Researchers: Monetary Policy Not Enough to Prevent Bubbles

Researchers: Monetary Policy Not Enough to Prevent Bubbles

07/05/2013 BY: KRISTA FRANKS BROCK

National monetary policy alone cannot reliably prevent or reverse housing bubbles, according to a recent report from the Lincoln Institute of Land Policy. The downfall lies in the fact that housing prices and housing markets vary widely across the country, stated the researchers in the report, Preventing House Price Bubbles: Lessons from the 2006-2012 Bust.

“Indeed, the evidence strongly suggests that the idea of a national housing market is fiction,” the researchers stated. “There are in fact hundreds of housing markets, albeit with some interconnectedness or shared features.”

Monetary policy and large national programs such as the Home Affordable Modification Program (HAMP) may help some markets while hurting others, according to the report.

The researchers turned to a quote from Nassim Taleb—scholar and author of The Black Swan —to illustrate their point: “Never cross a river because it is on average four feet deep.”

After illustrating the shortfalls of national policies in addressing housing market bubbles, the researchers from the Lincoln Institute of Land Policy offer a solution: local countercyclical capital policies.

“The basic idea is straightforward: when prices for a particular asset or sector are rising much faster than market fundamentals justify, bank regulators would increase the capital ratios for that asset,” the researchers explained.

Higher capital reserves make a bank safer and increase mortgage costs, dampening demand, according to the report. “[C]ountercyclical capital requirements offer two major benefits: they better enable financial institutions to withstand severe shocks, and they lower the likelihood of an extreme event,” the report stated.

The researchers detailed the effect countercyclical capital could have had on Fannie Mae leading up to the Great Recession. Fannie would have had to maintain higher capital, thus decreasing the amount of loans it acquired “that ultimately resulted in excessive losses.”

At the same time, Fannie would have been forced to raise prices on home loans, which would have decreased demand, “thereby reducing the magnitude of the house price bubble,” according to the report.

The countercyclical capital policy the Lincoln Institute on Land Policy recommends would rely on regional market models that would take into account home prices and economic indicators, including employment rates and household income, which affect home prices.

One of the obstacles to such a policy, the researchers stated, is “[t]here will always be resistance to raising capital requirements when times appear to be good.”

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