Wednesday, May 26, 2010

Enabling the enablers

Writing about U.S. business cycles in his wonderful textbook, Ed Leamer notes that eight of the ten post-World War II recessions are rooted in housing busts: "It's homes ... As far as homes are concerned we suffer from collective bipolar disease, swinging back and forth between manic buying and depressed waiting. In both manias and depressions, the housing market does not work right." (p. 196). He characterizes housing booms as giving rise to upward-sloping demand curves. Rising prices suggest more price rises and leverage opportunities facilitate boom-bust cycles. He goes on to discuss the "enablers" -- those who issue mortgages.

Russ Roberts singles out moral hazard from past federal government bailouts as the enabler of the enablers. Bond market participants relaxed their guard and went along for the ride because they had been given good reasons to think that government bailouts are likely -- especially re the GSEs, Fannie and Freddie.