Microeconomic in February of 2007,

Microeconomic

In February of 2007, when the subprime crisis began to emerge, few thought that it would threaten to send the global economy into a tailspin. Yet today we sit at the brink of recession. The federal government has committed to spending hundreds of billions of dollars to keep the economy afloat, and is likely to spend hundreds of billions more before we experience economic recovery. In order to help alleviate the crisis and to prevent this situation in the future, we must understand the root causes of this market failure.

Subprime lending refers to the practice of lending to borrowers who have less than ideal credit. In the long run, subprime loans are subject to higher than average rates of default. Financial institutions account for this by charging higher rates of interest. The problem with the subprime crisis, however, is that the rate of default has proven to be substantially higher than most lenders expected. There are two causes for this - both of them externalities.

The first externality was the interest rate policy of the Federal Reserve. When the dot-com bubble burst, the Fed lowered interest rates to "levels significantly below equilibrium" (Boeri & Guiso, 2007). This significantly increased the money supply. With stocks in the doldrums following the dot-com bubble burst and the September 11th terrorist attacks, the housing market one of the only booming markets in the economy. Flush with cash, financial institutions were compelled to lend, and this went into the housing market. These institutions ignored their own rules regarding subprime lending in order to write mortgages. Thus, the quality of subprime borrowers was much lower than normal during this period. Compounding matters, the quantity of subprime borrowers also increased, from 8% of new home mortgages in 2003 to 22% in 2005 (Brown, 2008). Had interest rates been kept in equilibrium, lenders would not have felt as though they had incentive to lend to this low grade of subprime borrower.

The second externality was the housing bubble. The interest rate policy and overzealous lending had helped to fuel a market failure in the housing market. Speculation had shifted demand out of equilibrium, resulting in rapidly escalating prices. However, interest rate policy came into play again, as the Fed raised rates in the middle of the decade seventeen consecutive times (Thoma, 2008). The rapidly rising interest rates put an end to the housing bubble. Subprime borrowers have a propensity to opt for mortgages that start at a low rate, only to reset at a higher rate a few years later. Many of these borrowers could not afford the reset rate, and with the bursting of the bubble were also unable to sell their homes. This led them to default on their mortgages. The housing bubble had enticed many borrowers into the market that could not afford it, and enticed lenders to overlook this fact under the assumption that appreciation of the underlying asset would mitigate default risk.

Consumer behavior also played a significant role. The housing bubble and easy access to cheap credit enticed people into the housing market who could not afford to be there. This behavior was influenced by the concept of the American dream, which places significant emphasis on home ownership as a symbol of status. This affects consumer behavior by driving abnormal demand for houses, especially in times of easy credit. Consumer behavior also affected the crisis in that subprime borrowers have a distinct preference for mortgages for low opening rates that reset later. This induced borrowers to take on larger loans than they could reasonably afford.

These factors all influenced supply and demand in the housing market. Easy credit induced speculators and subprime borrowers into the market, which drove up demand. Speculation in particular resulted in disequilibrium between supply and demand, as houses owned by speculators sat empty, or were flipped within months of purchase. The housing market, given the long production lead times and expensive fixed assets, is not well-structured to handle high rates of speculation. Thus, new home construction was at a high level when the bubble burst. This contributed to the glut of homes on the market, making it even more difficult for subprime borrowers in strife to sell their homes and pay their debts. The result is that the default rate increased rapidly.

One of the most alarming aspects of the crisis is the way that it has expanded beyond the housing market to affect the global economy. This aspect of the market failure has been caused in large part by imperfect information. One way in which imperfect information contributed to the market failure was in the low level of financial literacy amongst American consumers (Boeri & Guiso). Many of them did not realize the risks inherent with their actions. The public also did not understand the risks inherent in the deregulation that had occurred in the financial services industry, another contributing factor to the bubble.

But the crisis has spread around the globe in large part due to imperfect information regarding mortgage-based securities. Financial institutions bundled up their mortgages into these securities, but the structure of the MBSs was so complex that few buyers could properly discern the risks involved. The typical MBS was sold under different classes, or tranches, each with different levels of risk and return. Furthermore, the wide range of mortgages held in each MBS led to the impression that default risk had been differentiated out. Many were rated AAA, giving the impression in the marketplace that they were sound investments. Compounding matters, the U.S. current account deficit led to a surplus of foreign institutions seeking to invest U.S. dollars. When the availability of Treasury bills and near-government assets dried up, these investors turned to MBSs without fully understanding the risks (Wade, 2008). This imperfect information and unnatural demand spurred by government-mandated scarcity of other instruments led to the diffusion of MBSs around the world.

