Last week, I posted a summary to a New York Times op-ed by financial crisis expert Peter Wallison (“Nightmare on Elm Street: A Picture of the New Housing Bubble”). Wallison had argued that a new housing bubble was developing. I included with my summary a chart that he circulated privately to back up his claim.
In a comment on my post, J Climacus wrote: “I’d like to see a debate between you and [American Enterprise Institute scholar and Ricochet contributor] Jim Pethokoukis, who seems convinced that the problem is that there hasn’t been enough easy money, not that there is too much.” To me Mr. Climacus’ comment pointed to some of the most urgent issues in the economy today and widely spread confusion about them. I felt the response deserved a full post.
To begin, I am sorry to tell Mr. Climacus that, in my view, the reason for the housing bubble is not too much easy money. In fact, despite appearances, money has not been easy enough. Rather, the new housing bubble reflects a profound and troubling change in our economy and our nation.
Here is what I mean:
Because of the enormous growth in M1 beginning in the last third of 2008 (rising from roughly $1.4 trillion then to $2.6 trillion today), many conservatives have feared an explosion of inflation. Instead, from the start of 2008 to the end of 2013, prices have risen by an average of less than 1.7% a year. Some analysts insist we are actually in a period of deflation. What gives?
Milton Friedman taught that inflation (or lack thereof) is always and everywhere a monetary phenomenon. Money comes in two parts: 1) what the government creates and banks use for capital (about 16% of the total) and 2) bank credit (the remaining 84%).
Though the government-created part (which is included in M1) has exploded, bank lending has stalled. The reasons are Dodd-Frank and Basel III, the new international bank capital requirements. Cato Institute economist Steven Hanke has argued that, as a result, “total money supply is still 9.1% below its [long term] trend level, while private credit remains 7.2% below its trend level.” (Read Hanke’s article at the link for a fuller discussion covering the US but also numerous other economies, in particular the Eurozone, UK, and China.)
Still, if total money is growing so slowly, why is the housing bubble back?
The answer is that U.S. government policy through Fannie Mae and Freddie Mac, as well as administration fiat, favors the residential mortgage markets, including, as Wallison showed in his New York Times article, a return to practices akin to sub-prime lending. Not easy money but government favoritism is why a housing bubble is developing again, just as was the case with the last bubble.
As the government is pushing credit into housing, Dodd-Frank and Basel III are requiring that bank lending become safer, with “safer” determined by a scoring process. The scoring gives preference to U.S. government debt, convenient at a time when our government must finance unprecedented volumes of borrowing. It also favors the most credit-worthy companies and financial institutions—the Fortune 1000 and the big banks themselves (where it is mandating higher levels of bank capital).
Here is the problem: To the extent that banks hold housing-related paper, sketchy mortgage lending will lower their scores. With bank lending growing below trend already, someone will be squeezed, but who? The answer is the riskiest of the remaining players, which would be small businesses and start-ups, the major source of new jobs in the U.S. economy for the last several decades.
So, no, I do not believe our problem is too much easy money. And, yes, I believe money is too tight. But, more seriously by far, in a manner unprecedented in our history, the government has pushed aside the markets and is administering credit.
In so doing, it is directing credit away from the nation’s most powerful job and innovation creators and to the housing markets, the largest companies, the banking sector and itself. You might say, it is betting on yesterday and against tomorrow.
No wonder job and new business creation are all but dead in the water.