A problem that began with subprime mortgage loan delinquency has spread to the whole real-estate market (figure 4). In analyzing the problem of housing prices, the first thing we should recognize is that in a first approach, housing price fluctuations should not result in significant fluctuations in consumption. A rise in the price of the home increases the household’s asset value, but also increases the cost of living in it, so the net result should not be any material change in consumptions of goods different from housing. 3 Therefore, a first effect of a real-estate crisis should be a drop in the construction sector, not a drastic fall in consumption. Nevertheless, there are a number of factors that help explain the increased sensitivity of consumption and output to housing prices, and top of the list is transmission via the financial system. When the higher value of the homes is not capitalized by the owners but is mortgaged in a fast, fragile credit expansion, the ensuing contraction can be extremely severe, as we can see now. Despite the severity of the present crisis, so far its effects have been reined in by strong policy decisions oriented at warding off a financial implosion. The immediate policy reaction when the crisis was unleashed was the provision of liquidity and an aggressive cut to the fed funds interest rate in the US (figure 5). New credit facilities were designed and huge amounts of liquidity were injected, but tensions in monetary markets persist. (figure 6).
First I will review the harmful effects that the ongoing crisis will have on the future development of financial markets. Next I will discuss financial bubbles and booms in monetary policymaking, and the nature of the present crisis and possible consequences, to wrap up with the implications of the world growth scenario on the Chilean monetary policy. In the present turmoil, authorities have acted as lenders of last resort providing liquidity to ensure proper market functioning. Nonetheless, regarding financial bailouts two costs have to be balanced: averting a financial collapse with catastrophic consequences on the one hand, and the negative signals that come from said bailouts, on the other. Not only have the too-big-to-fail institutions been rescued, but also entities whose connections with the system are such that if they fail the whole financial system may be shaken. Troubled companies’ shareholders should not be bailed out, because it is important that risk evaluation is done more diligently in the future. Care must be taken in rescuing debtors of defaulted firms, because it may relax borrowing and repayment discipline, and punish good creditors by comparison. The tradeoff between these two objectives is clearly illustrated with the developments of the past week. Allowing the demise of Lehman Brothers was a sign that bailouts would not be up for grabs and even the downfall of a large investment bank would be accepted, but this may have accelerated the devastating chain of events that followed.