Explaining Away the Failure of Markets

Yesterday, I ran across a research paper published by The Federal Reserve Bank of New York that struck me as rather bizarre:

This article argues that the current housing crisis stemmed in large measure from a change in economic fundamentals and was only exacerbated by credit market conditions. Indeed, what appear in retrospect to be relatively lax credit conditions in the early part of this decade may have emerged in part because of then-justifiable, although ultimately misplaced, optimism about income growth. The subsequent credit crunch can be traced at least in part to a productivity slowdown that began in 2004 but was likely not recognized until 2007. With the slowdown in productivity came slowdown in the growth and expected future growth of income, which helped to stifle the housing boom and jeopardize mortgages and other investments predicated on ongoing growth. Thus, the U.S. housing sector served as the proverbial “canary in the mineshaft,” providing the earliest indication of a deterioration in underlying economic conditions.

Productivity Swings and Housing Prices, by Professor James A. Kahn of Yeshiva University, in Current Issues in Economics and Finance, Vol. 15, No. 3.

Here is what Professor Kahn seems to be saying: the mortgage brokers that sold zero down payment liar ARM’s weren’t relying on their ability to resell the loans to some investment bank, and the bank wasn’t relying on its ability to repackage the loans and sell them as mortgage backed securities to fixed income investors who were desperate for yield in the low rate environment being artificially maintained by Alan Greenspan, and the investors weren’t relying on the naïve belief that housing prices never go down to compensate for complete ignorance about the content of those securities, and the original borrowers were not counting on both permanent low rates and rising prices to allow them to refinance when the teaser rate ran out. IN FACT, according to Kahn, they were all relying on continued productivity gains leading to income gains that would justify the prices being paid for the houses. Unfortunately, they were relying on faulty productivity data.

I may have misunderstood Professor Kahn's point (since I did not think his paper made any sense), but this strikes me as little more than an attempt at misdirection. Rather than recognizing the current crisis as a massive systemic failure occasioned by three decades of a laissez-faire regulatory philosophy predicated on blind faith in the magic of the markets, Professor Kahn would have us believe that this was simply the normal functioning of the economic cycles exacerbated by a glitch in the economic data. Hey, shit happens!

The thing that makes me particularly skeptical about Kahn’s thesis is the fact that he takes for granted the connection between productivity growth and income growth. I don’t claim to be up on all the literature in the field, but I am pretty sure that this is a controversial issue among economists. Take a look for example at Where Did the Productivity Growth Go? Inflation Dynamics and the Distribution of Income which argued that only the top 10% of the income distribution that actually enjoyed the benefits of increased productivity. It seems like a bit of a stretch to suggest that the housing bubble was actually a rational market response to a econometric relationship that might not even have existed in the first place.

As regulatory reform is debated, I have a feeling that we will see more papers mining the data in the hopes of finding some way to shift the blame for the economic crisis away from Wall Street and the regulators who went along for the ride.