing required bank-reserve ratios?

In raising these questions, I assure my readers that I harbor no ideological or personal animus whatsoever against Jeff Hummel and David Henderson. Indeed, I love each of them as I would love a brother (which, in a sense, each of them is to me). I am puzzled by their persistence in attempting to persuade us with a story seemingly aimed at vindicating the Fed (while insisting, however, that, all things considered, the world would be better off without this central bank). I continue to believe that the Fed deserves a major part of the blame for the housing bubble because, however we tell this whole sorry story, our interpretation must inevitably include a plausible answer to the question: where’d the money (i.e., the dollars) come from?

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Robert Higgs - 4/21/2009

All the policies you mention certainly had the effect of distorting the flow of investment, Sheldon, and they conceivably might have created such a big distortion that we would have ultimately called it a housing bubble. But it would not have been as big a bubble as we actually had when the Fed was pursuing policies that fostered the substantial growth of money and credit. Easy money policies foster asset-price bubbles in part because they allow the most pumped-off sector(s) to expand rapidly without requiring an offsetting nominal contraction elsewhere in the economy -- everything appears to be hunky-dory until the distortion becomes too great to continue growing any longer, and then the downward cascade takes hold.

Sheldon Richman - 4/21/2009

Bob, assuming the Fed created no money in the relevant period but all the tax, housing, and banking interventions to promote home-ownership were in place (CRA, GSE guarantees, cap-gains tax differential, too-big-to-fail etc.), wouldn't there have been a price bubble and an overinvestment in housing relative to other things?

Bill Woolsey - 4/19/2009

I am quite certain that Higgs is very well educated in economics in general. I presume he has read everything that I have regarding macroeconomics and no doubt a good bit more. I remain baffled by some of his positions regarding macroeconomics. Looking over my past post, I did not mean to suggest that Higgs was unaware of many of the elementary points that I consider central to sound macroeconomic reasoning. (I am just baffled by his staements about sterilizing net capital inflows--possible, I agree, but hardly desirable. If there was a net capital inflow in the U.S. during the period, interest rates "should" have decreased.")

At first pass, I would say that if base money had been frozen or had grown at half of its actual rate, then the nominal price of homes would have risen less fast, but the relative price would have risen the same. (The Fed could have even made the same error of over expansion--at least in the slower growth rate scenario.)

In reality, if the 5% growth path for nominal expenditures (on final output) had switched to 2.5% or 0% or whatever in 2000, then I have no confidence in predicting what would have happened to the prices of houses or much else during the disinflationary adjustment period.

But I do take the "theoretical" position that in a fixed base money world, or one with a slower growth path of base money allows for asset price bubbles.

I favor a slower growth path of nominal income than the one the Fed put us on for the last 15 years or so. But I hold out no hope that making that correction will make asset price bubbles impossible.

Robert Higgs - 4/19/2009

Bill,

It probably serves no worthwhile purpose for me to demonstrate that I am not as ill-educated as you seem to think I am with regard to economics in general and macroeconomics in particular. So, let us try to move on.

Your post is a long one, and you touch on a variety of points. I have no quarrel with many of these points. Perhaps we can get to the heart of the matter my own post sought to emphasize by asking the following question: Were the Fed's actions between 2001 and 2006 (specifically in facilitating large increases in the monetary base and in various monetary aggregates) a necessary condition for the run-up in housing prices (and in corporate stock prices, as well) that occurred during that period? I answer "yes." Do you answer "no"? Note that in answering as I do, I am not thinking in terms of far-fetched theoretical possibilities or scenarios, but of the actual circumstances of 2001 to 2006, so the question may also be put: if everything else had been exactly the same, but the Fed had held the monetary base constant, or even held it to half of its actual growth, would the run-up in housing prices have been as great as it actually was?

Bill Woolsey - 4/19/2009

Some time ago, I read figures reported by Larry White regarding nominal income (total spending in the economy) rising above trend during the early part of the decade. These same figures have been emphasized by Taylor and so are now common knowledge. Greenspan ignored White, but responded to Taylor. It is sad that Greenspan took the usual central bank approach that it is never our fault, but I think that Henderson and Hummel have the more balanced approach--it was only a little bit the Fed's fault.

I believe that this sort of policy error made by the Fed early in the decade would cause something "bubble-like." And, more importantly, could help start a real bubble. However, there were many other government interventions in the housing market during the period that simultaneously could start a bubble and, further, encouraged lending into the bubble. I believe that the actual _bubble_ was mostly a matter of entrepreneurial mistakes.

