an investigation into the housing market

8/9/2019 An investigation into the housing market

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a fundamental economic inquiry

Maurits van der Vegt

T V E S t u d i o 2 0 1 0


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Maurits van der Vegt The Housing Market

1

An investigation into the housing market

A fundamental economic inquiry

Student: M. van der Vegt

Student id: s0506508

Course: Master thesise-mail: [email protected]

e-mail: [email protected]


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Contents

Tables 3

Figures 3

Introduction 5

Part I: Exploring the Theoretic World

Chapter One: A Rollercoaster of Economic Theory 11

Chapter Two: Theorizing The Housing Market 32

Chapter Three: What About Bubbles? 51

Chapter Four: A Framework for Analyzing the Housing Market 63

Part II: The case studies

Chapter Five: Introducing the American and Dutch Cases 72

Chapter Six: Boom and Manias 116

Chapter Seven: To Fall or not to Fall 136

Conclusion: Where Are The Regulators? 152

Bibliography 157

Appendix A American Historic Data 166

Appendix B Dutch Historic Data 170


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Tables

Table 1 American Housing Cycle 74

Table 2 Dutch Housing Cycle 76

Table 3 Acceptable mortgage-income ratio 112

Figures

Figure 1 Dutch and American House Price Indexes 73

Figure 2 Herengracht Index 75

Figure 3 American Housing Prices GDP, Inflation, and Unemployment 83

Figure 4 American Housing Prices Income and Leverage 85

Figure 5 American Housing Debt and Leverage 86

Figure 6 American Housing Stock and Number of Households 87

Figure 7 Gap Between Number of Households and Housing Stock 88

Figure 8 Percentage Change American Housing Stock and Nr. of Households 89

Figure 9 American Housing Index and Real Building Costs Index 90

Figure 10 American Housing Prices Affordability and Interest 92

Figure 11 American Housing Prices and Rent 93

Figure 12 American Housing Prices Rent Model & Supply-Demand Model 94

Figure 13 Dutch Housing Prices GDP, Inflation, and Unemployment 99

Figure 14 Dutch Housing Prices Income and Leverage 100

Figure 15 Dutch Housing Debt and Leverage 101

Figure 16 Dutch Housing Stock and Number of Households 102

Figure 17 Gap Between Number of Households and Housing Stock 102

Figure 18 Percentage Change Dutch Housing Stock and Nr. Of Households 103

Figure 19 Dutch Housing Index and Real Building Costs Index 104

Figure 20 Dutch Housing Prices Affordability and Interest 105

Figure 21 Dutch Housing Prices and Rent Index 106

Figure 22 Dutch Housing Prices Rent Model & Supply-Demand Model 107

Figure 23 American House Price Income Ratio 110

Figure 24 Dutch House Price Income Ratio 111

Figure 25 American Housing Prices and Consumer Confidence 117

Figure 26 Dutch Housing Prices and Consumer Confidence 117

Figure 27 American Housing Boom of 1971 to 1973 119

Figure 28 American Housing Market and Consumer Confidence 119




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Figures (continued)





Figure 35 Dutch Housing Boom of 1971 to 1973 125

Figure 36 Dutch Housing Market and Consumer Confidence 125









Figure 45 American Housing Bust of 1973 to 1975 136

Figure 46 American Housing Market Unemployment and Consumer Confidence 137





Figure 51 American Housing Flat Period of 1993 to 1996 141




Figure 55 Dutch Housing Flat Period of 1974 to 1975 144

Figure 56 Dutch Housing Market Unemployment and Consumer Confidence 145

Figure 57 Dutch Housing Bust of 1978 to 1985 145Figure 58 Dutch Housing Market Unemployment and Consumer Confidence 146

Figure 59 Dutch Housing Bust / Flat Period of 1990 to 1991 147


Figure 61 Dutch Housing Flat period of 2002 to 2003 148


Figure 63 Dutch Housing Bust of 2007 to 2009 149



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Introduction

There is perhaps no beguilement more insidious and dangerous than an elaborate and elegant

mathematical process built upon unfortified premises

(T.C. Chamberlain)1

(Hedge fund manager about the reason of its funds losses)

25-standard deviation events, several days in a row

2

Economics has evolved markedly since early economic thinkers like Hume, Smith and Ricardo.

Many economists have tried to add their own view, while the economic branch became

mathematically mature and nowadays sees many specialities under its umbrella definition. There are

macroeconomists or econometrists, statisticians (actuaries and so-called quants), financial

specialists, monetarists, business economists, and many others. Most specialties are also split

between the academia and business world, which are two worlds that show much less interaction

than might be expected. The business world has strongly embraced the Efficient Market Hypothesis

and its twin brother Modern Portfolio Theory. Probabilities and statistics are the core aspects of this

orientation. The academia on the other hand has retrenched itself in its specific specialties.

Macroeconomics is far more influenced by Keynes than some would like to admit. The aggregate-

demand-and-supply models (AD/AS models), widely used by central bankers, are evolutions of the

early Keynesian theoretic framework, only adjusted with new findings. The biggest discussion is still

the role of money and the working of markets, with (New) Keynesians

3opposing the (New)

Classicists4

1 D.W. Hubbard, The Failure of Risk Management(Hoboken 2009) 1672

G. Cooper, The Origin of Financial Crises (Petersfield 2008) 103

There are different ways to name the main schools of thought. I have chosen to use capital letters and indicateevolutions of earlier strands with New instead of Neo, which results in New Keynesians and New Classicists. The term

Classicists, as used in this paper, has been taken from the book Modern Macroeconomics by Brian Snowdon and Howard

Vane. Other terms are Classical economists, Neo Classical Economists or Neoclassical(s). These all are the same as theClassicist or New Classicist term used in this thesis.4 B. Snowdon, H.R VaneModern Macroeconomics. Its Origins, Development and Current State (Cheltenham 2005) 695

- 706

. Other specialists like finance and business economics are strongly founded in the

Efficient Market Hypothesis, with supporters like Samuelson. But we find more schools of thought,

like the institutional economics, which is attached to the Keynesian side. Accountancy on the other

hand is far more based on efficient market hypothesis (especially their use of specific asset valuationtechniques). The result is therefore a mismatch between the micro- and macro-economists, where the

macro-economists are ever more disillusioned by the classical dichotomy and its empirical problems


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(and moving towards other models), while the rest of the economic profession is still mostly

supporting the Efficient Market Hypothesis and its link to (New) Classical economics.

The progress, partly due to this patched network of academics and professionals, on the

micro- macro-mismatch is not very well researched. Each speciality seems to have retreated to its

own domain, which leaves policy makers with many different and incompatible solutions and

frameworks. The best example of these problems is the Basle Accord by the Bank of International

Settlements (BIS). The basic tools prescribed by the BIS are based on statistical models and business

structure influenced by the financial and business economics, while their problems are often systemic

of nature (which should direct attention to the fundamental assumptions).

Therefore this thesis addresses the empirical experience of asset bubbles (in this case housing

bubbles) within the economic debate as linked to policy outcomes. The derivative main thesis

question is restricted to find the main culprit behind the bubbles: is deregulation or monetary policy

the main cause for the creation of housing bubbles. This question can be retraced to the overall

discussion between the Keynes-based theories, with its emphasis on structural problems, and the

Classicists, who focus on excessive money creation (as money is just a veil over the real economy).

This paper is divided in two parts, a theoretical Part I and an empirical Part II. The theoretical

part will provide the basic framework how to interpret the empirical figures of Part II. This is more

than a standard framework as I will try to place this thesis within the current theoretical debate,

expressed by a discussion of all relevant theories and my own perspective on the debate and the

theories.

Part I will start with the macroeconomic theories to provide not only a historical overview of

the different macroeconomic schools of thought, but also to point the reader towards essential

theoretic elements that are essential to come to a comprehensive understanding of bubbles in general

and the housing market specifically. The macroeconomic schools of thought will be discussed by

presenting the views of each of them towards the main elements of macroeconomic theories (market,

prices, money, long- vs. short-run and micro- versus macro-economy) and a short comment about

bubbles within these theories.

