Saturday, April 25, 2009

Amateur Economists

From this week's Economist:

Subsidies to home ownership have also weakened financial services. They encouraged more people to buy houses (which was the point), but, logically enough, also encouraged lenders to take greater risks with housing. This was fine while house prices were rising, but the fall exposed how vulnerable banks’ balance sheets had become.

I don't know very much about this sort of thing, but lately I feel I've been learning a lot about how markets actually (and inexorably) work. Can the credit market and the housing market really be separated in this way, so that it was okay to take risks "while house prices were rising" on their own and in some separate market? I mean, didn't the banks' exposure to ever more innovative forms of risk keep creating new kinds of credit and therefore new buyers for houses they could not previously afford (wrong way to put it: they still couldn't afford it, but they could now finance it anyway).

The bubble burst because the only thing left to lenders was to come up with a clever scheme in which they, say, paid borrowers to take their money. Once new forms of articifical demand could no longer be created (through novel credit instruments, subsidies, and gov't guarantees), the fall had to come. Lenders did not suffer the effects of rising and falling house prices. They were an important part of the cause.

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