Wikinvest Wire

Rationalizing Bubbles, Shaping a Legacy

Wednesday, September 28, 2005

Two speeches in two days. One on mortgage banking, the other on economic flexibility. It looks like Alan Greenspan has shifted into full-time legacy-shaping, arse-covering mode.

Four more months of this, and then it's over.

Largely responsible for the mess that will be left behind upon his departure in January (we call it a mess, but then of course we have to - others think of it as a two-decade long party that never has to stop), Mr. Greenspan seems to be calming nerves, defending his policies, and sounding warnings - all with increasing frequency in recent months.

The speeches of the last two days are fine examples of efforts to allay the fears of a rattled citizenry, demonstrate how he is still on top of things, and to let everyone know what they need to do in order to assure their continued economic well-being after he departs.

Monday is for Mortgages

In Monday's speech on mortgage banking, we learn that he is so on top of things that he just co-authored a new report! His first report in nearly ten years, we are told. Titled "Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four-Family Residences", this is a largely impenetrable work that does however yield the following conclusion.

Regardless of the precise mix of factors that explains the decline in interest rates, the associated run-up in housing values has left households with a substantial pool of available home equity. According to data recently developed by Jim Kennedy of the Federal Reserve Board staff, and me, discretionary extraction of home equity accounts for about four-fifths of the rise in home mortgage debt.
Instead of stopping to marvel at what he was instrumental in creating, that is, the nearly trillion dollars per year of home equity that Americans are "extracting" from their homes, he casually continues with an explanation of how the data was interpreted, how half of this money goes directly to consumer spending, and how this explains our country's abysmal savings rate. A more appropriate response to this finding would be:

Holy Sh**t! What have I done? People are using their homes like ATMs!

Further on there is a discussion of housing market froth (little bubbles, lots of them) in local markets (lots of local markets) and how there has been a marked increase in the turnover of second homes and investment property. This increase may be an indication of speculative activity, but it probably just needs to be studied.

We are then introduced to a novel concept - that housing market froth has "spilled over into mortgage markets". Well! Those homebuyers just can't seem to keep their froth to themselves - they're spilling it on the mortgage lenders! Maybe a better way of putting this would be that the Fed started a credit bubble that turned into a mortgage bubble that enabled a housing bubble that is now only sustainable through interest-only loans and other exotic mortgages.

This characterization, as excerpted from the speech, just doesn't give proper credit to the source of the credit:
The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny.
So, just to be clear. Holding real interest rates below zero for years at a time and failing to regulate the banking industry while encouraging people to use ARMs - not froth-like. Homebuyers and mortgage lenders participating in a once-in-a-lifetime housing mania, desperate to buy and finance homes at astronomical prices - frothy.

Finally, we learn that we should all sleep well at night because loan-to-value ratios are just fine. Or, at least they are fine when looking at the 90 percent LTV mark combined with the last couple years of double-digit price appreciation.
In summary, it is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices.
But what about the marginal buyer who bought six months ago, surely not part of the "vast majority" cited, but still important. How about if prices decline at double-digit rates for a few years? How about a 40% drop in Southern California housing prices similar to what occurred about ten years ago after a far smaller run-up in prices? How much cushioning will there be then?

Tuesday is for Flexibility

In Tuesday’s speech on economic flexibility, after reviewing the impact of Adam Smith and John Maynard Keynes, we learn how 1980s deregulation loosed what Joseph Schumpeter termed "creative destruction" on an American public which had been conditioned to expect very little from their economy or its policymakers.

Deregulation, along with information technology, financial market creativity, reliance on market forces, and competition are the areas of "flexibility" that are considered critical to continued prosperity, according to the Fed Chairman.

Hmmm ... flexibility ... financial market creativity.

At least for the last few years, that's been the key area of flexibility, we postulate. And, reliance on market forces instead of government intervention - maybe not so much. Especially when it comes to exchange rates and long term interest rates.

About half way through re-reading the section on financial market flexibility, we had a feeling of deja vu and began to suspect that maybe we have postulated correctly. It seems that maybe "financial market flexibility" has an older brother named "productivity improvements", where the relationship can best be described by two series of events, the first series having started about ten years ago:
  • Stock market bubble
  • Technology driven productivity improvements
  • Stock market crash
And, the second series having started about five years ago:
  • Housing market bubble
  • Financial market flexibility
  • [End result of housing bubble]
So, the stock market is to housing market as productivity is to flexibility. An interesting theory, and perhaps a future graduate level economics final exam question.

It is as if the productivity miracle of the 1990s explained and justified the existence of the stock market bubble which everyone then sat around and watched burst. And, today, it is as if the new flexibility provided by asset-backed securities, collateral loan obligations, and credit default swaps explain and justify today's real estate prices. We don't know what the end result of the housing bubble will be, but it sure seems like there are a lot of people sitting around watching it.

