Question: Did Fiscal Policy Create the Housing Bubble?

Here’s an idea: Fiscal policy (or rather regulatory policy) may be more responsible for the housing bubble than the other proposed theories based on monetary policy and animal spirits.

There are two main schools of thought that exist in today’s political and economic schools that shape the way pundits debate issues related to the recession. There is the school focused on the low interest rates during the period of 2000-2006 that has a correlation with increase in prices of real estate. The other school sees predatory lending, derivatives trading, and the packaging of sub-prime loans as the cause for the crash which spiraled into global recession. The issue with both is that they reason from one change or observation, one that is largely small. With the monetary issue, while there has been some expansion between 2001-2004 of the money supply and slight rise above trend for NGDP I find that there is more. And with the fear of animal spirits I think such a belief is hardly driven by empirical evidence. It seems to be an even more rudimentary than the view that one industry grows in comparison to other because of relatively low interest rates. The issue with derivatives and sub prime loans deals with the longer term issue of improper banking regulation and the consequences of wanting to provide housing.

So really the question I am asking is that could the policies that gave the U.S. Fannie and Freddie, the FDIC insurance of small banks, and the long history of bailing out investment banks be the primary cause of the housing bubble. The history of small banks in the US is tremendous, with the restrictions on branching causing large instability throughout much of the gold standard. This limit on branching exists to an extent today and with FDIC insurance there is a creation of exuberance, this is the animal spirits not wall street bankers trying to make earnings goals so that they can lease a BMW.

While for a very long while I was partial to the theory that monetary expansion caused the housing bubble and then the crash, today I see that as only a background effect. To me monetary expansion can cause mal investment but the fallout of such mal investment wouldn’t be concentrated in one sector rather it could be representative of a large scale financial phenomena more related with uncertainty. The issue with the contemporary Austrian monetary theory is this exactly. The link between cause and effect, I feel, is many times over exaggerated. There are other issues in my opinion, mainly distortive and over bearing regulatory and fiscal policy since the late 90s.

On small banks Scott Sumner has a good post, so does Matt Yglesias, however I have reservations about some of his arguments.

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