Are credit limits or interest rates more important?

At another thread, NeoConned asked me a question:

Do you think the central banks manipulation of interest rates is the primary cause of bubbles in modern day economies?

Apparently other things like incentives put forth by the government (insinuated backstopping in case of failure etc) can add to the size of the bubbles but do you feel these incentives or the manipulation of interest rates can bring about bubbles in and of themselves or must they both occur together for the bubbles to form?

This is a good question but it was off-topic at that thread, so I have started a new thread. I reply:

In Section VI of my 2004 paper I write:

Credit limits are more important than interest rates and there are many people who cannot get credit at all. Interest rates only affect how much money is being transferred. They do not affect who gets it…

Recently, Stiglitz and Greenwald have raised the same issue. “That some loans are not repaid is central… Thus, a central function of banks is to determine who is likely to default, and in doing so, banks determine the supply of loans.” (2003, p. 3). This idea, that bank loans redistribute wealth from one class of people to another, is a fundamental departure from the classical view that banks merely divide the world into those who are willing to borrow at x% but not at x.1%, without regard to who those people are, their class or their importance to the government.

Recent events have confirmed my belief that credit limits are more important than interest rates:

Alan Zibel writes, “Lenders [who must satisfy Fannie and Freddie] are demanding bank statements, big cash reserves and second appraisals before they approve a loan to refinance a home. Mortgage rates are hovering around 6.6%, about the same level as a year ago.”

Clearly, if mortgage rates are the same as a year ago but the housing market is so much different (and worse) than a year ago, then mortgage rates are not the best measure of the market. Credit limits are.

Martin Feldstein concurs, “The dysfunctional state of the credit market means that many individuals and businesses are unable to get credit. Lowering interest rates will not stimulate demand for those who cannot get credit.”

At the macro level, most economists agree that the Federal Reserve loaning money to investment banks and holding loan auctions to avoid shaming the recipients is far more important than the fact that they lowered the discount rate. Also, the repeal of the Glass-Steagall act in 1999 is widely seen as a precursor to the current credit crisis, yet it had no direct impact on interest rates. Another precursor was the Community Reinvestment Act, which directed home loans towards people whom no banker would trust. Suzy at Debate Politics writes:

I am an economist by training and spent 25 years in the banking industry. I have personally sat in loan committee meetings and had bank examiners demand that we "not discriminate against low and moderate income borrowers". Never mind that the reason they are low and moderate income in the first place is their inability to make good financial decisions...like establishing a steady work history, paying bills on time, living within their means, obeying the law, buying insurance to guard against catastrophic illness or property loss, (women) having multiple children with multiple men. and on, and on.

The CRA was well intentioned, and lawmakers from both sides of the aisle rightly noted the positive effects that homeownership can have on a society. The problem was, these middle and upper class lawmakers made the erroneous assumption that if you put poor people in houses, they would suddenly start behaving like financially responsible middle class people. All of a sudden lawnmowers would replace lottery tickets and backyard barbeques would take the place of drive by shootings. Alas, these hopes for change were empty promises as they always are, and borrowers who had to get their down payments from "third party non-profit agencies" (by the way, someone always makes a profit, otherwise why are they in it) had nothing to fall back on when the hot water heater broke or the roof leaked. The houses fell into disrepair and by the time the foreclosure papers were posted, the occupants and hopes of any recovery by the lender long gone. But the originating lender didn't care...the loan had been sold, not their problem any more!

There is more blame to go around...mortgage companies and builders soon realized there was money being printed and there sprung up sompanies that specialized in getting subprime borrowers into low cost (and low quality) housing. You probably heard them advertising on the radio and saw the ads in the Sunday paper. Did you ever wonder what kind of people would need a no-doc loan? And who would be stupid enough to make such a loan? I think we all know the answer to that now...the ultimate lender was of course Fannie Mae or Freddie Mac, the original loan having long since been sold by the originating bank. All that bad paper, and Franklin Raines out the back door with his suitcase full of money...

A more recent example is the Cash for Clunkers bill. This has no effect on interest rates but only affects credit limits, making auto loans available to people with vehicles that are worth less than $4500 and which get less than 18 mpg, a group who were previously unable to buy a new car, that is, whose credit limits were zero.

REFERENCES

Aguilar, Victor. 1999. Axiomatic Theory of Economics. Hauppauge, NY: Nova Science Publishers, Inc.

Garrison, Roger. 2001. Time and Money: The Macroeconomics of Capital Structure. New York, NY: Routledge

Stiglitz and Greenwald. 2003. Towards a New Paradigm in Monetary Economics. Cambridge, England: Cambridge University Press