Was it the availability of credit that lead to the housing bubble?
Posted September 29, 2008on:
A popular explanation of the booming in house prices according to, well, everyone is that there was lots of “credit washing around” which convinced people that they should go and bid up house prices. An example of this logic is shown in this statement at the very good Big Picture blog:
The bubble in home prices, fueled by the ready availability of credit, resulted in an underestimate of the risks of residential real estate
Personally, I think this type of thinking has the causality all mixed up – if there was any error it was because people “underestimated the risks” associated with the price of residential real estate, and therefore given the “price” of credit the housing market appeared to be a better bet than it actually was. As a result, the entire blame for the bubble and associated crisis should lie with the fact that risk wasn’t being appropriately identified – not with some mystical belief that credit was springing up all over the place. If the risk problem was unsolvable, then we can blame central banks for leaving the price of credit (not its “availability) to low – however, this is a secondary issue to risk.
The whole concept of the “availability of credit” is somewhat of a misnomer.
There is always more credit available, always, it just may be at a higher interest rate than you are willing to pay. As a result, demand for credit (which falls as the interest rate rises) will always post a binding constraint on the ability of credit to appear in house prices.
During the current bubble money demand rose more than it should of according to fundamentals, because of higher price expectations and low perceived risk.
With no institutions available to counter act this change in expectations, and with the wrong information being disseminated by both the suppliers of credit as well as those that demanded credit, we ended up in an untenable situation – where something has to give.
As a result, I would not blame the free “availability” of credit for the housing factor – using this term is a smokescreen to deflect liability from central banks (which should have lifted interest rates faster and further) and the institutions that were supposed to help inform investors of risk.
BTW, if anyone is going to try telling me that higher interest rates increase the “availability” of credit, and therefore leads to more borrowing read this before saying anything – a demand curve is a binding constraint.