The findings of chapter one will offer a direction of research for chapter two, where I will

delve into the specifics of the housing market. Chapter two will present the micro-economic

perspective of the housing market, but also with links to the macroeconomic discussion of chapter

one. The findings of chapter two will include the market structure and main parameters of the

housing market as well as a perspective on fundamentals of housing prices.

The third chapter will turn specifically to a discussion about bubbles. It will discuss relevanttheories about bubbles and also a more specific discussion of bubble theories within the housing


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market. With bubbles being essentially a form of extreme price deviations, it is naturally linked to

chapter two that relates to the market structure, as well as the fundamentals.

Chapter four will take all elements of the first three chapters together in order to present an

analysing framework for the empirical Part II. This chapter will be the link between the theoretical

discussion of the housing market and the empirical figures as presented in Part II.

Part II offers a comparison between the American and Dutch housing markets. The choice for

these two is mainly the existence of housing bubbles in both countries, while the American market

has crashed, the Dutch market, after a bubble in the late 1990s, has only seen overall slow price

improvements during the 2000s, but no real crash. The case study will discuss the housing markets

on an overall basis, but will also focus on three identified parts, the boom period, the downturn and

the flat period.

Part II starts (chapter five) with analysing the two housing markets by way of the framework

presented in chapter four, which will encompass a short introduction of the structure of both markets,

the identification of periods of booms and busts and the long-term trends and fundamentals of both

markets. Chapter six and seven will focus instead on the specific periods of booms and busts and the

parameters behind the price changes.

Chapter eight will be the concluding chapter with an overview of the findings, an answer to

my thesis question and a perspective on how this thesis fits within the economic theories to complete

the picture of my research.

Finally, I want to make clear to the reader that my ultimate goal is to analyse the housing

market of the United States and the Netherlands over the past 40 years. Although I will review a lot

of economic theory, there is a difference with more economically oriented papers. My goal, as a

historian, is to understand what happened in the past, while an economist ultimately wants to be able

to tell how the housing market will react in the future. This has consequences for my appraisal of

some economic theories. Take for example the effect of uncertainty versus risk, where uncertainty is

based on the unpredictability of the future. Although this might be a real obstacle for economists, for

a historian it is less of an issue, which might make me elaborate less about its consequences, than an

economist would deem necessary. But I still hope, that understanding what happened in the past can

shed some light about the theories economists use to predict what might happen in the future. In that

sense, this paper is part of the economic debate.

The second part of this introduction gives some insight into the current discussion about the

asset markets (of which the housing market is an example) and its influence on the economy. I focus

here mainly on the issue of asset prices on monetary economics, as it best illustrates the currentknowledge gap (uncertainty about the exact role of housing within the economy and its relationship


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A third way housing prices have entered the debate are the wealth effects, and its derived

consumer effects, of volatility in asset prices.9

Especially with regards to the almost universal way of

gearing up housing investment (i.e. high debt-to-value ratios), where the owners are especially

vulnerable to price declines. The result of asset price declines might be a sudden drop in consumer

demand with possible devastating effects.10

Instead of demand side effects, others point towards the

supply side effects of a credit crunch that often accompanies a debt-deflation situation.11

The third

option is to look at the micro-economic elements of macro-economic effects of asset prices.12

Much of the discussion expresses itself in the way of researchers adapting current mainstream

models, either to have the asset price volatility play a bigger role in economic models, or to devise a

way for policymakers to react to asset price volatility.

13These discussions, as the ones above, are

primarily macro-economically oriented, often with no distinction between types of assets.14

9

F. Kajuth, The role of liquidity constraints in the response of monetary policy to housing prices,Journal of Financial

Stability (2010) 210 B. Bernanke, M. Gertler, Monetary Policy and Asset Price Volatility,Economic Review of the Federal Reserve Bank

of Kansas City (1999) 17-5111 C. Bean, Asset prices, financial instability and monetary policy,American Economic Review 94:2 (2004) 1512 F. Kajuth, The role of liquidity constraints in the response of monetary policy to housing prices, 513 C. Goodhart, The Boundary Problem in Financial Regulation,National Institute Economic Review 206 (2008) 4814

F. Kajuth, The role of liquidity constraints in the response of monetary policy to housing prices, 2

Other

economists are oriented towards microeconomic models, but the link between microeconomic and

macroeconomic models is more often than not non existent (in theory as well as between

practitioners, who have their own departments, journals, etc).

In short, the housing market does matter, but researchers are uncertain about how and when.

Also the problem is approached from different angles, that represent the researchers own background

(accountancy versus monetary economics, for example) or from different theoretic schools (New

Classicists versus New Keynesians, for example). This paper does not place the housing market

within these models, but by analyzing the workings of the housing market from a macro and micro

perspective might help the implementation of the housing market into these models.


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PART I

Exploring the Theoretic World


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Chapter One: A rollercoaster of Economic Theory

Economic theory is less straightforward than most outsiders sometimes think and most handbooks

pretend. The professionalization of economic science over a century ago has not resulted in aunanimously accepted basic paradigm and theoretic framework

15

The specific discussion about bubbles has also been directly affected by the different basic

assumptions between the different schools of thought. Therefore I start this chapter with identifying

in paragraph one the major differences in the broader economic debate. In the first paragraph I will

discuss a history of macroeconomic thinking. I will focus the discussion on five basic elements of

economics and bubbles as an added six element. After a short introduction of the specific school of

thought, I will review the six elements, starting with the view on how markets work, followed by the

view on prices and price determination, of course money is essential and will be the third element. In

order to get a better understanding of the characteristics of each school of thought and the differences

between them, I focus on the long-term versus short-term elements in each school, as well as the link

. Especially at the level of the

macro-economy, there are vast differences of opinion about the processes and functions of

economics basic elements (i.e. the market and money).

If we want to understand the phenomenon of bubbles we first need to understand the broader

economic debate about the structure of the economy and its basic elements. Not only is the

interpretation and analysis of bubbles rooted in this debate, the current regulatory framework and

monetary policies are also a result of this debate, which makes it a necessary starting point.

I will also use this chapter to make clear my own standpoints within this debate. Making your

own position clear within the broader debate is something that is not standard business, where

researchers focus on their own specialities without mentioning their basic assumptions and its place

in the broader debate. This sometimes creates the image of a cohesive thinking within economics,

which creates the possibility for policymakers to take economic thinking hostage, like for instance

we lately have seen with the current climate debate, or the fact that the economists get the blame

for the current financial crisis. Science is about discussion, disagreements and asking questions, that

is the way how science progresses. Researchers should protect this debate, starting by acknowledging

the differences in opinion.

15Most economic books struggle with this omission, either this lack of unanimity is ignored, for example in Oliver

Blanchard macroeconomics handbook. Another example is monetary economics by M.K. Lewis and P.D. Mizen, who

presents a comprehensive overview, but it fails to separate clearly the differences between theories, which leaves an

chaotic overview of theories without a clear direction. This leaves the interested reader to add an historical overview ofmacroeconomic thought to discern the many different opinions, like the book I used Modern Macroeconomics, by

Brian Snowdon and Howard Vane, in order to get a clear and thorough overview of the relevant theories. Of course

supported by more specialist books and articles.


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between microeconomic and macroeconomic views. As the final point a short perspective of each

school towards bubbles.

In the second paragraph I will present my own view on these different schools of thought, as well

as a set of elements that I deem essential to review in the second chapter when the housing market

will be analysed from a theoretic perspective.

1.1 A history of macroeconomic theory16

I focus my discussion especially on the period after WWI, but start with the classical economic

theory developed in the one and a half century before.

The Classicists

The classical economic discourse has given some fundamental insights that we still use today.

Without much statistical evidence available, these economists were mostly theoretically orientated.

