Editors’ Summary

The Brookings Panel on Economic Activity held its eighty-sixth conference in Washington, D.C., on September 11 and 12, 2008. Several of the conference papers examine aspects of the current financial crisis: the relationships among recent global financial imbalances, mortgage lending, and volatile commodity prices; the errors made by lenders in judging subprime mortgages and instruments derived from them to have fairly low credit risk; the effect of mortgage foreclosures on the dynamics of home prices; the impact of mortgage credit losses on the supply of credit; and the implications for financial regulation of spillovers from failing financial institutions. The remaining papers deal with the role of the unofficial economy in economic development, and the effect of an undervalued currency on economic growth in developing countries. This issue of the Brookings Papers on Economic Activity presents the seven papers from the conference, comments by the formal discussants, and synopses of the discussions of the papers by conference participants.

In the first paper, Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas make the case that outsized international capital flows, the U.S. subprime crisis, and recent swings in oil and other commodity prices are interrelated phenomena. They argue that the root cause of all of these developments is a global scarcity of sound and liquid financial assets relative to the demand for such assets. As emerging market and commodity-producing nations searched for ways to invest their newfound wealth, they focused on U.S. financial markets, their own being relatively underdeveloped. The strong demand for U.S. assets pushed down required rates of return and created an environment conducive to asset bubbles, with the expansion of subprime lending and the rapid rise in home prices among the consequences.

However, market attempts to accommodate this excess demand for U.S. assets contained the seeds of their own demise, because U.S. assets became “stretched” to an unsustainable degree. Ultimately, the housing and financial bubbles collapsed. At that point, according to the authors, the continued search for investment opportunities generated the dramatic run-up in commodity prices, especially oil. These new bubbles persisted until they weakened global economic activity to the point that the underlying demand for commodities receded.

In the view of the authors, these patterns will recur in some form as long as rapidly growing developing economies remain financially under-developed and the chronic shortage of financial assets persists. Only when the world economy generates enough safe and profitable stores of value to meet the demand by savers will this cycle end.

The second paper asks why sophisticated analysts did not anticipate that so many of the subprime mortgage loans and related assets they were holding would perform badly. Kristopher Gerardi, Andreas Lehnert, Shane Sherlund, and Paul Willen begin by showing that lenders made riskier loans in 2005 and 2006 than earlier, with the key difference being an increase in borrower leverage. However, they find that the change in mortgage characteristics was too small by itself to explain the recent surge in defaults. Instead, defaults have been spurred by the collapse in home price appreciation since early 2006.

To have misjudged the riskiness of subprime mortgages, then, lenders must have been mistaken about future trends in home prices, the sensitivity of foreclosures to changes in home prices, or some combination of both. Using data through 2004 only, the authors show that if analysts had known the future trajectory of home prices, they could have predicted the large rise in foreclosures with reasonable accuracy. Indeed, the authors’ reading of research reports and media commentary by mortgage market analysts between 2004 and 2006 suggests that these analysts had a reasonable sense of the potential impact on the subprime market of home price declines. However, these analysts generally assigned a substantial price decline a very low probability, apparently putting more weight on the historical rarity of such events than on the risk posed by the unprecedented jump in home prices during the preceding decade.

In the third paper, Karl Case explores the mechanisms through which home prices are adjusting to restore equilibrium in the housing market. He explains that two different mechanisms are at work today. One is...