Given the events of the past couple of months, interest, money, and the future of asset allocation is beginning to change. To better understand the conditions we see today, we must go back to the extension of the Housing and Community Act of 1992 which incentivized banks to come up with innovative ways to make houses more affordable to vulnerable populations. The banks responded by popularizing mortgage-backed securities (MBS), which created a massive housing bubble that ended pretty badly as we all remember. During the financial crisis, the Federal Reserve sought to lower interest rates, increase the money supply, extended its discount window program to central banks, and bailed out other banks in a desperate effort to flood the economy with the currency that was needed to quickly re-start the economy. But why? You see, neo-classical economics and monetary theory agreed that lowering the Federal discount rate should promote more borrowing from central banks, which then should have made it easier for private banks to borrow money from central banks, which they could then use to lend to companies at lower interest rates.
From the chart above, we can clearly see how lowering interest rates increased the money supply, and thus should increase the demand for money in the short-run. As the demand for money increases, an increase in investments should follow. Unfortunately, this also implies that inflation levels should have risen as we trade off growth for inflation. Given the amount of money put into the system, we can clearly see that this theory started to work flawlessly during the beginning of 2008 and thus, the economy should have recovered quickly after that. As this happened, the banks began to borrow enormous amounts of money, and the market speculated that higher levels of inflation were soon to follow.
After 2008, many people feared that such a massive increase in the money supply would create rapid amounts of inflation as more businesses borrowed cheap money at the same time that interest rates were reaching zero. The idea at the time was that this enormous sum of money would create growth in the US economy, which would translate into more jobs, but also more inflation. As time went by, nobody could explain why the U6 and U3 unemployment rate decreased as inflation remained flat, despite all of that money that was added to the economy. In 2008, some investor’s even feared hyperinflation as they thought the economy was going to be overstimulated. When inflation didn’t reach the target of 2% year after year, the market knew something had gone terribly wrong.
What Happened?
Although many argue that inflation didn’t surge in the US economy because of anemic growth and over-regulation, that’s only part of the story. Let’s remember that the money demand theory promised an increase in money supply (that did happen), along with an increase in money supply and demand for money as interest rates decreased. It never promised that this effect would occur in the real economy. You see, the assumption was that the money put into the banking system would quickly enter the real economy and spur inflation. Instead, a lot of that money was never loaned while some went into wall street. However, this doesn’t mean that theory was incorrect, after all, there were a lot of rules and constant changing regulations that prevented this money from being lent out, the biggest being the Dodd-Frank Act of 2010.
If you look at the money demand theory from an investor’s perspective, it signals that bonds were going to get pricier as rates went down since there’s an inverse relationship between price and interest rates. For example, as interest rates go down, the price of bonds go up. As a result, lower interest rates increased the price of bonds. Since Bonds and Stocks are often held in portfolios and measured against risk, if the value of bonds diminishes due to an increase in price, then it’s only natural for investors to switch to stocks as they seek to maximize their utility. This should have created a surge in the stock market as we moved from point A to point B, and it did.
In order to better understand why this happens, we can look at the Security Market Line (SML) that explains that for every unit of expected return, investors incur an extra unit of risk according to Efficient Market Hypothesis (EMH). Why would investors take on more risk? Because they have to invest in assets that are correctly valued, taking into account opportunity cost, risk, and total returns.
In summary, not only can old theories be used to explain Ben Bernanke’s plan to restore the economy after 2008, but there’s also significant proof that it did work to some degree. There was admittedly inflation in the stock market if we define inflation as a rise in prices only accompanied by lower value of those assets. The evidence can be seen by higher than expected P/E ratios which signals overvaluation of stocks as investors pay more for earnings. As we all know, money has to travel somewhere once it reaches a market, and it seems that a lot of that money went into the stock market and never reached the real economy, which is known as Financialization. This also implies that the real reason why the economy recovered very slowly (if at all) was because it never got any real help.
Now what?
Since we are now entering a world of higher interest rates and inflation, it is only obvious to think that Bonds will start to become more attractive again. However, that doesn’t mean that the stock market will go down or crash, it only means that returns on an annual basis will be lower compared to periods of lower interest rates. As we shift from B to A, it will be important to remember that major stock indexes such as the S&P 500 will not perform as well when compared to lower interest rate periods. As always, some industries will outperform the market.
References:
- Flynn McConnell Brue Microeconomics [Book]. – New York : McGraw Hill, 2015. – Vol. 20.
- Mankiw N. Gregory Principles of Macroeconomics [Book]. – Stamford : Cengage Learning, 2015.
- Nicholson Walter Microeconomic Theory [Book]. – Willard : Thomson South-Western, 2005. – Vol. 9.
