As I attempt to write my macro book, I keep Edward Leamer’s Macroeconomic Patterns and Stories close by. It really is one of those books that I have to read many times in order to absorb its insights.

I’m looking at chapter 15, “In Search of Recession Causes.” He writes,

give the banks a steep yield curve, falling long-term rates of interest, rising incomes of loan applicants and housing appreciation that makes loans self-collateralizing, and the banks will be very happy, indeed, and will compete intensely to find someone who wants a mortgage loan…

But if the yield curve flattens, or if overall income growth slows down or if home price appreciation stops, banks do not make intermediation profits and they must perform a different function–they must carefully identify borrowers with low default risk…it is called a “credit crunch,” which can put a big crimp in housing sales.

Be sure you understand what a credit crunch is. In a normal market, even very risky borrowers…have access to credit, if they are prepared to pay the interest rate premium…In an exuberant market, the lending standards can get very relaxed. But during a credit crunch, many borrowers simply are shut out of the market and denied credit.

In a prior post, I mentioned his credit-crunch model. As an expansion matures, long-term interest rates are going up, because of inflation fears. But the Fed is particularly worried, and it raises the Fed Funds rate relative to the long-term rate. This raises banks’ cost of funds. That, according to Leamer, reduces banks’ willingness to supply loans. But what he does not explain, it seems to me, is why the reduced willingness to supply loans takes the form of credit rationing rather than just higher interest rates on bank loans.

Here are my comments on the non-price rationing story.

1. I find it plausible that non-price rationing would cause more economic disruption than price adjustment. I believe we learned that from our experience with oil price controls and gas rationing in the 1970s. Gas lines are much worse than higher gas prices.

2. With bank lending, rationing by price might result in non-price rationing. That is, as you raise the interest rate, you find fewer borrowers who are likely to be able to make the payments on a mortgage. So perhaps the distinction between rationing by price and non-price rationing is less applicable to something like mortgage lending.

3. Prior to 1980, we had interest-rate ceiling on deposits at banks and thrifts. What this meant was that when interest rates rose, non-price rationing took place, as banks were unable to raise rates, so they could not keep depositors from fleeing. This in turn meant that mortgage credit was curtailed. So I understand how the Leamer applied back then.

4. But after 1980, we had the “atmosphere of deregulation,” which led to the banks and thrifts being able to pay a market rate to depositors. Should we have had the same type of credit crunches? I think not. And perhaps we did not. One can argue that after 1980, the relationship between the Fed Funds rate and the unemployment rate became a little more loosey-goosey. You still see the Fed able to raise the unemployment rate by raising the Fed Funds rate, but now it’s taking years rather than months for higher rates to stop the downtrend in unemployment, and there are a couple of periods (1984-ish; 1995-ish) in which tightening does not raise unemployment at all.

5. We could describe 2003-2007 as a credit anti-crunch (loosening mortgage standards) followed by a credit crunch (tightening mortgage standards by a lot). In both the anti-crunch and the crunch, government pressure played an exacerbating role, to say the least.

6. According to the Leamer model, quantitative easing should be contractionary. That is, if you think that banks ration credit when long rates are low relative to short rates, then what you want to do is let long rates rise, so that banks will lend more. I doubt that this is the right way to think about quantitative easing. Unless you have a story like (3) above, I don’t think you can say that an inverted yield curve will cause banks to ration credit.

To make a long story short, I believe in credit crunches. Prior to 1980, they were caused by the interaction of regulations with Fed tightening. And the financial crisis looks like an anti-crunch followed by a crunch. All of these crunches affected housing and consumer durables, and these are important sectors in the business cycle. However, I do not believe that, in the absence of regulatory distortions, an inverted yield curve causes a credit crunch.

Finally, I do not think that the whipsaw in the demand for housing and consumer durables is the big story of this decade. I think that the big story is structural change.