Brad DeLong argues that over investment in housing during the real estate boom was small relative to the size of the global economy. He attempts to explain the slow recovery from the consequent slump by arguing that credit cycles fail to operate subsequent to the collapse of the housing bubble. Every dollar of over investment in housing produced a $120 drop in output when the bubble collapsed because credit stopped flowing to fund new investments. Moreover, political resistance to government investment, financed by deficits, blocked one of the four remedies for restoring growth. That, along with a 2% inflation rate target, limited the impact of monetary policy. Real interest rates could not fall far enough to stimulate private investment when the expected return on investment was depressed.
The comments that follow DeLong's post raise some issues that DeLong did not consider. I have listed some examples below:
* As the value of real estate inflated during the boom households took out home equity loans to fund consumption. That source of spending dried up after the collapse; households were forced to rebuild their balance sheets. Consumer spending was hit with a double whammy. Households were forced to pay down debt during a period of high unemployment, slow growth in wages, and elevated job insecurity.
* Wall Street banks were in the business of producing mortgage based derivatives. They borrowed against the assumed value of the derivatives that they held to purchase a stream of new mortgages to produce the new derivatives that they manufactured. Many banks became illiquid when they were unable to borrow against derivatives that had lost their value. Many banks also became insolvent when the derivatives that they held lost value. The financial system would have collapsed if the Fed had not resorted to extraordinary measures, including placing the toxic derivatives on their balance sheet. This was not a typical slow down in the credit and investment cycle. Highly leveraged borrowing, to produce derivatives that declined in value, exceeded the value of the real estate purchased during the boom.
* The customers of the banks who purchased the toxic derivatives were also damaged. That included pension funds, endowments, insurance companies as well as international banks. Banks in Europe were prime customers for the toxic derivatives. Since they had a AAA rating they could invest in them without a requirement to place capital in reserve as a cushion against loss. Their balance sheets were in serious trouble when they had to write down the value of the derivatives that they held. That, along with investments in AAA rated sovereign debt that turned out poorly, had a major impact on the credit cycle in Europe.
* Central banks have kept interest rates extremely low for an extended period of time. Low mortgage interest rates have certainly been good for the damaged real estate market. They have also been good for the stock market in a number of ways. They have encouraged a rise in asset prices but they have not stimulated investment in productive assets. Large corporations are taking advantage of low interest rates to buy back their own stock and to pay out dividends. That is a quick way to increase stock values without making risky investments in new productive capital.
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