Keynes explains the financial crisis: housing deflation

Reading Keynes yields an embarrassment of topics. While I considered writing about the natural rate of unemployment, the American Reinvestment and Recovery Act, I decided look at something Keynes mentions as potentially extremely important: deflation. Specifically, the recent financial crisis provides an excellent testing ground for this topic.

 

Let me begin with a sentence from “The consequences to the banks of the collapse of money values”: “But consider what happens when the downward change in the money value of assets within a period of time exceeds the amount of the conventional “margin” over a large part of the assets against which money has been borrowed. The horrible possibilities to the banks are immediately obvious.” This was written in 1931, but it reads as if describing our recent financial crisis. Now for two graphs:

First housing in the United States (taken from calculatedrisk.com):

                                                           Next for the financial institutions

 

As should be apparent from the two graphs and a bit of thought, we see that the dramatic drop in housing prices had a large negative impact on the health of the U.S. financial system. In fact, the recent crisis seems to be a case study for many of the ideas Keynes sparked. This may not be entirely unsurprising—Keynes was writing alongside the Great Depression, it seems fitting that there was a resurgence of his ideas in the Great Recession. Real estate was not ignored by Keynes in his writing. In fact, he notes that deflation in housing may be especially impactful “both because of the very large sums involved and because such property is ordinarily regarded as relatively free from risk.” In fact, we see just this; a profound miscalculation of risk associated with real estate leading to a large bubble and subsequent crash in national housing prices.

But why should we care? As Keynes points out, it is of the uptmost importance not only to consumers but to banks as well. Most housing purchases are financed, that is the proprietor of the asset has financed it using someone else’s wealth as arranged through a bank. However, the lender is often assured of return based on a guarantee tied to the value of the underlying the asset. In this case study, the value of the house that the loan is financing supplies a guarantee to the creditor. What happens when the underlying assets drops so significantly? Well, as we saw in the financial crisis, if such default based on underlying asset deflation occurs to a significant degree, the entire financial system seizes and then freezes. Housing, interestingly, also massively impacts real household wealth. That is, a major form of individual “saving” takes the form of equity in real estate. This particular brand of asset deflation is particularly malicious, slashing consumer wealth and with it consumption spending in addition to devastating the financial sector.

 

Keynes does offer some solutions to the general problem of deflation. Many of these tools have evolved over time, but the general tool belt is the same: change monetary or fiscal policy to alter incentives and prop up the price of the underlying asset. Fast forward to the present day and we see a great deal of discussion about what can be done to encourage consumer spending and encourage faster growth: re-inflating housing prices has been one proposed path towards economic stimulus. So what would a Keynesian recommend? Would it be the tax subsidies for homeowners proposed by Simpson-Bowles? Or would it massive government purchases of unused houses and debt forgiveness? Or perhaps we should look at what actually got implanted. Just last week we see the Fed attempting to stimulate the economy in part through the housing market committing a massive amount of funds to purchase mortgage backed securities. For a fuller list of policies see: http://northochousingnews.com/news/3826.

 

Keynes was right to be thankful that Britain had not seen rapid deflation in real estate at the time of his writing. As demonstrated by a cursory examination of the impact of dropping housing prices in the United States (although we could have similarly looked at Spain) it is clear that such deflation has massive destabilizing impact on the financial system as well as Keynes noted. Additionally, this particular sort of deflation has a profound negative impact on net household wealth and with it consumer spending.