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I Vote Optimism on Interest Rates December 13, 2008

Posted by A Texan In Grad School in Economic Statistics, Economic Theories.
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It’s finals fortnight for me so I won’t be posting as much.  But, I highly suggesting reading everything over at www.cato-unbound.org.  This month’s topic is What Happened? Anatomies of the Financial Crisis.  The latest entry by U of C Econ Prof Casey B. Mulligan explains that low short-term interest rates had an effect on housing prices, but alone don’t come anywhere close to explaining the boom.  He claims that optimism of some sort is the only way to explain it.   Out of the options he gives, I think the main factor was future interest rate optimism.  But I also think he is underestimating the role of low short-term interest rates.

The people fueling the housing boom weren’t people who generally understand the implications of future interest rates.  After all, they took out adjustable rate mortgages, which is basically a short position on long-term interest rates (i.e. they imply a belief that long-term interest rates will come down and the home-owner won’t be hit with higher monthly payments).

But the part I believe Dr. Mulligan leaves out is that the low short-term interest rates allowed banks and other lending industries to vastly increase the amount of capital they could lend out.  With more capital to lend, they expanded into riskier mortgages.

I’m looking forward to the rest of the discussion at Cato Unbound, I’m worried though that December will end right when the discussion is on the verge of a real break-through.

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