by Calculated Risk on 9/18/2007 02:49:00 PM

Virtuous cycle and vicious cycle:

In many parts of economics there is an assumption that a complex system of determinants will tend to lead to a state of equilibrium. When this tendency is absent terms like virtuous circle and vicious circle (or virtuous cycle and vicious cycle) to describe these unstable pattern of events are used. Both circles are complexes of events with no tendency towards equilibrium (at least in the short run). Both systems of events have feedback loops in which each iteration of the cycle reinforces the first (positive feedback). The difference between the two is that a virtuous cycle has favorable results and a vicious cycle has deleterious results. These cycles will continue in the direction of their momentum until an exogenous factor intervenes and stops the cycle.

Perhaps, during the housing boom, a Virtuous Cycle was present as depicted in the following diagram:

Click on diagram for larger image.

Starting from the top (during the housing boom): Lower interest rates led to an increase in housing prices. And those higher housing prices led to ever increasing mortgage equity withdrawal (MEW) by homeowners.

A large percentage of this equity withdrawal flowed to consumption, increasing both GDP and imports during the boom years. There is a strong correlation between the trade deficit and mortgage equity withdrawal, and although correlation doesn't imply causation, it appears mortgage equity withdrawal was a meaningful contributor to the widening trade and current account deficits during the housing boom.

To finance the current account deficit, foreign Central Banks (CBs) invested heavily in dollar denominated securities. Some analysts have suggested that these investments lowered interest rates by between 40 bps and 200 bps (Roubini and Setser: "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006")

If these analysts are correct, and foreign CB intervention lowered treasury yields, then this also lowered mortgage interest rates ... and the cycle repeated. The result: a Virtuous Cycle with higher housing prices, more consumption and lower interest rates.

Now that the housing cycle has broken, what happens next?

The Vicious Cycle

The following diagram depicts the possible unwinding of the virtuous cycle.


As housing cools down (prices do not need to collapse), mortgage equity withdrawal declines. Then less MEW leads to a slow down in GDP growth and lower imports.

Lower imports might lead to a lower trade deficit, depending on the strength of exports. This could lead to less foreign CB investment in dollar denominated assets. And this could lead to higher interest rates followed by even lower housing prices and the cycle repeats.

The result: a Vicious Cycle with lower housing prices, less consumption leading to higher interest rates.

House prices are now falling. MEW is now falling. And the trade deficit is falling. And the LIBOR rate has increased.

An increase in long rates would be normal if the market expectations for the economy improve. What would be concerning is if long rates increased by more than normal because of the unwinding of investments by foreign CBs. This could lead - for the short term - to a vicious cycle as depicted in the second diagram.