A Policy Blunder of Monumental Proportions

Every once in a while, when the name of this blog starts to look stupid to its creator, Stephen Roach is there to center me - to refocus my attention on the task at hand, that of affixing blame for a problem which most people do not yet see.

Perhaps it works the other way as well. Perhaps Mr. Roach looks back on his previous writings and thinks to himself, "I've been saying the same thing for the last three years, but things just keep getting more and more unbalanced, and nobody wants to do anything about it". Perhaps he is an active reader of this blog and similarly draws strength from the views expressed here - naaahhh, probably not.

In addition to having a cool last name, Mr. Roach is the Chief Economist and Director of Global Economic Analysis at Morgan Stanley. He has been the subject of several previous posts here, most recently being referred to as the Energizer Bunny - but, in a good way.

In last Friday's From Bubble to Bubble, we are reminded once again that, by largely ignoring asset inflation over the last ten years (first equities, then real estate) the Federal Reserve may have committed "a policy blunder of monumental proportions", which gives rise to an intriguing possibility for a new blog:

The Policy Blunder Of Monumental Proportions That Greenspan Made

Uh, maybe not.

Looking back at the way people rationalized the equity bubble in 2000 (new era productivity, earnings potential), and how there are eerily similar rationalizations for today's property bubble (immigration, low unemployment, real estate is "local") he notes:

This is rubbish -- five years ago and, again, today. In March 2000, not all stocks had risen to dot-com excesses. But enough of them did to take the overall S&P 500 index down by 49% in the bubble carnage that followed over the next two and a half years. Today, nationwide US house-price inflation is at a 25-year high in real terms... In 25 of the top 100 metropolitan areas, the rate of home price appreciation was at least 20%... Something else must at work.

That something else is a bubble. Residential property has become the asset of choice for investors in a low-return world awash in liquidity... America’s equity and property bubbles have one key ingredient in common: The principal blame for both bubbles, in my view, lies with the Federal Reserve.

While it is not the Federal Reserve that is making interest only and option-ARM loans to unwitting consumers, the Federal Reserve has facilitated and encouraged these sorts of excesses, as noted on several occasions here - most notably, encouraging homeowners to take on variable rate loans and marvelling at the rise in sub-prime lending.

It seems that after ten years, when the real problem has evolved into too much liquidity, more liquidity is no longer a viable solution. When this point is reached all that is left is a "serial bubble-blowing strategy" to try to keep the whole thing from collapsing.

To counter post-equity bubble aftershocks, the Fed slashed its policy rate by 550 basis points to 1% -- vowing that it had learned the tough lessons of Japan... It pushed the real federal funds rate into negative territory for three years (2002-04) before finally taking it up to the zero threshold, where it remains today.

Out of this same mania, the property bubble was borne... The home became the cash machine -- the manna from heaven that drew its sustenance from rock-bottom interest rates. And it became contagious -- as most bubbles do. The more consumers succeeded in extracting purchasing power from their assets, the greater the demand for the asset. Once borne out of a legitimate effort at post-bubble life-style defense, the asset-based consumption mindset took on a life of its own. Like the carry trade in fixed income, this phenomenon created an artificial demand for the underlying asset. We now call it a property bubble.

Many in this country, and around the world, are quite pleased with where we find ourselves today - never before have so many people acquired so much wealth in such a short period of time. It almost seems too good to be true, doesn't it?

One of the great mysteries of asset bubbles is what causes them to pop. Yale professor Robert Shiller has long argued that asset bubbles invariably implode under their own weight... We all hope for the benign endgame. But the bigger the bubble and its associated imbalances, the less likely that becomes.

Don’t kid yourself. America’s property bubble didn’t just appear out of thin air. It is traceable directly to the equity bubble of the Roaring 1990s -- and to a central bank that remains steeped in denial. The real lesson of Japan is that there may well be no easy way out.

Easy way out? Who says things have to change? As time goes by, it becomes increasingly strange that nothing bad happens, but more and more time passes without a crisis. What if there never is one? With hedge funds, exchange rates, China, Iraq, oil prices, home prices, and so on, you'd think that something bad would have happened by now - but it hasn't.

What happens then? The U.S. consumer slowly chokes on his debt? That sounds like fun.