Despite the practical limitations these economists faced, they were able to provide a theoretic

framework, which was essential for the birth of the economic sciences. I will now discuss this

following the setup explained above.

The macroeconomists were focused on the workings of free markets, with Smiths famous invisible

hand, that brings supply and demand together (the economy is therefore inherently stable)

The market

17. With an

automatically stabilizing economy short term fluctuations were deemed irrelevant, while the focus

was on long term growth. The economy was not seen from a closed economy only, as the economist

David Ricardo introduced the concept of comparative advantages and showed why trade is good, in

principle, for everyone involved (and therewith in the long run destroyed mercantilism). Ricardo

also influenced several principles, like Ricardian equivalence18

16

To avoid an oversupply of footnotes, please note that this entire chapter is based on the following books: M.K. Lewis,P.D. Mizen,Monetary Economics (Oxford 2000); B. Snowdon, H.R. Vane,Modern Macroeconomics. Its Origins,

Development and Current State (Cheltenham 2005); O. Blanchard,Macroeconomics. 4th

Edition (Upper Saddle River

2006); J.E. Stiglitz, B. Greenwald, Towards a New Paradigm in Monetary Economics (Cambridge 2003); M. Altmanedit.,Handbook of Contemporary Behavioral Economics. Foundations and Developments (New York 2006)17 B. Snowdon, H.R. Vane,Modern Macroeconomics, 3718

Ibid., 111-112

, which is an argument against

government expenditures, and for this paper his insights regarding the valuation of land. It took awhile before a comprehensive classical school of thought developed. It was Leon Walras who

translated the invisible hand and free market ideas into a mathematical framework. Leon Walras

introduced an equilibrium model based on an auctioneer principle that always and continuously


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clears and is based on Says law, that states that supply creates its own demand, with the result that

the economy will always be in equilibrium.

Prices play a central role in the classical theories. As markets are efficient, demand and supply are in

equilibrium at a specific price. A market price is therefore the price that results in the clearing of

markets. The Walrasian system was in fact a barter economy with relative prices to each other (real

prices). The classical system splits the assessment of real prices, that are prevalent in the Walrasian

barter system, while the nominal prices are the result of the introduction of money. It is important to

note that Says law, the quantity theory of money and the Walrasian system all inhibit a certain

assumption. That assumption states that supply determines aggregate output and supply itself is

subsequently affected by the interest rate. This makes the interest rate crucial, but in the classical

theory interest is of course not set by anyone, instead classical economists argue that the interest rate

is the result of the demand for investments and savings.

Prices

19

The Walrasian system was in fact a barter economy with relative prices, but even though relative

prices are relevant, we live in a monetary economy. The quantity theory of money (developed in

Cambridge (UK) and Chicago

Money

20) provided the link between the real economy, as described by

Walras, and the monetary economy, which result in nominal prices (the standard theory, in US terms,

is written as M*V = P*T, or money stock times velocity equals prices times transactions). Monetary

based inflation would drive up all prices in the Walrasian system on a weighted basis and would

therefore not have real effects (higher prices would not result in lower demand or higher supply)21

.

So money was neutral. Real inflation was of course possible in sub-markets (or even all together),

due to higher demand than supply.

The classicists ignored short-run fluctuations, but were interested in long-run fluctuations as

described by business cycles and of course long-run growth of the economy. The latter not without

reason, as slightly higher growth rates result in major improvements in real income in the long-run

Long-run/short-run

19B. Snowdon, H.R. Vane,Modern Macroeconomics, 71-72

20 Ibid., 61-63; The Cambridge school is best known by its proponent Alfred Marshall and the Chicago school is best

known by its proponent Irving Fisher (Chicago adopted Fishers theory, but Fisher was a Yale professor). Both

developed somewhat similar ideas based during the late 19th and early 20th century. Their ideas were the start of a specificstrand of macroeconomic theory, but not new as the development of this theory can be traced back via John Stuart Mill to

earlier thinkers like John Locke, Cantillon and David Hume.21

Ibid., 71-72


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(the divergence between rich and poor countries is often linked to this cumulative effect22

). As the

economy was inherently stable, short-run fluctuations were ignored23

.

Micro-macro economy

The beauty of the Classicist theoretic school is its elegant set of theoretic models that encompass all

levels of the economy. With the Walrasian system in place, most economists before Keynes were

focused mostly on microeconomic research (Robertson, Pigou, Hayek), with a micro-economically

dissenting group of the Austrian school (represented by Hayek). But furthermore the microeconomic

foundations were based on the maximizing behaviour of economic agents, which resulted in the

stable equilibrium state of the macro-economy.

22 A.G. Kenwood, A.L. Lougheed, The growth of the international economy 1820-2000 (London 1999) 32423

Snowdon, B., H.R. Vane,Modern Macroeconomics (Cheltenham 2005) 37

BubblesIn principle bubbles are not possible in classical theory. But some Classicists saw the theory as

relatively rigid and accepted the possibility of short-term money non-neutrality. So short-term

deviations from the ideal outcome were accepted by some classicists, with some possibility for

bubbles. These deviations focused mostly on distortions from government policies, as well as simple

fraud by economic agents. Still, the deviations were considered to be temporary and in the long-run

irrelevant.

Keynes and Orthodox Keynesianism

As is widely known, Keynes presented a radical departure from these classical theories. He argued

that many of their assumptions were not reflected by actual experience, therefore he created an

entirely new view on the economy, although it was completely macro based. With the experiences of

the Great Depression and the compelling arguments by Keynes, pushed many researchers into the

Keynesian school. One further note is that in this section I will reflect on Keynes mostly in the

orthodox Keynesian fashion as developed between 1936 and 1965. Several researchers, though, did

not agree with the interpretation of many orthodox Keynesians. Some critics, like Axel Leijonhufvud

are New Keynesians, but more radical positions are taken by Post Keynesians, who see themselves as

representing what Keynes really argued for (Post Keynesians will be discussed later in this chapter).


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Although Keyness General Theory was mostly descriptive and only supported by a few

mathematical models, shortly after publication Hicks introduced the so-called IS/LM model as the

mathematical interpretation of Keyness theory. The Investment & Saving (IS) relationship is a short

description for the real economy, while the Liquidity-preference & Money (LM) relationship is the

monetary side of the economy.

The market

24Keynes argued that equilibrium in the economy was reached only

with full employment, which in fact made him argue that the economy was most of the times in

disequilibrium and was inherently unstable.25

The instability was the result of fluctuations in

aggregate demand (note that Keynes dismissed Says Law), where demand would not meet supply

(spare capacity). After these demand shocks the economy would not automatically return to

equilibrium, due to wage and price rigidities (i.e. markets are not efficient). Therefore this

disequilibrium effect needed to be corrected by government action, which due to some of Keyness

assumptions, should be pursued by fiscal policies, as he thought that monetary policies were mostly

ineffective.26

He argued that monetary effects were indirect, in which monetary effects (note that

monetary policy is and was enacted through the supply of money) might have unpredicted

consequences. If we look at the quantity theory of money, a rising M might result in changing V, P

or Y, according to Keynes.27

Concluding, Keynes did not believe in the Walrasian system that continuously clears, but

pointed towards coordination problems (wage and price rigidities) that would result in inefficient

markets, which in turn would need government action to return to equilibrium status. Please note that

the IS/LM model is controversial

28, although many (New) Keynesians still support it.

With wage and price rigidities Keynes absolutely did not believe in flexible prices. Changes in

wages, argued Keynes, would be very rigid in their downward pressure, but in the case of higher

supply or lower demand for labour this would not result in lower wages, which have as outcomeinvoluntary unemployment. Sadly, Keyness theory was only directed towards the aggregate level,

while the micro-foundations for the rigidities were not explored. It was even worse, due to the

Prices

24Snowdon, B., H.R. Vane,Modern Macroeconomics, 103-106

25 Ibid., 14426 Ibid., 10927

This is a reference to the quantity theory of money or Fishers equation: M * V = P * T, where M is the money stock,

V is velocity (how many times the stock is used for a certain amount of transactions), P is the price level, and T is fortransactions, although it is also written as Y or real income. Classicists consider the V and the T to be constant, so putting

money into the economy would result to their theory directly into inflation, presented by P.28 The New Classicists dismiss the IS/LM model entirely, as do many Post Keynesians and even several New Keynesians(of whom some resort to adjustments to quantity theory of money). On the other hand it still has many defenders, who

argue that it might not be perfect, but is a workable and insightful model (Tobin, Mankiw) that is more applicable than

for example the Walrasian model.


