Carlos Garriga and Aaron Hedlund
The global financial crisis of 2007–2009 helped usher in a stronger consensus about the central role that housing plays in shaping economic activity, particularly during large boom and bust episodes. The latest research regards the causes, consequences, and policy implications of housing crises with a broad focus that includes empirical and structural analysis, insights from the 2000s experience in the United States, and perspectives from around the globe. Even with the significant degree of heterogeneity in legal environments, institutions, and economic fundamentals over time and across countries, several common themes emerge. Research indicates that fundamentals such as productivity, income, and demographics play an important role in generating sustained movements in house prices. While these forces can also contribute to boom-bust episodes, periods of large house price swings often reflect an evolving housing premium caused by financial innovation and shifts in expectations, which are in turn amplified by changes to the liquidity of homes. Regarding credit, the latest evidence indicates that expansions in lending to marginal borrowers via the subprime market may not be entirely to blame for the run-up in mortgage debt and prices that preceded the 2007–2009 financial crisis. Instead, the expansion in credit manifested by lower mortgage rates was broad-based and caused borrowers across a wide range of incomes and credit scores to dramatically increase their mortgage debt. To whatever extent changing beliefs about future housing appreciation may have contributed to higher realized house price growth in the 2000s, it appears that neither borrowers nor lenders anticipated the subsequent collapse in house prices. However, expectations about future credit conditions—including the prospect of rising interest rates—may have contributed to the downturn. For macroeconomists and those otherwise interested in the broader economic implications of the housing market, a growing body of evidence combining micro data and structural modeling finds that large swings in house prices can produce large disruptions to consumption, the labor market, and output. Central to this transmission is the composition of household balance sheets—not just the amount of net worth, but also how that net worth is allocated between short term liquid assets, illiquid housing wealth, and long-term defaultable mortgage debt. By shaping the incentive to default, foreclosure laws have a profound ex-ante effect on the supply of credit as well as on the ex-post economic response to large shocks that affect households’ degree of financial distress. On the policy front, research finds mixed results for some of the crisis-related interventions implemented in the U.S. while providing guidance for future measures should another housing bust of similar or greater magnitude reoccur. Lessons are also provided for the development of macroprudential policy aimed at preventing such a future crisis without unduly constraining economic performance in good times.
“Reform” in the economics literature refers to changes in government policies or institutional rules because status-quo policies and institutions are not working well to achieve the goals of economic wellbeing and development. Further, reform refers to alternative policies and institutions that are available which would most likely perform better than the status quo. The main question examined in the “political economy of reform” literature has been why reforms are not undertaken when they are needed for the good of society. The succinct answer from the first generation of research is that conflict of interest between organized socio-political groups is responsible for some groups being able to stall reforms to extract greater private rents from status-quo policies. The next generation of research is tackling more fundamental and enduring questions: Why does conflict of interest persist? How are some interest groups able to exert influence against reforms if there are indeed large gains to be had for society? What institutions are needed to overcome the problem of credible commitment so that interest groups can be compensated or persuaded to support reforms?
Game theory—or the analysis of strategic interactions among individuals and groups—is being used more extensively, going beyond the first generation of research which focused on the interaction between “winners” and “losers” from reforms. Widespread expectations, or norms, in society at large, not just within organized interest groups, about how others are behaving in the political sphere of making demands upon government; and, beliefs about the role of public policies, or preferences for public goods, shape these strategic interactions and hence reform outcomes. Examining where these norms and preferences for public goods come from, and how they evolve, are key to understanding why conflict of interest persists and how reformers can commit to finding common ground for socially beneficial reforms. Political markets and institutions, through which the leaders who wield power over public policy are selected and sanctioned, shape norms and preferences for public goods. Leaders who want to pursue reforms need to use the evidence in favor of reforms to build broad-based support in political markets. Contrary to the first generation view of reforms by stealth, the next generation of research suggests that public communication in political markets is needed to develop a shared understanding of policies for the public good.
Concomitantly, the areas of reform have circled from market liberalization, which dominated the 20th century, back to strengthening governments to address problems of market failure and public goods in the 21st century. Reforms involve anti-corruption and public sector management in developing countries; improving health, education, and social protection to address persistent inequality in developed countries; and regulation to preserve competition and to price externalities (such as pollution and environmental depletion) in markets around the world. Understanding the functioning of politics is more important than ever before in determining whether governments are able to pursue reforms for public goods or fall prey to corruption and populism.