This market failure has had widespread consequences. The MBS market has collapsed and financial institutions have either failed or required significant government intervention to stay afloat. We have entered into a credit crunch, as banks overreact to the risk of default. This has lowered investment and resulted in job loss. Consumer confidence has fallen and the economy appears headed for recession. Because MBS sales to foreign investors spread subprime default risk around the world, the global economy is in jeopardy as well.

The government has responded to this crisis in several ways. One response has been to initiate a bailout package to keep financial institutions afloat. This legislation has two main objectives. The first is to restore consumer and market confidence in the financial system. The bank closures that had occurred had resulted in a steep decline in confidence. The result was that investment levels dropped and stock market investors panicked. The second objective was to stabilize the banking system in the hopes of easing the credit crunch. Banks typically overreact to crises by tightening credit too far. However, the government wanted to reassure the banks that they would be supported, in the hopes that the banks would then begin to loosen credit and allow for economic investment. The second response has been to lower interest rates. This again is intended to spur a return to equilibrium credit levels. The rate is currently at 1%, which is likely out of equilibrium. This means that banks should be as flush with cash as they were at the outset of this crisis. This also can have an impact on consumer confidence.

These moves have not yet had the intended affect on the economy. The bailout package has been viewed by the market as more of a tourniquet than any sort of healing process for the economy. Market and consumer confidence remains low. The mortgage market is especially poor. This market is often viewed in terms of demand elasticity, but the issue now is supply elasticity. Banks have a certain level of mortgage losses that they deem tolerable and are unwilling to lend if losses exceed that range. The bailout package may provide a cash infusion to banks, but it does not directly address the issue of supply elasticity. Neither does the cutting of the interest rate. In theory, such a cut would spur banks to increase supply of capital. However, that has yet to occur. This indicates that there are factors that contribute to supply elasticity other than raw interest rate numbers. In order to spur supply, those factors will need to be addressed. At this point, they have not been.

The moves have also failed to alter consumer behavior. In some respects, imperfect information amongst consumers contributed to the market failure in the first place; now, it is contributed to the lack of recovery. Consumers for the most part do not understand what is happening with the economy and therefore are not apt to be responsive to government maneuvers to restore confidence. Consumers are unlikely to change their behavior based on information, because they do not understand the information they are receiving. They will only respond to outcomes that they feel directly. Thus, the government's actions are not having the desired impact on consumer behavior.

A disagree with the government's approach. The interest rate cuts are particularly worrisome. The massive cuts in the early 00s helped to spur the crisis because they had a profound impact on the money supply and helped to restore consumer confidence. Cuts of the same magnitude have been implemented now, but without the same results that were seen in the early to mid 00s. Worse yet, if those results were seen, we could find ourselves in a repeat of the housing bubble. If something spurs a surge in consumer confidence, for example a strong holiday retail season, this could help convince banks to loosen their credit. With the low rates, the market would once again be flooded with capital. This would spur a resurgence in the housing market. At first, a glut of homes would be available, put on the market by homeowners who are no longer underwater. But once this initial supply of homes is exhausted, the bubble would begin to grow, especially since new housing starts tends to lag the housing market by at least a year. I feel that the Fed's approach to this market failure is risky, and if they did not increase rates quickly at the first sign of market recovery another bubble could easily follow.

I believe the Fed must keep rates where they are for now because raising them would send the wrong signal to the market and only serve to further erode consumer confidence. But I would highly recommend that rates are increased at the first sign of improved confidence. The Fed added too much fuel to the fire in the early 00s. This time they should be more cautious and keep rates increasing incrementally, low enough to spur the economy but increasing slowly to keep it from overheating. I would recommend strongly against lowering rates further. If consumers and financial institutions are not responding to the current rate levels, give them time to build their confidence. To lower rates further would increase the risk of stagflation and a Japanese-style prolonged recession.

A also do not agree with the bailout of the financial industry.

If we go back to the savings & loan crisis two decades ago, the industry received a $160 billion bailout. This was felt by many observers at the time to be the wrong move, because it would insulate the financial services industry from the lessons of the free market (Brown, 2008). The government claimed the bailout was necessary for the public good. History has shown that the financial services industry did not learn its lessons about bad mortgages, contributing to the current crisis. In a free market, such behavior would be punished with the effect that the banks would not repeat the behavior. Yet, government interference in the name of the public good had the effect of changing that behavior (or not changing it, to be more accurate). Thus, I feel that the government is repeating their error with this current bailout package. The markets want banks to suffer.