Apparently it's all about the risk. And, how we have somehow, through innovation and technology (and with help from a real estate market that goes briskly in one direction - up), managed to disperse all of today's housing market credit risk to the point that it almost doesn't even exist anymore. Almost.
The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection.

These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago. After the bursting of the stock market bubble in 2000, unlike previous periods following large financial shocks, no major financial institution defaulted, and the economy held up far better than many had anticipated.

If we have attained a degree of flexibility that can mitigate most significant shocks--a proposition as yet not fully tested--the performance of the economy will be improved and the job of macroeconomic policymakers will be made much simpler.
Yes that's right - much of the system today is based on hedge funds selling credit default swaps (i.e., loan default insurance). This is the major support of today's financial market flexibility, and about the only thing that can sustain today's home prices given rising interest rates and current incomes of home buyers. Reading the multiple qualifiers and meager results sought in the concluding parapraph of the excerpt above, it is clear that the author is under whelmed.

The section on "too much stability" is one of the more intriguing parts of this speech. Mr. Greenspan has been talking about this a lot as he nears retirement - good to have all plausible explanations out there ahead of time just in case the whole thing comes tumbling down next February (recall that the crash of 1987 occurred only six weeks after the Fed Chair transitioned from Volcker to Greenspan).

It is as if he laments having been too successful at his job - that by providing too much stability he has created instability.
... history cautions that extended periods of low concern about credit risk have invariably been followed by reversal, with an attendant fall in the prices of risky assets. Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender.

Therefore, because it is difficult to suppress growing market exuberance when the economic environment is perceived as more stable, a highly flexible system needs to be in place to rebalance an economy in which psychology and asset prices could change rapidly. Indeed, as I have pointed out in the past, policies to enhance economic flexibility need to be as integral a part of economic policy as are monetary and fiscal initiatives.
We can only conclude that should something go awry with the housing bubble, we will see things that we never dreamed of before - flexibility on a grand scale. Just think back to late 2000 when asset backed securities were little more than a twinkle in the eyes of Wall Street, struggling at the time to understand reversals in equity markets.

And lastly, the oft repeated "I did the right thing by not popping the stock market bubble" rationale - once again, for good measure. It doesn't really fit in with the flexibility theme of this speech, but maybe it just hadn't been stated publicly in the last week or so and there was fear of this truism fading from our collective memory. Clearly, after a year or so of questions about whether the stock market bubble had morphed into a housing bubble, the "no-popping policy" of the Fed warranted repeating. If people hear something repeated enough times, they tend to believe it, regardless of its merit.
Relying on policymakers to perceive when speculative asset bubbles have developed and then to implement timely policies to address successfully these misalignments in asset prices is simply not realistic. As the Federal Open Market Committee (FOMC) transcripts of the mid-1990s duly note, we at the Fed were uncomfortable with a stock market that appeared as early as 1996 to disconnect from its moorings.
By the late 1990s, it appeared to us that very aggressive action would have been required to counteract the euphoria that developed in the wake of extraordinary gains in productivity growth spawned by technological change. In short, we would have needed to risk precipitating a significant recession, with unknown consequences. The alternative was to wait for the eventual exhaustion of the forces of boom. We concluded that the latter course was by far the safer. Whether that judgment continues to hold up through time has yet to be determined.
See, it just wasn't realistic to pop the stock market bubble - it's as simple as that. Better to wait for the boom to exhaust itself, then play the hero. Better to swoop in and save the day, taking no responsibility for creating any of the problems in the first place.

It is clear that "exhaustion" is and will continue to be the monetary policy prescription for the housing bubble - it is not clear, however, what can possibly be done to save the day.


Anonymous said...

Maybe there is some post-hoc historiography by Greenspan going on here, but the comment:

"In short, we would have needed to risk precipitating a significant recession, with unknown consequences. The alternative was to wait for the eventual exhaustion of the forces of boom. We concluded that the latter course was by far the safer."

needs to be read in light of some of his other speeches, about how it is the job of a central banker in a world of uncertainty to manage risks. It looks like he is trying to justify his '99-2000 approach to the stock in light of that overall risk-management philosophy of central banking. Since it was not at all clear at the time that his assessment of the risks (as he described it after the fact, with whatever degree of credibility) I am not sure it is entirely fair for you to say, as you do with what appears to be a certain degree of sarcasm: "See, it just wasn't realistic to pop the stock market bubble - it's as simple as that. Better to wait for the boom to exhaust itself, then play the hero. Better to swoop in and save the day, taking no responsibility for creating any of the problems in the first place."

