Tyler Cowen on the Housing Crisis and the Real Economy

Tyler Cowen brilliantly covers a lot of ground but let me pluck those portions that pertain to the macroeconomy:

The fundamental problem in the American economy is that, for years, people treated rising asset prices as a substitute for personal savings … asset prices haven’t been rising much lately, so many people will need more savings for their retirement or for possible emergencies … The second problem is that the American economy is enduring a credit crisis, with many banks trying to raise more capital and make fewer loans. Savings are good for the economy when they lead to investment, but there is no guarantee that financial institutions will be allocating capital efficiently. The third problem is that lower consumer spending will require the American economy to make some shifts. That may mean fewer Starbucks and fewer new homes but more tractor production for export to foreign markets. In the long run, shifting some consumption to investment is probably beneficial to the economy; in the short run it means job losses and costly readjustments … What should policy makers do? One path that is likely to prove counterproductive is further fiscal stimulus in the form of tax rebates. Such stimulus can raise consumer spending and bolster the economy in the short run, but it works — if it works at all — only by pushing consumers to spend rather than to save. It merely postpones needed adjustments by providing a grab bag of goodies at exactly the wrong time.

Brad DeLong once described recent global macroeconomic history in terms of locomotive engines. First, there was the late 1990’s business investment boom. Then there was the residential investment boom prompted in part by the easy monetary policies designed to at least partially offset the collapse of the first locomotive engine. As Tyler notes, the resulting increases in housing prices led to a reduction in private savings, which was accompanied by the Bush fiscal stimulus (or was that irresponsibility) to dramatically reduce national savings.

Now that the residential investment boom has also collapsed, we have a few choices. One is to make sure national savings stays low – something neither Tyler nor I would recommend. The other would be to find policies to encourage investment and net exports to insure that the rise in national savings does not end up leading to insufficient aggregate demand. While I have long advocated a continuation of the return to easy monetary policies, I am mindful of how Tyler closes this piece:

HAVE you ever tried to undo a bunch of tangled wires or cords? If you don’t pull on the right wires in the right order, the mess becomes worse. If you pull too hard, the whole thing can break. But if your first pulls are good ones, the untangling becomes easier with each move. That’s like our economy’s situation today. If we expect too much too quickly, we’ll make matters worse. But there is a way out of the mess, and it lies in our hands. Be careful, and start pulling.

While plugging – as in the little Dutch boy and the leaky dike – sounds like the opposite of pulling, I happened to like how Alan Blinder rebutted the criticisms of recent Federal Reserve policy from Willem Buiter:

Mr. Buiter slams the Federal Reserve, European Central Bank and Bank of England for what he says was a mishandling of the financial crisis and monetary policy over the past year. He gives the worst marks to the Fed, saying it’s too close to Wall Street and financial markets — responding to their needs to the detriment of the wider economy. Mr. Buiter, a former member of the BOE’s Monetary Policy Committee, said the Fed overreacted to the economic slowdown — misjudging the importance of financial stability to the overall economy — and created a deeper inflation problem as a result … Assigned the task of critiquing the paper was Alan Blinder, the former Fed vice chairman, who gave high marks to the central bank. Mr. Blinder brought his point home to the crowd with a tale of a little Dutch boy (Mr. Buiter was born in the Netherlands), entertaining the crowd of international central bankers, academics and Wall Street economists:

One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. He started to stick his finger in the hole, but then he remembered his moral hazard lesson. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout. And doing that would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a floodplain.” The boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned, including the little Dutch boy.

Mr. Blinder continued: “You might have heard an alternative version of this story circulating around the Fed.”

In this kindler, gentler version, the little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. … It was painful. The little Dutch boy would much rather have been somewhere else. But he did it anyway. And all the foolish people who live behind the dike were saved from the error of their ways.