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neoclassical synthesis,29

Keynes gives more emphasis to quantities than to prices.

the micro-foundations were classical in nature and therefore ignored many

of the assumptions made by Keynesians (they believed in efficient markets, flexible prices and

rational maximizing behaviour of economic agents).

30Something that is in stark contrast

with the Classicists, but with inefficient markets, prices are less relevant as New Keynesians would

point out (see section New Keynesians). For example, consumption is based on income and not on

interest, as with Classicists. Also Keynes argued that investment was not only based on the interest

rate (i.e. the cost of capital), but also on expected profitability. Expectations were, according to

Keynes, very unstable (animal spirits). Interest plays an entirely different role with Keynes, purely

the price for parting with liquidity, while Classicists argued that the interest rates were determined in

the real economy, due to thrift and the marginal productivity of capital.31

In 1958 the Keynesian economist Phillips introduced his Phillips curve, a statistical discovery that

argued there was a negative relationship between inflation and unemployment.

Money

32This would give the

Keynesians the mechanism to get to full employment by accepting a certain rate of inflation. The

Phillips curve was based on a statistical relationship, that was entirely based on empirical findings,

but had no theoretical underpinnings. A flaw that would open the door for the monetarists.

Long-run/short-run

Keyness General Theory was mostly short-run focused. Stabilizing short-run fluctuations (in

demand) became the focal point, while long-run growth was mostly ignored by Keynesians, although

Solows growth theory was adopted in the sense of the neoclassical synthesis. Post-war

Keynesianism started explaining business cycles from Keyness multiplier effects (changes in

investment influences income by multiple times according to Keynes). Which points towards real

effects causing business cycles (in contrast to Monetarists and early New Classicists).

This is the area of the neoclassical synthesis. Keynes did not provide micro-foundations for his

macro-economic theory. The Orthodox Keynesians accepted the Classicist micro-foundations (under

Micro-macro economy

29 B. Snowdon, H.R. Vane,Modern Macroeconomics, 21; The neoclassical synthesis was a way through which several

economists, most notably Samuelson, tried to reconcile Keynesian macroeconomics and classical microeconomics, this

reconciliation was called the neoclassical synthesis.30 Ibid., 5831 Ibid., 6232

Ibid., 135


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the banner of the neoclassical synthesis), a decision that they later would probably regret during the

new classicist revolution.

There were several flaws in orthodox Keynesianism. As stated, it actually lacked any micro-

economic foundations, as the classical microeconomics were accepted as the mainstream theory.

Furthermore, the Phillips curve was based on statistical relationship, that was entirely based on

empirical findings, but had no theoretical underpinnings. Milton Friedman (not coincidently from

Chicago

Bubbles

Keynes of course did not believe in perfect markets, but his theory was a macro-economic theory

without specific micro-economic specifications. But bubbles are normally confined to specific

market environments (housing market, stock market, commodities) and therefore in a micro-

economic sphere. On the other hand, his idea of rigidities, money non-neutrality and uncertainty

(preference for safe assets) can all be considered ingredients for bubbles.

Monetarists

33), started the attack or counterrevolution as it is generally called. The monetarists were

attacking specific elements and assumptions of Keynes, they did not attack the whole theory. That

would have to wait until the New Classicists came to the forefront.

The monetarist argument rested on the role of money. Instead of Keyness non-neutrality of money,

Milton Friedman argued that money can have real effects in the short-run, but was neutral in the

long-run, or what he called superneutrality.

The market

34He reintroduced the quantity theory of money and

showed empirically that velocity was stable in the long run (in contrast to Keyness argument) and

that inflation was mostly a monetary phenomenon.35

Milton Friedman never formally adopted the

Classicist assumptions, as he accepted short-run non-neutrality of money. But he did not accept long-

term money non-neutrality as that would imply long-term money illusion with economic agents,

which Milton Friedman thought was too absurd to assume. He therefore introduced expectations to

adjust short-run money illusion, or unanticipated inflation, but with long-term neutrality, as

economic agents adjust previous errors. The introduction of adaptive expectations (expectations

adjusted for past errors)36

33 As stated in the review of classical theories, the Chicago school is focused on the quantity theory of money. The fact

that Friedman was the one who revived this theory into mainstream thinking and that he is a proponent of the Chicago

school and affiliated to the University of Chicago, does make his orientation seem almost unavoidable.34 M.K. Lewis, P.D. Mizen,Monetary Economics, 169-17135 Ibid., 166-16736

B. Snowdon, H.R. Vane,Modern Macroeconomics, 227

into models of economic relations was a major innovation by Friedman


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(Keynes also gave expectations an important role in his reasoning, but he argued that these were

unstable, with an unstable velocity as a consequence). Milton Friedman refocused on money and

without long-term money illusion argued that the Phillips curve was also incorrect in the long-run.37

He adjusted the Phillips curve model with expectations and so to come to a natural rate of

unemployment (Later renamed by Keynesians (Tobin and Modigliani) into NAIRU, or Non

Accelerating Inflationary Rate of Unemployment).38

At the natural rate of unemployment,

equilibrium was reached, or in modelling terms it could be called full employment.

Prices

Milton Friedman ignored real prices, as he focused on the role of money without a general theory. He

did make nominal price changes, in the long run dependent on money supply and not on rigidities

like Keynes.

Milton Friedman made money central in his argument. The main argument was that the quantity

theory of money was not about income or prices (as Classicists and Keynesians argued), but about

the demand for money.

Money

39The demand for money was based on wealth constraints, return on money

versus other assets and the asset-holders tastes and preferences.40

Rising money balances (resulting

from central bank open market operations for example), would create a shift in the portfolio of assets

until the marginal rate of return of all assets were equal again. This portfolio shift was the central

element for effects of money supply on the real economy (which were also temporary). Friedman not

only agreed that money could have short-run real effects, but he also argued that changes in the

money supply were also the major factor influencing nominal income, instead investments, which led

to variations in aggregate demand as stated by Keynesians.41

Friedman argued that all recessions

were the result of changes in the money supply.42

This was possible as he argued, that money

demand was stable, so only money supply could result in economic fluctuations.

With the introduction of expectations Friedman cleared the way for the New Classicists. In fact

Milton Friedman argued that short-run demand management, as proposed by Keynes, would be

Long-run/short-run

37 B. Snowdon, H.R. Vane,Modern Macroeconomics, 17538 Ibid., 18739 M.K. Lewis, P.D. Mizen,Monetary Economics, 153-15440 Idem41 Ibid., 15442

Snowdon, B., H.R. Vane,Modern Macroeconomics, 171


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19

useless as the effects by higher government expenditures would be anticipated on by economic

agents and thereby eliminating the effect.

Micro-macro economy

Milton Friedmans argument was based on the quantity theory of money, and an adjusted Phillips

curve and his natural rate hypothesis. All are macroeconomic concepts.

Milton Friedman made money central and introduced expectations, but the Monetarists are much

closer to Keynesians than their successors, the New Classicists. One of Milton Friedmans students,

Robert Lucas, became the frontrunner of this reintroduction of Classicist macro-economics. With

expectations, Milton Friedman reached his natural rate hypothesis. Lucas took expectations further

(based on John Muth (1961)) towards his rational expectations hypothesis (in contrast to monetarists

adaptive expectations).