Leaving aside whether or not there was a bubble in real estate and what causes such things, I have difficulty in standing aside when I read what I think is an analysis that ignores basic macroeconomics.

For example, Higgs claims to be puzzled regarding net capital inflows and interest rates. I find _his_ claim puzzling. If we didn't have central banks manipulating the supply of money through the banking system, what would determine interest rates? My view is that, ceteris paribus, if foreigners want to put more savings into a particular country, that increases the supply of savings (and given other assumptions, the supply of loanable funds) and lowers the market clearing interest rate. Unless something else is assumed to be perfectly elastic, interest rates should change as Hummel and Henderson described. There are implications for the allocation of resources, and importing Chinese consumer goods and building more homes here in the U.S. would be an expected response. (And that wouldn't be a bubble.)

I am inclined to a sort of neo-wicksellian approach which means that monetary disequilibrium can interfere with that market clearing process in interest rates. So I would agree that the Fed could have strerilized the impact of additional saving by creating monetary disequilbrium. In a static framework, the Fed could destroy money, creating a shortage of money, and this, through a vareity of methods could offset the surplus of loanable funds and downward pressure on the interest rate. Of course, the resulting depression of output and disinflation or deflation of prices also put downward pressure on real and nominal interest rates (especially through reduced demand for loanable funds) and so a central bank committed to keeping interest rates high can be very disruptive.

As for all of the growth rate statistics that Hummel and Henderson quote, the notion here is that _ceteris paribus_ they mostly suggest disinflation during the period. From a naive monetarist approach, that is about as far as it goes. In reality, the demand for money could have grown more slowly during the period so that slowing growth of monetary aggregates can reflect an inflationary policy.

Base money is a reasonably accurate measure of something that is very important--the medium of account. The dollar is defined in terms of base money. However, that is only part of the quantity of money. Experience and theory provides little reason to expect a constant demand for base money. The broader measures of the money supply have always involved measurement errors, errors that have plausibly worsened in recent years. With the development of sweep accounts, "checkable deposits" no longer come close to measuring that key portion of the medium of exchange. MZM includes things that do not serve as the medium of exchange. But, even if we did have a good measure of the money supply, the demand to hold money could change.

Anyone who still thinks that the sum of currency, measured checkable deposits, savings accounts (including unmeasured checkable deposits and true savings deposits), and under 100,000 CD's measures anything especially interesting haven't been paying attention.

As for Higgs final question. Where did the money come from for the bubble in residential housing? Mostly less investment on other, more productive endeavors. And that is why it was a waste.

Money doesn't literally fill up an asset bubble. Any actual transactions involve transferring money from buyer to seller, leaving the seller with the money.

That subprime mortgages were bundled and made into AAA rated CDOs which required only 20% capital for banks as opposed to the 100% for commercial loans meant that bank credit went into home mortgages rather than commercial loans. That money market mutual funds invested into asset backed commerical paper issued by investment banks, and that this commerical paper funded CDOs that funded subprime mortgages looks to me to be a free market phenomenon. Entrepreneurial error.

The Fed and banks can lend money into existence. There is no guarantee that the fact that people who accept money that is spent want to hold it. And so, deposit holdings don't necessarily reflect decisions that free up resources from other uses, resources that can be used to produce homes or whatever it is that bank loans are used to fund. In my view, that why monetary disequilibrium impacts interest rates, credit, and loans.

The notion that new money must "go somewhere" is just mistaken. Yes, it is always held by someone. If the demand to hold money rises when asset prices rise (say, because housing prices rise) then rising home prices will bring the demand for money into equilibrium with the quantity. But it isn't that the money is being used up in the housing market. It is the demand to hold money is being impact by asset prices.

The fundamental principle of macroeconomics, like all economics, is scarcity. A second important principle is that the flow of current output generates a matching flow of income. Also, for every borrower there is a lender. And for every buyer there is a seller. And, of course, the medium of exchange and the medium account are fundamental to macroeconomic disequilibrium because there is no special market or market price for these things.

William Marina - 4/19/2009

I agree with Bob Higgs argument.
At the same time, economists tend to put forward nice number/figures with which they claim they can meaningfully measure the economy.
But, the Fed has been overall promoting inflationary policies for almost a century now, and at a certain point such policies begin to have cultural consequences, especially on a society's values and overall Worldview.
I pointed this out in an article in 1977, "Inflation and the Disintegration of the Social Order," which can be found under my name at the Independent Institute's web site, www,independent.org
These shifts in values, in time preferences, are quite real and have enormous effects on the economy, even if they cannot be nicely measured by economists such as Henderson and Hummel.