In an op-ed($) appearing in today's Wall Street Journal (hat tip CB), Alan Greenspan explains how we got into the current mess and the role the Federal Reserve played.
After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own. There was clearly little the world's central banks could do to temper this most recent surge in human euphoria, in some ways reminiscent of the Dutch Tulip craze of the 17th century and South Sea Bubble of the 18th century.
I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.
Demand in those days was driven by the expectation of rising prices -- the dynamic that fuels most asset-price bubbles. If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. In fact, home prices continued to rise for two years subsequent to the peak of ARM originations (seasonally adjusted).
I and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.
The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.
A few comments:
Low interest rates, in and of themselves, would not have caused the housing bubble as we now know it.
Prudence would have dictated an approach where, back in 2001 or 2002, the world's second most powerful man might have said, "Look, we've got to take real interest rates to zero. Let's keep an eye on things so we don't just create another bubble somewhere else."
The bad stuff didn't start happening until a couple years later, after the Fed-sponsored transfer of mortgage backed security origination from Fannie and Freddie to Wall Street was complete and everyone joked that, "If you can fog a mirror, you can get a home loan".
2. Once again, the complete failure to recognize a bubble early on is glossed over in the now common bubble defense, "Can't see 'em forming, can't pop 'em when you do see 'em". This is more evidence of why naive economists at the nation's central bank should not be entrusted with the power they currently possess. Had any of them pulled their noses out of their statistical data and spent some time in the real world, they would have seen the bubble formation clearly.
3. To say that "the impact on demand for homes financed with ARMs was not major" is just laughable.
4. To say that "if low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages" is ludicrous.
5. It's nice to know that we'll eventually be able to "get back to business". Whew! Some of us were worried that this mess might turn into something more serious.
For a more reality-based (and much funnier) explanation of the roots of the mortgage mess, see "An interview with Alan Greenspan".