Bubbles

Milton Friedmans attack on Keynesianism was also macroeconomic. It does have room for price

distortions in the short-run, as he held a believe of short-run non-neutrality. If there is room for

bubbles in Milton Friedmans theory it is on nominal terms, as real effects should peter out quickly.

New Classicists & the Real Business Cycle

43The term rational was brilliantly stated, as it made critics wary to reply

(how to reply to rational? Argue for something irrational?).

According to John Muth, expectations are actually informed predictions, but will also affect current

actions by economic agents and should therefore be central to any economic model. Robert Lucas

restated it to his rational expectations, which entailed that expectations are reached based on all

available and relevant information to come to the best possible guess of the future value of a

particular economic variable.

The Market

44Errors can be made, but these are random and in statistical terms have

a mean of zero.45

43 B. Snowdon, H.R. Vane,Modern Macroeconomics, 22544 Idem45

M.K. Lewis, P.D. Mizen, Monetary economics, 214

The rational expectations hypothesis is not the real contrast with Keynesianism (as

New Keynesians have adopted its principle). That contrast came with the reintroduction of a

Walrasian system. At any point of time economic agents reach optimal demand and supply responses

(as based on the optimization principle in micro-economics), which results in the economy being in


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constant equilibrium.46

In short, Lucas argued that macroeconomics should be based on micro-

foundations.47

With the Neoclassical Synthesis, this was never the case with Keynesianism. Robert

Lucas solved this by returning and adapting Classicist macro-economics. The market is defined by

perfect competition in which all economic agents are price takers (prices are the result of supply and

demand equilibrium and firms, consumers and workers have no individual influence on prices).

Lucas argued that even the labour market was in equilibrium as he showed through a substitution

model where workers chose between work and leisure. Unemployment is therefore always voluntary

in new classical models (the return for work is for some workers lower than the return on

leisure).48

Another result was the appearance of the Real Business Cycle school, which completely ignored

monetary influences (they dismissed Robert Lucass lagged adjustment to unanticipated inflation

based on transaction costs, as they dismissed transaction costs

An important consequence of economies being always in equilibrium is that the aggregate

demand fluctuations of Keynes did not matter anymore. Lucas shifted the focus back to aggregate

supply, which also proved to be a catalyst for the development of new growth theories.

49) and argued that fluctuations were

based on technology shocks (i.e. supply shocks) in the real economy.50

Another important part of the

RBC was that they saw the underlying trend in the growth rate of the economy as very smooth, with

fluctuations around the trend with a statistical mean of zero (i.e. stabilization does not matter) and

the fluctuations are not structured, but show a so-called random walk.51

Whatever its flaws, the New Classicists had a very elegant set of models. A Walrasian system

and quantity theory of money for macro- and monetary economics based on classical microeconomic

foundations. That was (and still is) what it makes it so compelling. Keynesians, and especially New

Keynesians do not have a complete set of models for every section of economics.

Prices

With the economy always in equilibrium and markets being efficient, the prices always reflect the

equilibrium of demand and supply. In short, the price is always the market price and is always thecorrect price.

52

46

B. Snowdon, H.R. Vane,Modern Macroeconomics, 23047 Ibid., 22048 M.K. Lewis, P.D. Mizen,Monetary Economics, 215-22049 B. Snowdon, H.R. Vane,Modern Macroeconomics, 233-23550 Ibid., 30851 Ibid., 308-30952

O. Blanchard,Macroeconomics.4th

Edition (Upper Saddle River 2006) 583

That is principle, but Lucas accepted that expectations would be based on

incomplete information (note the difference with New Keynesian imperfect information in the next

section), so the economic agent would have to decide if the experienced price rise was based on real

effects (higher demand) that would require more output, or that it was a monetary effect (inflation)


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that would not require more output. The lag in information results in adjusting behaviour of agents

towards the natural rate, which will result in swings around the natural rate (Lucas argued that agents

do not adjust immediately to new knowledge due to transaction costs).53

Although Robert Lucas was a student of Milton Friedman, the influence of money in New Classicist

models was slowly taken away. Lucass rational expectations implied that money was always

neutral, but as even Friedman accepted, money supply can have real effects. Lucas therefore invented

his policy surprise hypothesis, in which unanticipated inflation will result in economic agents

incorrectly thinking the price changes were due to real effects.

Money

54Money supply was seen as creating

inflation and New Classicists also argued that governments have an inflation bias (higher inflation

brings them benefits), so they argued for a rules-based monetary policy (one that simply follows

rules), instead of a discretionary monetary policy (one that can react to unexpected shocks).55

The

new classicists were essential in the reasoning behind independent central banks and their inflation

targets (=rules based).

Although Robert Lucas had some short-run adjustment periods to unanticipated inflation, this

disappeared with the Real Business Cycle school. The fluctuations that the economy experiences are

random and unpredictable in nature and as they have a mean of zero, are irrelevant in the long-run

anyway.

Long-run/short-run

56The return to the Classicists school of thought, with some adjustments, was complete.

Micro-macro economy

Robert Lucas was very critical of the Neoclassical Synthesis which accepted a Keynesian

macroeconomic theory alongside Classicists microeconomic theory. Lucas has been essential in

presenting a comprehensive set of macro- and micro-economic theories.

Either from a macroeconomic point of view with Lucass Walrasian equilibrium system or a

microeconomic point of view with Eugene Famas Efficient Market Hypothesis

Bubbles

57

53 B. Snowdon, H.R. Vane,Modern Macroeconomics, 240-24154 Ibid., 242-24755 B. Snowdon, H.R. Vane,Modern Macroeconomics, 257-26256 Ibid., 33057

An explanation of the Efficient Market Hypothesis is given in chapter two.

, there is no room

for price distortions whatsoever, as prices reflect equilibrium. Just like Classicists, the only room for

distortions are government policies and fraud, but these are again only possible to short-term


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22

deviations, as the system is considered to be self-stabilizing. But as the empirical evidence is so

compelling in favour of bubbles, especially in stock markets, some have tried to implement bubbles

within a New Classicist structure, most notably the rational bubbles, although most dismiss rational

bubbles as a correct explanation.

New Keynesians & the New Neoclassical Synthesis

The 1970s saw the attack on Keynesianism by Lucas and the New Classicists. But Keynesians took

the critique of Lucas regarding micro-foundations serious and started research to create a Keynesian

micro-economic theory to supplement the macro-economic theory of Keynes. According to New

Classicists this was a useless effort as they considered Keyness macroeconomic theory

fundamentally flawed as well. But the New Keynesians have come up with several very compelling

and influential research findings, most notably with respect to imperfect markets and its

consequences.

New Classicists based their argument on micro-economic foundations of perfect markets where all

economic agents are price takers. But New Keynesians argued that many markets have firms that set

their prices themselves (mostly based on a simple mark-up system).

The market

58As they are price setters, this

brings doubt about equilibrium in markets. Especially due to asymmetric information New

Keynesians showed that credit markets (mostly promoted by Joseph Stiglitz59

) and labour markets

are known for asymmetric information and are not known for elements of perfect optimizing agents

that have perfect information within an efficient market setting.60

58 B. Snowdon, H.R. Vane,Modern Macroeconomics, 372-37659 J.E. Stiglitz, B. Greenwald, Towards a New Paradigm in Monetary Economics (Cambridge 2003) 13560

B. Snowdon, H.R. Vane,Modern Macroeconomics, 392

The result is that New Keynesians

have come up with all kinds of complex analysis of specific markets. The result is the mainstream

acceptance that goods, labour and credit markets are all imperfect markets, which all breach new

classical equilibrium assumptions.

On the other hand New Keynesians have accepted the rational expectations hypothesis,although many New Keynesians do not see this as particular influential (Gregory Mankiw argued

that its influence was highly overstated and that the central element of New Classicists is their

Walrasian system with continuous market-clearing).


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A last interesting result of the New Classicists counterrevolution is the acceptance of supply

fluctuations as well as demand fluctuations by New Keynesians.61

Many New Keynesians have also

accepted growth theories and the role of technology in improving potential supply.