This article helped me understand a lot about the economy, and how not only the US, but my parents were affected by mortgage loans from banks. My parents actually bought a house in 1995 for an amazing price in a great area in Houston, TX. Which explains the 1992 Housing and Community act, and how it was intended to help banks make houses more affordable. My mom was discussing how the economy was great at the time, and houses were extremely affordable. Banks were giving out loans, but the interest rates were climbing and so was inflation, this caused many people to become in debt and not be able to pay. People make mistakes all the time when being offered a loan, because they believe at the moment it can be done. Then later realize it is out of their price affordability. This is something that everyone should work on when purchasing or borrowing any kind of loan.
This is a very good article that tries to explain why all the money that was put into the system did not make it to the real economy. I agree with what the author states in his calculations that show what should have happened. But it clearly did not. The problem was that after 2008, Congress created the Dodd-Frank Act and scared the banks. So even though the Fed gave the US low short term interest, the banks did not use it for how the money was intended. It seems that a lot of the money went into the stock market from the banks because they were afraid of the Dodd-Frank act. So they took the money and invested it for themselves. Some would also argue that the US did get inflation, but not in the way the government measures it today. With the collapse in oil prices and therefore how much people pay to fill up their tanks. A lot of people will feel that inflation has been low. However, the Dodd-Frank Act was repealed for banks of a certain size last month. With this Act repealed, will we now get the money used as it was intended? Of course here again the Fed and Congress are not on the same page because the Fed is no longer providing a low interest environment. However, many will argue that the money can now do what the Fed wants because the current rates are still very low compared to the rest of history.
The article talks about the Housing and Community act of 1992, how it ended wrongly and how they tried to recover the economy by bringing in more money into the economy. The Housing and Community act of 1992 made it very easy for people to buy houses and caused a housing bubble that eventually popped because most people could not afford their house. After the fall out, to fix the problem of the little supply of money they lowered interest rates so more money would be used and distributed throughout the economy. The plan was a rather good one in the sense that it increased the money supply. However, with an increase of money supply, this caused the demand of money to go up as well as risks for making more money. This in turn caused the people to invest the money they’ve been getting into stocks, leading it to pile up in the stock market rather than circulating throughout the economy.
This article discusses the financial crisis that occurred around 2007-2009. With the Housing and Community Act of 1992 being implemented encouraging banks to make buying homes more affordable to people who could not afford homes before. The creation of mortgage-backed securities and subprime mortgage loans was one of the main reasons leading to the housing market crash in 2008. Another cause of the financial crisis was due to banks’ lending money to homeowners unable to afford their payments for their homes in the future and stocks being over-evaluated, In the article graphs being displayed are showing the flow of money being projected through loans being given in the economy with the money demand theory. In the article, it describes the reason for the lack of these actions to the Dodd-Frank Act of 2010. In an attempt to fix this problem The Federal Reserve increased interest rates to stimulate inflation and an increase in investment purchases. The plan went the opposite with the money being used for stocks and not loans.
Many factors lead to the U.S. economy to tank in 2008 and one of the factors that caused the financial crisis was the Housing and Community Act of 1992 that was made to allow more people to afford housing. However, this created a huge housing bubble that contributed to the financial crisis in 2008. In order to once again stimulate economic growth, the Federal Reserve put together a plan that would bring more money into the economy, while also lowering interest. In theory, this plan should have world and it should have caused inflation rates to continually rise, but the inflation rates never rose. Many people were anticipating the rise of inflation rate, overregulation by the government never allowed this to happen. The money supply never hit the real economy and the growth never occurred. Some of the money did go to Wall Street and due to the prices of bonds going up, it sparked a growth in stocks. More and more people invested their money into stocks, which halted the growth in the economy. A shift in policies has seen the economy reverse to higher interest rates and inflation which will spark huge changes in the economy.
The devastating financial crisis of 2007–2008 was inevitable because of the terrible mortgage market made up from the Housing and Community Act of 1992. This act allowed people to buy a home with little credit to repay off the loans sometimes causing unemployment and emergencies to the economy. The lending of money by banks to people who were not qualified pushed the market to its breaking point and money was unable to stable the market. The Dodd- Frank Act of 2010 was the aftermath result of the crash in a quick attempt to fix the sudden drop of the market. In the worst recession to build up the market back up, this was the time to promote the financial stability.
I really enjoyed reading this article. The article discusses how banks came up with new ways to make houses more affordable to the population by creating the Housing and Community Act of 1992. This Act did not last and caused a bubble that eventually [popped and the government tried to fix the problem by lowering interest rates. However the banks did not use the money how they should have. Intended a lot of the money went into the stock market, no the economy.
-Tariah Johnson