Interest Rates Following Financial Re-Regulation
Campbell, Jeffrey R., Hercowitz, Zvi, Economic Perspectives
This article uses a calibrated general-equilibrium model of lending from the wealthy to the middle class to evaluate the effects of tightening household lending standards. The authors simulate a rise in down payment and amortization rates from their average values in the late 1990s and early 2000s to levels more typical of the era before the financial deregulation of the early 1980s. Their results show a drop in loan demand. This substantially lowers interest rates for an extended period. Counterintuitively, tightening lending standards makes borrowers better off.
Introduction and summary
Mortgages and other forms of household borrowing typically require collateral, such as a house or car. Typical loan contracts require borrowers to take an initial equity stake in the collateral (the down payment) and to increase ownership further by repaying the loan's principal before the collateral fully depreciates (amortization). Since the New Deal, government regulation has substantially influenced these terms of private contracts. In the 1940s and early 1950s, the Federal Reserve Board imposed stringent minimum down payment rates and maximum amortization periods for home mortgages, auto loans, and loans to purchase other consumer durable goods. The suspension of these regulations in 1953 allowed consumer credit to grow steadily until the credit crunch of August 1966. The financial deregulation wave of the late 1970s and early 1980s triggered innovations in consumer lending that further decreased households' ownership stakes in their housing and other tangible property. Many observers have blamed precisely this deregulation for the most recent financial crisis, so it seems very possible that households' required ownership stakes will be rising as policymakers look at their options for improving the regulation of consumer loans and other financial contracts.
In this article, we employ a model of lending from the wealthy to the middle class to evaluate the effects of raising the equity requirements of household debt. We build on our earlier analysis of the Carter-Reagan financial deregulation in Campbell and Hercowitz (2009). In that article, we found that lowering equity requirements raises the demand for household credit and thereby increases the interest rate. This resembles the simultaneous increases in household debt and interest rates during the mid-1980s, even though we abstract from rising government deficits, which are the standard explanation for that period's high interest rates. In this article, we examine the implications of reversing this process by increasing down payment rates for new loans and by forcing all loans to amortize faster. The model's results show that this reform reduces loan demand. The interest rate falls 78 basis points over three years and then very slowly returns to its level before the reform. In an alternative version of our model in which producers cannot absorb the capital freed by tightening household lending standards, the interest rate falls 129 basis points over the three years after the reform. These results are potentially of interest to monetary policymakers because they can guide an assessment of how financial market reforms impact the "neutral" interest rate required to keep the economy's output at its potential in the absence of business cycles.
In the model, saving households are rentiers living off of their wealth, so the low interest rate unambiguously harms them. Nevertheless, the low rate has two beneficial effects for borrowers. First, the lower interest rate reduces the carrying cost of debt. Second, the lower interest rate brings down the user cost of capital and thereby encourages investment. These investments increase the demand for labor and thereby raise wages. Overall, the model's predictions show that borrowers' welfare gains are equivalent to raising their consumption permanently by 0.9 percent. If we treated the household credit market in isolation from the rest of the economy, then this second effect would be absent. …