As a result of imperfect markets, prices are also less telling. The resulting market price is not the

result of equilibrium between supply and demand, but can be the result of institutional factors or

other complex market relationships. Joseph Stiglitz for example showed that banks will not accept

higher interest rates if the associated risk is even higher. Higher interest rates will result in costumers

with much higher risk (as they are the ones willing to accept higher interest rates), so the quality of

loans will deteriorate with higher interest rates. At a certain level the risk of default will be higher

than the interest rate and the bank will decide not to lend,

Prices

62 which is in conflict with New Classicist

assumptions.

New Keynesians have also abandoned the nominal rigidities of Orthodox Keynesianism, especially

influenced by the Monetarist argument of long-term money neutrality and have introduced many real

rigidities (again most notably asymmetric information).

Money

63Also several researchers have pointed

towards the non-neutrality of money, at least in the short run. Therefore it is now widely accepted

that money has some non-neutral aspects, although the inflationary aspects of money supply are still

accepted.

The Real Business Cycle school is mostly dismissed by New Keynesians as utterly wrong,

Long-run/short-run

64but the

idea of business cycles has gained interest with New Keynesians. The focus has been placed on so-

called stylized facts.65

61 B. Snowdon, H.R. Vane,Modern Macroeconomics, 34162 J.E. Stiglitz, B. Greenwald, Towards a New Paradigm in Monetary Economics, 104-11663 B. Snowdon, H.R. Vane,Modern Macroeconomics, 37864 Ibid.,341-34365

Ibid.,306

These are several economic factors, like industrial production, consumption,

business/residential/inventory investments, among others. Over a long period of statistical data they

have been given directional identities, for example consumption is pro-cyclical and coincident with

the cycle. Unemployment is countercyclical, but no clear pattern has been discerned. Any theory

about business cycles should explain the stylized facts correctly. A problem is that the explanation is

strongly dependent on the choice of particular assumptions in the model used. So models that explain

these stylized facts correctly can in practice exist, while their structures and assumptions are in


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complete contrast to each other (like real business cycle models and New Keynesian business

models).

Micro-macro economy

Due to Lucas assertion that Keynesianism lacked micro-foundations, New Keynesians focused on

formulating micro-foundations in support of the macro-economic theory of Keynes. They mostly

accept Keyness macro-economic theory, although a unifying macroeconomic theory that includes

the researched micro-foundations by New Keynesians has not been presented (or reached

mainstream academia at least).

The name does suggest a thesis that is in contrast with Keynes, but to the contrary, Post Keynesians

define themselves as the true followers of Keynes. They argue that Keynes proposed a far more

radical approach to economics. Especially Keyness arguments about uncertainty (which is entirely

unpredictable in nature in contrast to risk) was the central element in his theory. It needs to be noted

that the Post Keynesian group is highly heterogeneous and holds many different points of view.

Bubbles

New Keynesians are focused on micro-economics with imperfect markets in mind, or in short, theyaccept, in principle, the possible existence of bubbles. As most New Keynesians were mostly

theoretically oriented, it was due to several more empirically based researchers to start the research

into bubbles (Robert Shiller, Charles Kindleberger, among others). Although bubbles are still a

relatively minor research area within the New Keynesian world, interest, especially after the dot.com

bubble collapsed (and even more so after the housing bubble in the US), has been rising.

Post Keynesians

66So

I will give a short overview of certain central elements in Post Keynesian thinking, but will also

focus on Hyman Minsky, as his insights are currently mentioned in relation to the recession.

The Post Keynesians argue that Keynes dismissed three Classicists principles to escape the

auctioneer economy and discover the actual economy. He dismissed the gross distribution

principle, where everything is substitutable for everything, as is the basis for the Walrasian system

and is the principle behind Says law.

The market

67

66 B. Snowdon, H.R. Vane,Modern Macroeconomics, 45167

Ibid., 455-456

The result is an inherently unstable economy, as Keynes

indeed argued. Another point stressed by Post Keynesians is uncertainty about the future. Instead of

rational expectations, which believe that the past can be used in statistical analyses to predict the


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future, they argue that the true case of Keyness uncertainty is a future that is simply unknown and

not based on past results. Post Keynesians call this true uncertainty.68

Although Minsky is considered to be a Post Keynesian (probably relating his stance on inherent

instability, and his bigger role for future uncertainty), his Financial Instability Hypothesis is

remarkably only micro-economically oriented, with the focus on the financial system.

69He argued,

somewhat like Ben Bernanke, that the financial system acted as an accelerator (pro-cyclical). Hyman

Minsky put forward a description how a stable financial system would increasingly absorb credit to

support speculative investments. The stable system started with normal lending practices, where the

principle and the loan itself could be redeemed from the return of the investment. Good economic

prospects would attract speculators who finance investments with ever more debt. In the end some of

these speculators would resort to Ponzi schemes. The investments financed by Ponzi schemes do not

cover the interest or even the principle of the loan. These Ponzi schemes can only continue when the

investments deliver a capital return (the investment itself is worth more) or because new capital (debt

or investment) is found. When economic conditions deteriorate these Ponzi schemes are normally the

first to collapse.70

The downturn that followed according to Hyman Minsky was more in the sense of

Fishers debt deflation (and not unlike the argument of Joseph Stiglitz).71

In contrast to New Keynesians, the Post Keynesians still focus mostly on nominal prices. The reason

they give is that the actual world works with nominal prices and reacts to nominal prices.

Prices

72Post

Keynesians argue that the non-neutrality of money does not imply money illusion, non-neutrality

means that money is a real phenomenon. Keynes argued that under true uncertainty there does not

exists a forward-looking real rate of interest, as the Classicists argue. Also Post Keynesians argue

that our economy is based on nominal contracts, not real contracts. According to Post Keynesians

these nominal contracts are irrational in a Classicist world. But these nominal contracts are essential

in containing true uncertainty. Nominal prices should be the focal point, while real prices are afictitious element from a purely theoretical world.

73

Minsky focused on speculation, where debt influences asset prices in upswings and downturns. The

asset prices are pushed upwards by more demand from speculative, debt financed, investors. The

liquidation of these speculative investments has a higher supply of assets during the downturn (debt-

deflation period).

68 Ibid., 46369 M.S. Lawlor, Minsky and Keynes on Speculation and Finance, The Social Science Journal 27:4 (1990) 435-43670 P. Mehrling, The Vision of H.P. Minsky,Journal of Economic Behavior & Organization 39 (1999) 139-14371 Idem72 B. Snowdon, H.R. Vane,Modern Macroeconomics, 461-46273

Idem


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26

Money

Post Keynesians argue that, as we live under true uncertainty, money is never neutral. The only way

money can be neutral, is if true uncertainty does not exist (which is in contrast to Keyness own

arguments).

With such a diverse group it is difficult to give a unifying view, but with uncertainty given, the long-

run is unpredictable and therefore we are unable to foresee what is needed and should not focus on

it.

Long-run/short-run

74This brings us to the short-run focus of Keynes, which is also the focus of most Post Keynesians

and especially about the specific elements of short-run instability.

Micro-macro economyAlthough Post Keynesians adhere to Keynes and therefore are mostly macro-economical oriented,

the group is very heterogeneous and therefore some have had a more micro-economic orientation.

Minsky, for example, was focused on the financial system, which implies a micro-economic

orientation.

During the 1970s and 1980s a new brand of economics has arisen. Behavioural economics is based

on the assumption that it is necessary that the assumptions in economic analysis and models should

also be tested on actual experience, for example rational expectations.

Bubbles

It is no surprise that currently many market observers use the emblem of a Minsky Moment to

describe current experiences. We have seen many ponzi schemes being discovered, either as

investment funds (Bernard Madoff), or as specific investment instruments (some adjustable rate

mortgages had the possibility to pay less interest than required with the gap between actual payment

and required payment being added to the principle loan). The frequent use of the term after the crash,

in contrast to before, does raise some doubt about the actual knowledge of Minskys theory with

these market observers. Minskys Financial Instability Hypothesis is in fact a description of a debt-

fuelled speculative asset bubble (with real effects). Although his thesis has been partly overtaken by

New Keynesians in the last two decades.

