Cheap Credit, Collateral and the Boom-Bust Cycle

This paper proposes a model of booms and busts in housing and non-housing consumption driven by the interplay between relatively low interest rates and an expansion of credit, triggered by further decline in interest rates and relaxing collateral requirements. When credit becomes available, households would like to borrow in order to frontload consumption, and this increases demand for housing and non-housing consumption. If the increase in the demand for housing translates into an increase in prices, then credit is fueled further, this time endogenously, both because of the wealth effect (the existing housing stock is now more valuable) and because housing can be used as collateral. Because a lifetime budget constraint still applies, even in the absence of a financial crisis, the initial expansion in housing and non-housing consumption will be followed by a period of contraction, with declining consumption and house prices. My mechanism clarifies that boom-bust dynamics will be accentuated in regions with inelastic supply of housing and muted in elastic regions. In line with qualitative predictions of my model, I provide evidence that differences in regions’ elasticity of housing and initial relaxation of collateral constraints can explain most of the 2000-2006 boom and the subsequent bust in house prices and consumption across US counties. Quantitative evaluation of the model shows that reversal in the initial relaxation of collateral constraints is important in explaining the sharp decline of house prices and consumption. However, the model shows that most of the decline would have happened even without a reversal in the initial expansion of credit, albeit over a longer period of time. ∗MIT Economics (email: [email protected]). I am especially grateful to my advisors Daron Acemoglu, Simon Johnson and Rob Townsend for their invaluable guidance, encouragement and support. I also thank Adrien Auclert, David Autor, Abhijit Banerjee, Joaquin Blaum, Fernando Broner, Marco Di Maggio, Sebastian Di Tella, Hamed Ghoddusi, Bengt Holmstrom, Nobu Kiyotaki, Yan Ji, Greg Leiserson, Guido Lorenzoni,Michael Peters, Ali Shourideh and especially Adam Ashcraft, Veronica Guerrieri and Iván Werning as well as seminar participants at MIT. All errors are my own.