On the other hand, it could perhaps be fairly said that perhaps he didn't identify all of the risks he should have, that risks need to be assessed over the long term as well as the short term, and he hasn't given enough weight to the long-term risk that his short term risk avoidance would lead to an ever-inflating credit bubble.

Anonymous said...

Greenie has been a bubble-enabler who never wanted to be the wet blanket once things really got going and it was clear to many that it was going to end badly.

This is probably the gist of this comment - that, in retrospect, he too quickly dismisses policy options early on when first recognizing "irrational exhuberance" and allows bubbles to grow, when maybe he should have done somthing other than be the cheerleader. This cheerleading occurred for both the stock market bubble in the late 1990s and the housing bubble until recently.

Once the bubbles start to grow uncontrollably, he never wanted to be the one to stop them - better to viewed as the problem solver than the problem creator.

Anonymous said...

Does that mean you will be changing your name soon?

Anonymous said...

Just read in the LA times how the cost of living to maintain a bare-bones decent existence in California has gone up 12% a year over the last 3 years, yet these Fed fraudsters go around claiming inflation is under "control"

Sad to see the economic fate of the world hang on the whims and fancies of one man on top of a small cabal.

I hope history would judge Greenspan for what he is - one of its worst villains. His easy-credit policies are destroying the American middle-class, and redistributing the wealth to the financial elite. I hope capitalism and freedom survive Greenspan's legacy.

Anonymous said...

12:49 -

After four months we're all stuck wiht the mess that greenie made

Anonymous said...

Re. the housing bubble. The tragedy here is: where I live (extremely over-priced New England suburb), I don't see a bunch of out-of-town speculators buying expensive s$hitboxes. I see lots of ordinary, young, hardworking couples - with maybe one or two loud brats in tow - stretching to buy a modest ranch or split-entry, mostly to escape "apartment hell". These aren't financial sophisticates; talking to them about "historical valuations" would be pointless. These are the kinds of people who are going to get hurt most by Greenspan's grand "I don't do bubble pops" experiment. If the Fed chief can't understand the value of asset price stability to ordinary folks like these, well - he's simply not qualified for the job.

Re. deregulation. Another grand experiment, and the jury is still out on that one. 20 years on, it appears that in at least one industry - airlines - we have an unmitigated disaster, with virtually every key player already in bankruptcy, or close to it. The net result being serious loss of pension benefits to salaried employees, and an ultimate taxpayer-funded bailout of this underclass via the PBGC. With the inevitable downdraft in the financial markets (which haven't really popped just yet), next on the line is likely all finance-related businesses - mortgage providers, GSE's, commercial banks, service providers like mutual funds, you name it. There, the impact will be much broader, and definitely result in - that's right - regulation. These things go in cycles. And through it all, rank-and-file employees and taxpayers get the shaft.

Anonymous said...

There was an interesting speech by Janet Yellin in London on September 27 where she discusses, among many interesting things, whether the fed should target asset, specifically, house prices.

Here is what she said:

"As a starting point, the issue is not whether policy should react at all; I believe there is quite general agreement that policy should be calibrated to the wealth effects of house prices on output and inflation. The debate lies in determining when, if ever, policy should be focused on deflating the asset price bubble itself.

"In my view, the weight of a decision to deflate an asset price bubble rests on positive answers to three questions. First, if the bubble were to collapse on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble?

"My answers to these questions in the shortest possible form are, "no," "no," and "no." . . . Since the short answer is not satisfactory and the thorough one overwhelms our time limits, I will compromise and give just a brief explanation for my trio of 'nos.'

"In answer to the first question on the size of the effect, it could be large enough to feel like a good-sized bump in the road, but the economy would likely to be able to absorb the shock. For example, a reversion to the long-run price-rent ratio would appear to represent a shock that is only about half the size of U.S. stock market collapse in 2000 and 2001.

"In answer to the second question on timing, the spending slowdown that would ensue is likely to kick in gradually, because it mainly affects household wealth. That would give the Fed time to cushion the impact with an easier policy.

"In answer to the third question on whether monetary policy is the best tool to deflate a house-price bubble, there are several points to consider. For one thing, no one can predict exactly how much tightening would be needed, or by exactly how much the bubble should be reduced. Beyond that, a tighter policy to deflate a housing bubble could impose substantial costs on other sectors of the economy that would lead to equally unwelcome imbalances. Finally, it's possible that other strategies, such as tighter supervision or changes in financial regulation, would not only be more tailored to the problem, but also less costly to the economy."

This humble commentator would also argue that the use of monetary policy to target asset prices is fundamentally at odds with the notion of a free market economy where the free interplay of supply and demand are supposed to determine asset prices.