Behavioural economics

75

74 B. Snowdon, H.R. Vane,Modern Macroeconomics, 465-46875

M. Altman,Handbook of contemporary behavioural economics (London 2006) 80-81

It will be no surprise that

behavioural economics brings psychology into the economic discourse and that is not a moment to

soon. As for example research by the bank of England showed in 2003, which reported stark


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differences of inflationary expectations between different groups of people (inflationary expectations

were influenced by age, geographical location and occupation, and housing status).76

Also talking

about bubbles, terms like mania, euphoria, irrationality and others come up. So apparently behaviour

is important in explaining bubbles.

Behavioural economics is mostly oriented on the assumptions used in economics, not with a specific

reference to any of the above mentioned mainstream schools. That said, most mainstream schools

sometimes do use somewhat similar models (for example the IS-LM model can be used to describe

the Keynesian, Monetarist and Classicist theories). The assumptions are at centre of the differences.

Lets review an example. The role of saving is rather important in many economic models.

Classicists argue that the price for postponing consumption now is essential.

The market

77 Keynes pointed

towards liquidity preferences, but these are either linked to income levels (transactions and

precautionary motives) or interest (speculative motive).78

The marginal rate of return is also

important to Monetarist models. Most savings preferences are based on Fishers time preference

theory.79

But Behavioural economists have found this principle very lacking. Not only has research

found that people are far more oriented to present consumption, also the temporal consistency (i.e.

saving preferences do change little over time) seem incorrect.80

Furthermore, the differences between

people with different backgrounds (like the above stated example of inflation expectations) are very

significant and preferences even differ with different circumstances.81

As saving is considered to be

important for investments in an economy, which in turn is essential for future growth paths,

economists might be wise to reconsider their assumptions. Overall, most research of behavioural

economics point towards frictions, lags, path dependency and the like. Therefore New Keynesians

and Behavioural economists do appreciate each others theories, while the Classicists are mostly

criticized for oversimplification, or outright wrong definitions of their assumptions (wrong in the

sense that they do not seem to coincide with actual human behaviour).

Equilibrium prices are very useful, as they hold a lot of useable information about specific markets,

supply and demand, and in longer-runs even trends in the economy. But with inefficient markets

prices become much less telling. Prices can be significantly influenced by specific market forces or

Prices

76 Bank of England, Economic Models at the Bank of England,BoE Paper(1999) 2-877 M.K. Lewis, P.D. Mizen,Monetary Economics, 11778 B. Snowdon, H.R. Vane,Modern Macroeconomics, 10479 M. Altman,Handbook of contemporary behavioural economics, 297-29880 Ibid., 299-30081

Ibid., 301


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28

even specific market players. Behavioural economics does not specifically delve into the realm of

price determination, which leaves us with the ambiguous price setting mechanism of imperfect

markets from New Keynesian models.

Peoples attitude towards money is of course very interesting. Keynes argued that money matters

as people give it some valuable attributes, in contrast to Classicists who argue against any form of

money illusion, as it is nothing more than a veil on the real economy. Again Behavioural economists

side with the Keynesians. People tend to value money for its own sake, not only as a representative

of possible consumption.

Money

82

Behavioural economists have mostly showed that preference for present consumption is high, but

that they will react different in different circumstances.

Long-run/short-run

83This presents economics with some

interesting afterthoughts. Uncertainty for the future becomes greater, as the past is not necessarily a

good predictor of the future. Also policy becomes far more difficult as circumstances can be

perceived differently by economic actors at different moments in time. Policy action that works in

the past, does not necessarily work in the future.

Micro-macro economy

Behavioural economics is differently oriented than the other discussed schools of thought. They

work on either the individual behavioural level or they look at groups, either small to very large.

These outcomes have consequences for assumptions in either micro-economic models or macro-

economic models.

Terms normally associated with bubbles, like manias and euphoria, seem very well placed withinbehavioural economics. Price determination has been relatively well researched from a behavioural

perspective. Probably most popularly by Khaneman and Tversky (Khaneman received the Nobel

price in 2003 for his research), with their illusion of validity, which states that people are prone to

experience much confidence in highly fallible judgment.

Bubbles

84

82 M. Altman,Handbook of contemporary behavioural economics, 29183 Ibid., 309-31184

Ibid., 709

This means that people use concepts that

are simply not reflected by empirical experience, but do still have profound confidence in it (an

example is the assertion by many investors that low price-earnings ratios have a higher return than


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29

high price-earnings ratios, while empirical research has shown that large p/e ratios often relate to

high returns).85

Another relevant item is so-called positive illusion, or that people are biased

towards positive predictions.86

1.2Assumptions from macro-economic theory within this paper

Research has shown that professional investors are consistently

overoptimistic on the predicted returns of their own investments. Other research has pointed towards

the low intensity of analysis when we are optimistic, while we significantly up our analysis effort

when we are pessimistic.

As shown in section 1.1 there are many different strands of viewing the economy. Most notable is

the contrast between believers in perfect markets and those who do not. Much empirical research

from the past has shown support for all models, even those that are in strong contrast to each other.

This strange experience that contrasting models can both explain empirical events, can be attributed

to specific parameters (normally based on assumptions) used in these models.

Is there any consensus in macro-economics, today? Although a New Neoclassical Synthesis

has been proposed that combines New Classicist and New Keynesian theory, although the

elementary part of New Classicist has been dismissed (i.e. continuous market clearing), so in macro-

economics there seems to be a stalemate. The old IS/LM model is still dismissed by many, but

several New Keynesians still accept it as useful (like O. Blanchard, J. Tobin, G. Mankiw, among

others). But the micro-foundations of New Classicists theory and the main assumptions of the macro-

economic theory of New Classicists have also been under strong attack. So we are left with a bit of

uncertainty where macro-economics is heading.

So, although I like its theoretical and mathematical consistency, I personally dismiss

Classicists and New Classicists theories. Central elements of these theories, like continuous market

clearing, voluntary unemployment, perfect markets, perfect competition, money neutrality, are highly

controversial or even dismissed by mainstream economists. The most important reason for its

continuing appeal, in my opinion, is its mathematical consistency and the practicality of its

assumptions within current use of Portfolio Theory, while in contrast the critics do not have such an

elegant and comprehensive set of theories.

Both main theoretic schools of thought have their theories expressed in their own

mathematical models. The New Classicists have a less complex structure for their theory in contrast

to the New Keynesians, which translates into a more consistent and mathematically sound model. To

my opinion the best theory should be that which is best in translating the actual experienced

85 M. Altman,Handbook of contemporary behavioural economics, 70986

Ibid., 712-713


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30

economic circumstances within a workable theoretic framework. But even if only the usability of

each mathematical model is the yardstick for which is the best theory, I want to point out that this is

not automatically in favour of the more mathematical sound New Classicists models, as Joseph

Stiglitz and Bruce Greenwald concluded that New Keynesian models present better analytical results

than New Classicists models.87

Finally, I think that the understanding that markets are imperfect and inefficient is not only

important for governments and regulators, but also for businesses and investors. If they want to make

a profit in the market, it is necessary to understand how the market works. Maybe not necessarily in

order to make a profit (as even monkeys can apparently make money by trading stocks

Another point I would like to make is related to the typical discussion of (New) Keynesian

versus (New) Classicists, as seen especially in many newspapers. This discussion is often focused on

the role and impact of government spending, with Keynesians seen as proponents of (continuous)

government deficit spending and Classicists arguing that government spending is always wasteful. I

think the main element dividing the two theories is not the success of government interference, but

the workings of the market. Changing our perspectives this way, we see New Classicists arguing that

markets are stable and efficient and New Keynesians arguing that markets can be unstable (not

necessarily all the time) and that markets are complex structures that work different per sector and

under changing circumstances. I think that much research done over the past decades has shown that

New Keynesians are right to argue that markets are unstable and that markets work in very complex

ways. How to react to this finding of unstable complex markets is a derivative question from the

main argument. And New Keynesians are also not in agreement with each other what the exact role

of the government should be, while there are few who would argue in favour of continuous

government deficit spending as being effective.

