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Don't Blame Low Interest Rates For The Bubble

Brad DeLong doesn't like a new piece by rational expectations defender Robert Lucas in The Economist. In particular, Delong calls out Lucas for this claim:

One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September.

DeLong's response:

...some economists did indeed forecast the financial crisis of 2008--or, rather, forecast that Alan Greenspan's low interest rate policies of 2002-2004 (policies I approved of and endorsed, by the way) ran an unacceptable risk of getting the economy wedged into a position like the one it now is. All praise and honor to Dean Baker, Richard Thaler, Robert Shiller, Michael Mussa, and their posse.

The risk DeLong refers to is summed up by Mussa:

The very low level of policy interest rates is an imbalance (relative to normal conditions) that reflects exceptionally easy monetary policies to combat economic weakness. This policy imbalance poses an important challenge for the future conduct of monetary policy. Situations of low policy interest rates and low inflation tend to be associated with unusual inertia in the processes of general price inflation, which makes traditional indicators of rising inflationary pressures less reliable as measures of the need to begin to tighten monetary conditions. Also, these situations tend to be associated with high valuations of equities, real estate, and long-term bonds, which can become fertile ground for large, unsustainable increases in asset prices.

One interpretation of what Mussa writes here is that low interest rates cause asset-price bubbles, which is what DeLong seems to think--as do many others (though Mussa doesn't make that claim in the rest of the paper). This popular view makes sense on the surface: We had a period of generally declining rates between 1980 and 2007, during which time we had two major bubbles here in the U.S.

But the causal link isn't quite so clear. Here are two pieces of evidence against: First, in a paper to be published in the Quarterly Journal Economics, Amir Sufi and Atif Mian look at what happened to subprime neighborhoods during two periods of declining rates: the early 1990's and the early 2000's. 

If low interest rates cause an expension of credit to lousy credit risks, eventually creating a bubble, we should expect to see subprime lending booms in both periods. In the early 2000's, mortgage growth in subprime zip codes did greatly outpace growth in prime areas. But the situation was reversed a decade earlier: Lenders were originating loans in prime areas at a faster rate than subprime areas:

Likewise, in the 2000's, subprime zipcodes saw price gains that were significantly higher than prime areas. In the early '90s, by contrast, home prices rose slightly more in prime areas than in subprime areas:

The caveat is that even though the rate decline was bigger in the early '90's than in the 2000's (5 percentage points versus 4), the level of the interest rate might be what matters (3% versus 1%). But it seems like there are better explanations, the role of securitization during the recent boom being the most obvious.

The second piece of evidence comes from one the guys DeLong himself cites: Robert Shiller. Here is what the Yale economist wrote in a 2007 paper

In this paper I will critique this common view about interest rates and asset prices. I will question the accuracy and robustness of the “low-long-rate-high-asset-prices” description of the world. I will also evaluate a popular interpretation of this situation: that it is due to a worldwide regime of easy money.

I will argue instead that changes in long-term interest rates and long-term asset prices seem to have been tied up with important changes in the public’s ways of thinking about the economy.

Shiller goes on two cite a few examples of weak relationships between rates and prices, including:

There was however a major upward correction in dividend yields (downward correction in stock prices) between 2000 and 2003 unexplained by any rise in long-term interest rates. In the US, real stock prices fell in half from peak to trough. A good part of the downward correction has been reversed since 2003, even though over this period long-rates have generally risen, not fallen.

What both of these papers illustrate, in my view, is that a low rate environment is not a sufficient condition for bubbles to form. (It might not even be a necessary one.) And what that means is that we should avoid knee-jerk reactions to low rates.

--Zubin Jelveh