Cole Kenny said...

I've posted a Bubble poll on my site. The more participants, the more interesting the results. Cole @ The Boy in the Big Housing Bubble

Tim said...

You know, the thing that really bugs me about this whole Fed asset bubble popping nonsense, as evidenced in the Yellen speech above, is that the asset bubble shouldn't have been allowed to form in the first place. You rarely hear anyone at the Fed talk about bubble formation, and when they do, they claim they really could't be sure it was going to turn into a full-fledged bubble.

Most of the Fed policy discussion starts with the existence of a bubble, as if it just appeared one day - by that time it's already too late.

A simple example would be, when the S&P500 goes up 20% of more in one year, then you should take notice. If it looks like it's headed for another 20% increase the next year, then it's time to do something. That's exactly what happened in 1996 when the "irrational exhuberance" warning was issued. Instead of doing something, we got the "productivity miracle" explanation and another three years or so of 20% gains. Meanwhile the Nasdaq was going crazy.

You can make the same case for housing prices starting about five years ago. It was clear to many people in 2003 that this was a bubble - Fannie Mae was already getting into trouble. But it was allowed to go on until today, where it looks like things might finally be peaking.

Anonymous said...

He has shifted from
you can't tell it is a bubble until after it pops
we knew it was a bubble in the late 90's and our best option was to wait for it to pop on its own (forces of the boom exhaust themselves)

I'd guess this shift was forced by the eventual release of the minutes that made it very clear they were aware of the stock market bubble. Note that he never explains why it was appropriate to lie. This is why he needs to repeat the stock bubble story over and over, so he can gradually shift his story.
His my success at creating stability is what caused the problems is his set up for how he justifies his record after the stuff hits the fan. I think the point you made about their (Allen & colleagues) total avoidance of the subject of how the bubbles started is telling. Why can't they bring themselves to discuss this. Anyone interested enough in economics to get a degree in it would HAVE to be curious about this, why the deliberate self censorship? Thanks for the blog Tim

Anonymous said...

Tim, in your 6:15 pm comment, you set some rather arbitrary percentage benchmarks on when the fed should intervene to pop a bubble. But the idea of targeting asset prices is inconsistent with the notion of a free market economy, because buyers and sellers in the open market are supposed to set asset prices. Who is the fed as the God of markets to say when an asset is too expensive: that determination is supposed to be made by the buyer who weighs the opportunity cost against the use he or she intends to make of the asset. Also, which assets are you going to target? Today, you are saying it should be financial and investment assets such as houses and stock. Tomorrow, someone else may decide to regulate the price of, say, ball bearings, or corn, or iron ore. What principled distinction ca you come up with to distinguish these latter categories of goods from the assets you do want to target?

I think the notion of saying that the fed should target asset prices is different from saying that real interest rates in the economy as a whole are too low, or the fed has adopted an unprincipled, results-oriented, ad hoc approach to monetary policy which has caused a credit inflation. The policies implied by these latter criticisms are consistent with free markets in a way targeting the specific prices of specific assets is not.

Tim said...


I'm not sure where to go with this, but I feel compelled to respond in some way. If you're an economist, I fear we will never be able to really understand each other ...

My point about the S&P500 example is really very simple and has nothing to do with "intervening to pop a bubble" - someone should have done something BEFORE it became a bubble - in 1996 or 1997.

The market capitalization of the 500 biggest public companies is a fairly big deal - it's not like it's the price of bananas. When this rises 30+% in 1995, then 20+% in 1996, maybe someone at the Fed should have done something to prevent things from getting out of hand - to prevent an exhuberant market from becoming a bubble.

The same case could be made for real estate - it's not like it's the price of bananas, and two years ago, many people realized that home prices were rising rather rapidly, but there were no substantive monetary policy changes or regulation. The time to do something to prevent a real estate train wreck in 2006 was in 2003.

Anonymous said...

Tim, I am not an economist, so maybe there is hope that we will understand each other.

Your Sept. 29 responses to my comments of 11:04 Sept. 28 are along the lines of most of the critiques out there, but fundamentally these critiques are no different or better than the problem they are trying to solve. They criticize the way Greenspan has intervened in the economy through artificially lowering real interest rates, but all they propose to do is replace one form of short-term, results-oriented interventionism with another, one based on the targeting of asset prices, a form of intervention which, as I think Janet Yellin has tried to argue, is unworkable and undesireable.

I think if we go back and re-read the history of the great central bankers, say, for example, Paul Volcker, we will find that their policies were not based on intervening in the market to achieve a particular short term set of results, but were based on following principles, in the case of Volcker, the principles of monetarism, including the principle that monetary growth should be kept stable.

I am not sure where I am going either, but I will have more to say about this later.


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