Fed Attribution Error
By Arnold Kling
Gold, the single best market indicator of a currency’s true value, hit a high of $740 in the summer of 2006, and its 12 percent fall since then neatly foretold the troubles borrowers and lenders are experiencing today. With property no longer bolstered by a falling dollar, the pullback of lenders from the housing market became more certain.
Interestingly, there’s a broad consensus today that the Fed’s switch in bias towards rising interest rates in June of 2004 tells the tale of the present problems. History suggests otherwise. Rather than a market driven by low nominal rates of interest, the single best indicator of housing’s health is the price of gold given its useful measure as the best proxy for the dollar.
I hate it when pundits claim that the Fed is behind everything that happens in financial markets. I call this the Fed attribution error. In Tamny’s case, it is compounded by using the price of gold as an indicator, a practice that I view as the economic equivalent of astrology.
(Note: I may be in a bad mood. Like Tyler, I am dealing with the departure of a daughter for college.)
One of my beefs with Austrian economists is that they focus on the time premium as a determinant of interest rates while neglecting the risk premium. They, too, can become obsessed with issues of fiat money and gold.
In my analysis of credit markets, the risk premium plays a central role The risk premium moves for reasons that have nothing to do with the Fed.
Just as Douglass North sees the world as filled with challenges for establishing property rights and monitoring behavior (challenges that give rise to institutions such as corporations, contracts, standards, etc.), I see the world as filled with challenges for allocating financial risk. People with savings constantly have to be buying securities without knowing exactly the underlying risks.
We absolutely do not live in a Modigliani-Miller world of perfectly transparent financial intermediation. As an insurance company or a venture capitalist, my techniques for evaluating and managing risk are proprietary. The underlying risks that I take are never going to be perfectly transparent to my investors.
Given the inherent lack of transparency in financial intermediation, the market is constantly developing new institutions and practices for allocating risk. When innovations are successful, risk premiums go down. But, as in other sectors of the economy, not all innovations work.
What we are seeing in the housing market is not some astrological misalignment of the constellations of interest rates and gold prices. What we are seeing is some innovative risk-assessment and risk-transfer mechanisms that blew up.