The 30-year fixed-rate mortgage created by FHA was intended to calm down both sides of the residential credit market and encourage the resumption of borrowing and lending. Real estate lending troubles were at the center of the sharp decline in economic activity that we call the Great Depression, though we cannot blame real estate “bubbles”. Instead, it was the conscious and deliberate monetary policy of the time that led to a profound deflation (the price level fell 30 percent in 3 years between 1930 and 1933) that precipitated the decline in real economic activity. In addition to the sharp rise in unemployment caused by this decline in the price level, the deflation also disturbed the relationship between the assets and liabilities of borrowers. The dollar (nominal) price of real assets and wages fell with the overall price level, while debts were denominated in dollars, and still owed in dollars. The deflation increased the real value of these nominal debts. The situation can be thought of as dollar prices of assets declining while dollar prices of debts stayed fixed, raising debtors’ indebtedness. Or it could be thought of as real values of assets staying fixed while real values of debt rose. Expressed either way, borrowers were in trouble. Borrowers were in trouble because even if they were still employed, their dollar incomes fell 30% (unless they were government employees, whose incomes stayed the same in dollar terms) along with the price level while the dollar obligations on their debts remained the same. Borrowers could not pay their mortgages nor could they refinance them.

The FHA-insured 30-year mortgage succeeded in calming both sides of the market. Lenders were more willing to lend because FHA took the risk of default. Borrowers were more willing to borrow because the loans were long-term and did not require them to refinance before the loan was paid off in the way the earlier 5 to 10-year term, non-amortizing loans did. Both sides felt more secure. The biggest risk the government was taking by insuring FHA mortgages was not the particular default risk, but the risk of a large change in the price level. It was the change decline in the price level between 1930 and 1933 that bankrupted borrowers, caused widespread default, and thus bankrupted banks too. It was anticipated at the time of FHA’s creation that the price level would be stable long-term because the dollar was still tied to gold. It was believed at that time that so long as we were on the gold standard, serious inflation could not occur.