In response to my response to Thoma, Free Exchange writes

Even if we assume that the there is no net negative effect from the loss of housing wealth, the decline in home prices would be very damaging. For one thing, prices in most markets would immediately fall to below replacement cost level, which would mean a sudden stop in residential investment and the loss of hundreds of thousands of jobs. Markets would only clear in some areas at prices near zero. In others, it’s uncertain whether markets clear at positive prices.

In a world where housing prices are the only fully flexible price this is true. I wouldn’t argue that stock market crashes can’t induce recessions just because  the stock market, by design, always clears.

However, if all prices were fully flexible then the replacement cost of housing will fall as the demand for new homes falls. The price of materials will fall. The price of labor will fall.  Contractors will find it cheaper to do business as business declines.  Construction would shed labor, but it would be because many construction workers wouldn’t keep working as their wage collapsed.

This would be a cause for concern, but it would not be a recession. The key feature of a recession is that there are many people who want to work but cannot find work.

Look at a similar phenomenon going on right now. The unemployment rate for workers with a bachelor’s degree is 4.6 percent. That’s higher than normal but its not even approaching the 14% unemployment of those without a high school diploma. 

This is not to say that the market for those with bachelor’s degrees is not lousy. It may very well be. What that often means, however,  is that individuals with bachelor’s degrees have to  take jobs they wouldn’t otherwise take. They take jobs with worse pay, worse conditions and less career advancement. In short, they see their real wage drop. This is bad, but its not the haven’t-been-able-to-find-work-for-over-a-year bad that many less educated people experience.

That’s the difference between a world with flexible prices and one with rigid prices. In the flexible price world, when the demand for the service you used to provide goes away, you wind up doing something you’d rather not do or getting paid less. In the rigid price world you end up in the bread line or at least the unemployment line, for as long your unemployment benefits last.

Free Exchange continues

For another thing, you’d still have a lot of suddenly insolvent banks, due to the massive number of individuals unable to pay off their mortgages at market-clearing sale prices. Granted, an immediate market clearing should make it obvious right away which banks were insolvent and which were all right, but even in an ideal world it would be difficult to manage the winding down or sale of failed banks without some hit to the real economy. Just taking the above factors alone gets us a pretty nice recession.

Do massive unexpected defaults matter produce recessions in a world with fully flexible prices? This is a big question and one that I’ve struggled with. If they do then, as Thoma seems to suggest, we need a whole knew Macro. We know that waves of defaults can cause bank failures and bank failures can cause crippling recessions.  If this process doesn’t work through a channel involving sticky prices then New Keynesian theory can’t explain why it happens at all.

Perhaps ironically, this turns on the question of adjustable rate loans. In a fully flexible price world all loans would (at least effectively) have adjustable rates. If not then there is at least one very important price which can’t be adjusted.

In theory, and I apologize for going quickly but there is a lot here for a blog post, the following would happen. A huge drop in demand for houses and other durable goods would lead to an instant drop in the price level. This leads to an expansion of the real money supply. A rapidly expanding real money supply drives down interest rates. Collapsing interest rates suddenly bring down payments for many people living in their homes. This implies that many less are pushed into default and those not near default see their disposable income rise. In short, we have the equivalent of automatic monetary and fiscal stimulus. The very forces that started the financial crisis work to end it.

What concerns me about this story is the zero lower bound. Suppose that interest rates really need to fall to –5% for the money market to clear. That way some people would actually be getting paid to have a mortgage.

While prices for goods can fall below zero — i.e. the garbage collector — it is difficult for nominal interest rates to fall below zero. I could simply say, “well then the nominal interest rate is a sticky price.” To some extent that’s true but its also a cop out. The zero lower bound is not usually what we think of when we talk about the sticky price mechanism.

So, perhaps we need a theory based on sticky prices and the zero lower bound. However, ad hoc additions to deal with very specific problems make me uncomfortable as well. It works but its uncomfortable.

Lastly Free exchange writes

And then of course you have to remember James Hamilton’s point—that modeling the macroeconomic effect of the 2008 oil price spike predicts a recession that looks very much like the one we got, all without recourse to market crashes and credit crises.

I don’t mess with Jim Hamilton.