By Arnold Kling
By 2001, as the demand for safe assets began to rise above what the U.S. corporate world and safe mortgage‐borrowers naturally could provide, financial institutions began to search for mechanisms to generate triple-A assets from previously untapped and riskier sources.
…even if correctly rated as triple-A, the correlation between these complex assets distress and systemic distress is much higher than for simpler single‐name bonds of equivalent rating.
His story is that there was an “excess demand” for safe assets, due to increased savings in emerging-market countries. He is correct that the financial sector satisfied this demand with assets that were in fact not safe.
His ideas bear some resemblance to my view (see lecture 9) that the nonfinancial sector wants to issue risky long-term liabilities and to hold safe short-term assets. But Caballero takes it as given that either the financial sector or government has to find a way to satisfy “excess demand” for safe assets. Instead, I think that the market needs to find a natural equilibrium, in which savers have to accept either low return or some risk and borrowers have to offer a high return or undertake low-risk projects (such as making a large down payment on a house).
Also, note that the excess demand for financial intermediation may have come from the borrowing side as well as the lending side. See real time economics.
Finally, Mark Thoma points to a post by Economics of Contempt that lists various economists and pundits who denied the existence of a housing bubble. I myself could have made that list if he had used my June 2004 article which said,
I would argue (and other economists would agree) that the bubble is in the bond market, not in the housing market. That is, if interest rates remain close to where they are today, then there is no reason for house prices to collapse.
However, in my defense, a fair amount of the run-up in house prices took place after I wrote the article. If prices had stayed where they were in June of 2004, we would not be talking about a housing bubble today. Indeed, the accusatory blog post contains too many quotes dated from the first half of 2005 or earlier (one quote even goes back to 2003). Given the data that was available on house prices as of early 2005, I think it is a stretch to call people fools for not calling a housing bubble. The really dramatic run-up in house prices came in the final two years of the bubble.
To put it another way, if you had asked these folks at the time they made their offending statements, “suppose house prices rise another 30 percent in the next two years. Would that cause you to worry?” My guess is that at least some of us would have said, “yes.”