Tuesday, September 25, 2007

Sticky Price, Sticky Homeowners or Sticky Mortgages

Ed Leamer says that Housing IS the Business cycle. As I mentioned before I was struck by the comment in paper, the name and author of which escapes me, that "contracts could be indexed for inflation for instance mortgages could have variable rates"

After all, most mortgages didn't have variables rates and at the time and most people considered variable rate imprudent. I think most people still consider a One Year ARM imprudent and thats really what the author was getting at. So if housing IS the business cycle then perhaps, housing contracts or more specifically mortgage loans ARE the source of the monetary lever.

Now how does this account for the passage by Hume often quoted by Mankiw that increases in the supply of money first quick the work of every man and only later lead to a general increase in prices. The implication of that passage is that the effects of the money supply on the economy have operated the same way for at least four hundred years. Was mortgage stickiness a problem in 18th century England? Perhaps, there were other important nominal contract, bonds or agreements.


Now suppose that the source of the business cycle is owner occupied housing and long term mortgage loans (think of it as time-to-build communities). Then one question is why the devil is it such a bad idea to get variable rate loans? The empirical evidence suggests that is. I know that despite going way out on a limb and leveraging myself to high heaven, I have avoided them. Yet, I am not sure why. It has something to do with not being able to predict my expenses but why should that matter this much? Is it some form of extreme loss aversion? Is it as simple as neighbor capital? The longer I live somewhere the more painful it is for me to liquidate my holdings. I don't know.

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