"After the Money's Gone" - Krugman 12/14/07

If the subprime/credit/liquidity crisis is of interest, I would recommend reading Krugman's column from this past Friday. There are a lot of angles to be considered in the current market shake-up and Krugman focuses his column on some of the long term impacts and why they can't be fixed by the Fed's rate cut presription.

Krugman describes two of the biggest problems with the current crisis in succinct manner:

First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.
Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.

This means that when (probably not if) house prices return to the historical norm then those who borrowed for a lot of the house cost (i.e. subprime borrowers) will be left with a house that is worth less than the mortgage on it. This is negative equity, which can lead to more foreclosures-- which are less likely to be able to recoup the costs to the lender-- which means more bank right offs of bad loans. (The financial blog Calculated Risk mentioned by Krugman is a helpful site to peruse to understand the size and scope of the coming negative equity crisis.) This is another example of a vicious cycle argument of economics and I believe shows how a free market will from time to time go to far. I'm not sure what the end of this crisis will look like, but if home values fall 10-30% there will be a lot of problems for homeowners, lenders, borrowers, and the economy in general. (A potential positive side effect may be to inform homeowners that home equity loans to support personal consumption aren't a good idea in the majority of cases.) In addition, this will hopefully teach some a lesson that these bad lending, borrowing, and consumption practices can't always be fixed in a reactionary method by the Fed... we either need to regulate up front or accept these severe consequences as a part of the free market in real estate transactions...

Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.

Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed.