Easy money is secondary to bank regulation in triggering housing booms
I’ve already reported on the excellent piece of research that Jordà et al published last year. Last month, they elaborated on their previous research to publish another good paper, titled Betting the House. While their previous paper focused on gathering and aggregating real estate and business lending data across most major economies since the second half of the 19th century, their new paper built on this great database to try to extract correlations between ‘easy’ monetary conditions and housing bubbles.
Remember their remarkable chart, to which I had added Basel and trend lines:
They also produced the following chart, which shows disaggregated data across countries (click on it to zoom in). I added red vertical bars that show the introduction of Basel 1 regulations (roughly… it’s not very precise). What’s striking is that, almost everywhere, mortgage debt boomed as a share of GDP and overtook business lending. It was a simultaneous paradigm change that can hardly be separated from the major changes in banking regulation and supervision that occurred at that time.
Their new study repeats most of what had been said in their previous one (i.e. that mortgage credit had been the primary driver of post-WW2 bank lending) and then compares real estate lending cycles with monetary policy. And they conclude that:
loose monetary conditions lead to booms in real estate lending and house prices bubbles; these, in turn, materially heighten the risk of financial crises. Both effects have become stronger in the postwar era.
As I said in my post on Jordà et al’s previous research, most (if not all) of what they identify as post-WW2 housing cycles actually happened post-Basel implementation. I wish they had differentiated pre- and post-Basel cycles.
They start by assessing the stance of monetary policy in the Eurozone over the past 15 years, using the Taylor rule as an indicator of easy/tight monetary policy. While the Taylor rule is possibly not fully adequate to measure the natural rate of interest, it remains better than the simplistic reasoning that low rates equal ‘easy’ money and high rates equal ‘tight’ money. According to their Taylor rule calculation, the stance of monetary policy in the Eurozone before the crisis was too tight in Germany and too loose in Ireland and Spain. In turn they say, this correlated well with booms in mortgage lending and house prices (see chart below).
At first sight, this seems to confirm the insight provided by the Austrian business cycle theory: Spain and Ireland benefited from interest rates that were lower than their domestic natural rates, launching a boom/bust cycle driven by the housing market. (While Germany was the ‘sick’ man of Europe as the ECB policy was too tight in its case)
And while this is probably right, this is far from being the whole story. In fact, I would say that ‘easy’ monetary policy is only secondary to banking regulation in causing financial crises through real estate booms. As I have attempted to describe a little more technically here, Basel reorganised the allocation of loanable funds towards real estate, at the expense of business lending. This effectively lowered the market rate of interest on real estate lending below its natural rate, triggering the unsustainable housing cycle, and preventing a number of corporations to access funds to grow their business. By itself, Basel causes the discoordination in the market for loanable funds: usage of the newly extended credit does not reflect the real intertemporal preference of the population. No need for any central bank action.
What ‘easy’ monetary policy does is to amplify the downward movement of interest rates, boosting real estate lending further. But it is not the initial cause. In a world without Basel rules, the real estate boom would certainly have occurred in those proportions, and quick lending growth would have been witnessed across sectors and asset classes. The disproportion between real estate and business lending in the pre-crisis years suggests otherwise.
* They continue by building a model that tries to identify the stance of monetary policy throughout the more complex pre-WW2 and pre-1971 monetary arrangements. I cannot guarantee the accuracy of their model (I haven’t spent that much time on their paper) but as described above, everything changed from the 1980s onward anyway.
PS: The ‘RWA-based ABCT’ that I described above is one of the reasons why I recently wrote a post arguing that the original ABCT needed new research to be adapted to our modern financial system and be of interest to policymakers and the wider public.