Easy credit and optimistic perception of fundamentals impacts price bubbles, notes recent NBER paper coauthored by a Fed economist.
In a study of the 1910s farm price bubble, economists Raghuram Rajan and Rodney Ramcharan conclude that optimistic fundamentals in the commodities markets correlated with flood of credit to fuel farm price bubble which collapsed in 1920 when communists in Russia decided to starve their people by selling grain to the world in order to finance themselves.
“Thus both the perceived shock to fundamentals as well as the availability of credit seem to be correlated with higher land prices. What is particularly interesting is the interaction between the two. As the availability of credit increases from a low level, the shock to fundamentals is associated with a greater impact on land prices, suggesting that the availability of credit amplifies shocks,” say the authors.
To many, conclusions of this paper maybe nothing new but an affirmation of what goes on in the banking industry – loan officers flock to hot sectors in search of credit-worthy borrowers and, as a result, flood the sector with cash fueling prices.
Despite these affirmative qualities, this paper is significant for several additional reasons.
First, it contributes to an ongoing debate as to whether easy credit fuels bubbles in the first place. Glaeser, Gottleb and Gyourko, for example, argue convincingly that cheap credit explains very little of the housing bubble. They say that “lower real rates can explain only one-fifth of the rise in prices” and that they find “no convincing evidence that changes in approval rates or loan-to-value levels can explain the bulk of the changes in house prices”.
Other literature, obviously, disagrees with these conclusions and Rajan and Ramcharan conclusions belong in this camp.
Second, since the collapse in Lehman, the Fed has been increasingly looking at the issue of price bubbles seeking to get a theoretical handle on it with prospects of developing some measures to control them. The Fed is, of course, no longer dismissing bubbles as a phenomena that will correct itself and has hired its army of economists to look for a policy role for itself. This paper, of course, adds to this body of effort.
Third, and of contemporary relevance, is that the the story of the 1920 farm price bubble collapse that one can read in this paper reminds all too much of the exuberance in today’s farm prices. Fueled by rise in corn prices, farm prices are sky high in places like Iowa.
For some parallel:
“The national average of farmland values was 68 percent higher in 1920 compared to 1914, and 22 percent higher compared to 1919,” say the authors.
“Iowa’s current statewide average price for farmland, $6,608 an acre, is a record in nominal dollars. But it’s also a record in inflation-adjusted dollars. Just before the crash in land values in the 1980s, Iowa land values had reached about $6,000 an acre in the 1970s,” writes Daniel Looker at agriculture.com.
The fundamental exuberance in today’s farm market has been corn price which has tripled on optimistic views for the corn demand used to make fuel with statistics showing that corn usage in making fuel has outstripped corn usage for food.
What’s different this time, investors argue, is the leverage.
“Mortgage debt per acre increased 135% from 1910 to 1920, approximately the same rate of increase as the per acre value of the ten leading crops,” write the authors.
“Investors discount worries of a price bubble, if only because the rapid appreciation in land doesn’t seem to be fueled by easy credit. In states such as Nebraska, roughly half the land purchases are for cash. The USDA estimates that farm real-estate debt fell 3% this year and remains 35% lower, on an inflation-adjusted basis, than 30 years ago,” says WSJ.
Of note is that the farmer income suffered for a long time when the bubble burst in 1920 even though those with high leverage got flushed out.
Paper is available here.