Failure to Launch:
Housing, Debt Overhang, and the Inflation Option
June 26, 2018
This paper was originally released by the ADEMU on April 14, 2018 and has been accepted for publication by American Economic Journal: Macroeconomics.
A decade after the 2007-2008 financial crisis, US unemployment has receded to near historic lows, economic growth has returned, and house prices are approaching their previous heights. However, in the shadow of the slow recovery, policymakers are left wondering what could have been done differently to accelerate the return to economic health and avoid years of misery and dislocation.
Ever since the stagflation of the late 1970s and early 1980s, markets have relied on an ironclad commitment from the Federal Reserve to prioritize low inflation through good times and bad. However, given its status as the worst economic disruption since the Great Depression, the financial crisis and associated housing bust marked the most stern test of this resolve. In response to shortcomings of some of the more direct housing market interventions (e.g. HAMP, HARP, etc.), a growing chorus at the time suggested that policymakers temporarily tolerate a limited period of higher inflation aimed at boosting house prices and eroding some of the value of the outstanding mortgage debt that was dragging down the economy. This paper, authored by Aaron Hedlund, released in April through ADEMU, and now accepted for publication at American Economic Journal: Macroeconomics examines the wisdom of such an outside-the-box policy intervention.
As with any policy, temporary inflation involves trade-offs. One key advantage it has over other legislative interventions is the limited nature of its scope, greater immunity to political manipulation, and the speed with which it can be implemented. Beyond these considerations, this paper weighs the following costs and benefits of temporary inflation:
- Inflation erodes the value of outstanding mortgage debt. Most US households would see an improvement in their personal balance sheets, and homeowners looking to sell would have more flexibility to price their houses to sell in a timely manner rather than be stuck in distress.
- On the flip side, holders of mortgage-backed securities would receive a devalued stream of repayments, though this hit would be mitigated by a reduction in outright defaults from borrowers.
- Households relying on non-interest-bearing fixed income would see a modest reduction in purchasing power, though some implementations of the temporary inflation policy could subsequently reverse this decline.
- Interest rates on new mortgages could rise while the policy is in effect, though banks would also be less wary of foreclosure risk when lending.
The main analysis comes down to quantifying these trade-offs and arriving at an estimate of net impact. The central finding of this research is that a period of temporary higher inflation would likely have cushioned the blow of the crisis and accelerated the recovery by boosting house prices, reducing foreclosures, and bolstering consumer spending. Notably, this study confirms the wisdom of maintaining a commitment to low inflation during typical recessions, but the policy proves promising in the unique circumstances that prevailed during the crisis — namely, immense debt overhang, a historical drop in house prices, and an unprecedented wave of foreclosures.