Financial Innovation and Housing: Implications for Monetary Policy

Douglas W. Elmendorf
Douglas W. Elmendorf Former Brookings Expert, Dean - Harvard Kennedy School

April 21, 2008

In its latest World Economic Outlook, the IMF devotes chapter 3 to “The Changing Housing Cycle and the Implications for Monetary Policy.” The chapter examines how innovations in housing finance around the world have changed the role of housing in the business cycle and perhaps changed the way that monetary policy should respond to developments in housing. The chapter is a stimulating analysis of an important and clearly timely topic.

My comments focus on the U.S. situation and address two subjects: first, the effect of housing-related financial innovation on the sensitivity of the economy to different disturbances, and second, the implications of these evolving sensitivities for policymaking.

Financial innovation and the housing sector

On the first subject, the most important message to take from this chapter and other research is that financial innovation amplifies the effect of certain economic shocks and dampens the effect of others. There is no easy answer to the question of whether financial innovation has made the economy more or less volatile on balance.

Several years ago, I wrote a paper with Karen Dynan and Dan Sichel in which we tried to catalog the channels through which financial innovation affects economic volatility. The paper identified myriad channels affecting nearly every aspect of the economy; a central theme was that one could not deduce, as a matter of logic, whether the net effect of innovation was to raise or lower volatility. For example, we explained that financial innovation helps households and firms to smooth their spending through temporary shortfalls in income, but it also enables households and firms to boost spending too much if they become over-exuberant.

Financial innovation can push economic volatility in different directions for several reasons. One is that innovation takes many forms, and different changes in the financial system have different effects on volatility. Another is that economies have different initial conditions; securitization of mortgages has different effects in a system of regional banks with deposit-rate ceilings than in a system of nationwide banks without such ceilings. A third reason is that the importance of different economic disturbances changes over time, so the impact of augmenting or damping certain kinds of shocks will matter more or less in certain periods. Lastly, a single type of innovation can affect differently situated households and firms differently, so one needs to aggregate the various responses.