Fama on the financial crisis and "credit bubbles"

Eugene Fama, father of the efficient markets hypothesis, makes some good points in this interview in The New Yorker Magazine. Questioned as to whether the credit market could be considered efficient if "people were getting loans, especially home loans, which they shouldn't have been getting," he replied:

That was government policy; that was not a failure of the market. The government decided that it wanted to expand home ownership. Fannie Mae and Freddie Mac were instructed to buy lower grade mortgages.

In other words, it wasn't inefficient markets that led to the financial crisis, it was government intervention in markets that caused the crisis.

Questioned as to whether the credit market bubble that inflated and then burst could be considered an inefficiency that led to the 2008 financial crisis, he replied:

I don’t even know what that means. People who get credit have to get it from somewhere. Does a credit bubble mean that people saved too much during that period?

I like this response because I have argued along the same lines before. To say that a credit bubble (commonly viewed as a significant rise in the ratio of household debt to GDP) caused our problems is to ignore some important facts. In the absence of any evidence that the money supply grew by an unusual amount relative to the size of the economy (on average, M2 grew only 1% per year faster than GDP from 1997-2008), then the large increase in credit outstanding that we observed over those same years was the result of voluntary private sector activity.

Credit can be created by one person lending money to another, but that does not result in any increase in money outstanding, nor does it create any new demand. (New money is created only when banks extend credit via the fractional reserve system; when they do so, then the money supply expands.) If I take money out of my pocket and lend it to John, I have created credit, and the money I don't spend he now has to spend. Perhaps he turns around and lends it to George; that adds further to the amount of credit outstanding, but again it doesn't increase the amount of money in the system, nor does it create any new demand—it only shifts demand from one party to another.

From this it follows that, as Fama notes, if you argue that there was "too much credit" in the system, then you are also saying there was perhaps too much saving. Yet many of those who worry about too much credit also argue that another big problem in the U.S. economy in the past several decades has been profligate consumption and a very low savings rate. Someone is very wrong here, and it is the misunderstanding of how credit works that explains it.

Those who point to a credit bubble as the culprit in this crisis fail to understand that the growth in credit is not the same as an inflationary expansion in the amount of money. Credit can grow very rapidly or very slowly without creating any necessary implications for inflation. In a low and stable inflation world, it is entirely possible for credit to experience rapid growth. Indeed, rapid growth in credit is most likely to occur when conditions are stable and confidence is high.

When inflation is high and volatile, lending money becomes a very risky business and credit dries up. I know, because when I lived in Argentina during the triple-digit inflation of the late 1970s, I discovered that the average maturity of loans was measured in months, not years. To buy a house, for example, the best terms I could find were 30-60-90: one third of the price in 30 days, the next third in 60 days, and the final third in 90 days. When inflation and risk are high, no one wants to lend. Lending flourishes, in contrast, during periods of stability and confidence.

If you're looking for a guilty party to blame for the financial crisis, blame the federal government for mandating inefficiencies in the way FNMA and FHLMC operated, and blame the Fed for keeping interest rates too low for too long. The Fed's easy money policy caused the demand for money to decline. As a result of easy money, people came to want less money and more things, and that's one reason why housing, commodity and gold prices rose so strongly in the years leading up to the crisis. The price of the dollar fell and the price of things rose, and the rise in housing prices greatly exceeded the rise in incomes. This was the "bubble" that eventually popped: prices that got out of line with the ability to pay.

Moral: don't confuse "credit" with inflationary monetary policy. They are two very different things.