Abstract
This paper investigates the impact of what the extant literature has come to view as some of the major causes of the 2007 US housing market crisis. In particular we investigate the hypothesized effect of, lax financial regulations, the “savings glut” that is invested in the US from abroad, government support for increased home ownership, rising homeowners’ equity due to the real-estate boom, expansionary monetary policy, and bankruptcy reform. We examine how these hypothesized causes, working through household and institutional level decision-making, based on information availability and incentives, influenced the outcomes in the market for homes. Using a system dynamics model of household finance, we overlay the hypothesized causes chronologically to extrapolate their real-world simultaneous impact and test the hypothesis that they could have together led to the crisis, by simulating and checking against observed data. We find that with the exception of lax financial regulations, each cause by itself provides only a partial explanation of the crisis. Interestingly, the controversial expansionary monetary policy of the Federal Reserve, blamed by some for fueling the crisis, actually prevents the housing market boom from becoming too large. However on the downside, it discourages household savings and causes the fall in home prices to be deeper, due to weak household finances that result from low savings. We confront our model’s assumptions and outcomes with US economic data. We find our model assumptions are justified and simulation results are strongly supported by the data.
Highlights
The US housing market crisis that began in August 2007 has led to a vast literature that has offered several, sometimes contradictory, causes for the crisis
This paper uses a system dynamics model of household finance to understand how some of the main hypothesized causes, working through household and institutional level decision-making based on information availability and incentives, influenced the outcomes in the market for homes
In experiment 1 the fraction of assets borrowed by households increases (Equation (7)) due to lax financial regulations that result in excessive lending to households, in experiment 2 cheap money increases the cash that is available to households (Equation (5)), in experiment 3 interest rates are lowered by the Fed (Equation (6)) and kept low for a prolonged period of time and in experiment 4 bankruptcy reforms force households with financial troubles to put a smaller fraction of their tight finances towards servicing their mortgage debt than they would earlier have (Equation (9))
Summary
The US housing market crisis that began in August 2007 has led to a vast literature that has offered several, sometimes contradictory, causes for the crisis. The major categories of causes that are hypothesized to have led to the crisis occurred in the following: First, the earliest cause can be traced back to 1975 when the credit rating agencies were elevated in status This along with failure to keep pace with financial innovation is hypothesized to have led to overly easy credit availability to households and firms. We confront our assumptions and our results with actual data surrounding the US housing crash of 2007 This helps to justify our assumptions and to test which of the hypothesized causes of the crisis are able to replicate the real world outcome.
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