88

87 B. Snowdon, H.R. Vane,Modern Macroeconomics, 40988

www.beursgorilla.nl

), but

certainly in order to understand the risks appropriately. As will also become clearer in the rest of the

thesis, I will base my further analysis on the New Keynesian assumptions, supplemented with

elements of Behavioural economics (which to my opinion, can be regarded as an extension of New

Keynesianism).


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31

The next chapter therefore has to focus on several aspects of the housing market to find out

which theory is most appropriate for assessing the housing market. Does it work more according to

New Classicist theory or New Keynesian and therefore the chapter will have to investigate several

economic issues:

1) the (in)efficiency of the housing market:

Is the housing market considered to be efficient or not (efficiency in the terms of Eugene

Fama and his Efficient Market Hypothesis). If the market is considered to be inefficient, the

prices in the housing market are not equilibrium prices and that can have important

consequences for the assessment of price distortions.

2) The structure of the housing market:

I will construct on overview of the elements of the housing market in order to look for

economic relationships in the structure. If the market is considered (in)efficient, I should be

able to find market frictions (or rigidities as Keynesians qualify them).

3) The price determination process:

If bubbles are some sort of price distortion, we should also overview how economic agents

determine housing prices, not only market prices, but fundamental values as well.

4) Behavioural aspects:

All economic agents exhibit certain behavioural aspects. I will have to review all important

economic agents and how their behavioural aspects might influence market behaviour.

5) Micro/macro:

I will be looking at the micro level (i.e. the housing market), but will have to reflect to macro-

influences as well. So the links between macro and micro level should be given due attention.

Especially the influences of changes in general government policy should be consideredcarefully.


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Chapter Two: Theorizing The Housing Market

As we have seen in the previous chapter, the vision of different macro-economists has not seen

consensus about the crucial elements of the economy, namely markets and money. Now we need toput this in perspective to our specific sector of interest, the housing market. So we start with

dissection the economic determinants of the sector. The first paragraph will, in a descriptive manner,

review all elements and economic agents that interfere with the housing market. I start with looking

from a micro perspective, followed by a section with a macro perspective and end with a summary of

the important elements. In the second paragraph I discuss some existing theories that are applicable

to the housing market, first I will discuss valuation theories and then theories about market structure.

The third paragraph functions as a conclusion of this chapter summarizing the main points of

interest.

2.1 The Housing Market: How to look at it?

The micro perspective will look at the level of the individual sale, while the macro perspective will

look at the aggregate level. In a descriptive manner I will try to capture the main elements of the

housing market in the first two sections, which will present the input for the third section in which I

summarize all main determinants of the housing market. These determinants will be an important

input for the analysing framework as presented in chapter four.

From a micro-perspective

Let us start simple. The housing market consists of people who want to buy and people who want to

sell houses. Seller and buyers reach a price they both agree on to make a transaction possible. All

those transactions at a certain moment in time define the housing market. Analysing the entire

population of transactions get you total turnover, average housing prices and the like. Important to

note is that the overall group is a heterogeneous group, not only by the quality and size of the house,

but the buyers differ as well (in age, income, wealth, preferences, etc). The agreed price is influenced

on the individual level by several factors. The reference price is normally based on recent sales in the

region, but also influenced by third parties like real estate agents and investors. The overall price

level is of course influenced by many other factors, like unemployment, GDP growth, etc.

If we look at the transactions than we see specific factors coming into play. First of all it

presents a swap of a house for money. The seller receives cash from the buyer and delivers a house

in return. The house can be an existing house, or a newly build house. Furthermore, there is not only

the sale of a house, it cannot be seen without the sell of land, not necessarily at the same time.


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The buyer needs to present a large cash amount. To get this amount the buyer can save this

amount or borrow the amount (or a combination of savings and loans). A higher savings-rate might

therefore result in higher demand for housing in the future. But housing is primarily financed through

mortgages, normally totalling several times a buyers annual gross salary. The mortgage is a loan the

buyer in principle needs to pay back with interest over a period of usually up to 30 years.89

The long

duration of the loan in combination with a high level of borrowing versus income means a high credit

risk (risk of default) for the lender, so the buyer needs to present the house as a collateral for the

loan. The collateral is not only a safeguard for the lender that he gets his money back, but also acts as

an incentive for the borrower to repay the loan (if the buyer does not want to loose his home).90

The

amount the buyer can borrow depends partly on his ability to pay interest and instalment each period.

Normally a person is able to pay around 33 percent of his monthly income for either rent or a

mortgage,91

so if you restate that roughly 30 percent of gross income is available for mortgage

related payments (considering 3 percent maintenance and taxes costs92

The buyer can either be an owner-occupier or an investor. The owner-occupier is interested

not only in the future value of the estate, as after all he is investing, but also (and maybe more so) in

finding a house that fits his current and future preferences.

), you can see that a lower

interest rate will result in higher prospective borrowing. The mortgage is the link between the

housing market and the financial market.

93

89 F.J. Fabozzi, F.P. Modigliani, F.J. Jones, Foundations of Financial Markets and Institutions. 4

thEdition (Upper Saddle

River 2008) 50090 T. Steijvers, Collateral and credit rationing: a review of recent empirical studies as a guide for future research,

Journal of Economic Surveys 32:5 (2009) 92591

See for example: www.fharesearchcenter.com (fha stands for federal housing agency, see chapter five). The percentage

of mortgage payments (interest, amortization and other costs) versus income can vary with the mortgage originator andspecifics like guarantees and borrower-specifics (special regimes for low-income borrowers). Some researchers use lower

ratios, like in the report the following report they use a ratio of 28 percent: M. Collins, D. Crowe, M. Carliner,

Examining Supply-Side Constraints to Low-Income Homeownership,Harvard Working Paper(2001) 992 E.L. Glaeser, J.M. Shapiro, The Benefits of Home Mortgage Interest Deduction,NBER Working Paper(2002) 1293 M. Munro, S.J. Smith, Calculated Affection? Charting the Complex Economy of Home Purchase,Housing Studies

32:2 (2008) 349 - 367

His preferences are the result of the

composition of his household (kids or not, for example), the distance to his employer, the level of

public services (schools, hospitals, etc) and the preference for specific living conditions (specific

leisure, like restaurants or playgrounds, etc). An owner-occupier normally buys a house to own it for

at least several years. An investor is only interested in the risk-return level of the investment. The

(possible) income of a house is from rent (note that there is never a 100 percent occupation level, as

the investor will experience periods that the house is not rented out) and expenses are capital costs,

maintenance costs, and administrative costs (including taxes). The risk is derived from the tenant,

like not paying rent, or damage to the property. Other risk are higher interest rates (higher capital

costs), counterparty risk (the bank recalling the loan, due to a banking crisis), and asset valuation risk


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will tend to borrow as much as possible (which might not be the optimal financial structure for him

personally), in order for him to be able to buy his dream house97

. An investor will himself assess

the optimal financing position (the ratio of debt and equity), which yields him the highest return,

while lowering the risk to a, for him, acceptable level98

. The bank or mortgage advisor will also

make an assessment, which will depend on the desire to hold a specific mortgage (with a specific

risk-return ratio) or on the expected level of interest for reselling the mortgage to security investors,

like pension funds (with their longer term liabilities are also interested in longer term assets, in

contrast to many banks).99

If the bank holds the mortgage on its own books the desire to hold specific

mortgages will depend on the structure of its balance sheet. Has it a need for riskier assets or not. It is

even possible that if a bank has to much risk, it will defer any request for mortgages as it will only

invest in government bonds in order to lower

an investigation into the housing market

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