The Roots of the Mortgage Crisis
Bubbles cannot be safely defused by monetary policy before the speculative fever breaks on its own.

BY ALAN GREENSPAN
Wednesday, December 12, 2007 12:01 a.m. EST

On Aug. 9, 2007, and the days immediately following, financial markets in much of the world seized up. Virtually overnight the seemingly insatiable desire for financial risk came to an abrupt halt as the price of risk unexpectedly surged. Interest rates on a wide range of asset classes, especially interbank lending, asset-backed commercial paper and junk bonds, rose sharply relative to riskless U.S. Treasury securities. Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction.

The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums.

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World. A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: Fairly well educated, low-cost workforces were joined with developed-world technology and protected by an increasing rule of law, to unleash explosive economic growth. Since 2000, the real GDP growth of the developing world has been more than double that of the developed world.

The surge in competitive, low-priced exports from developing countries, especially those to Europe and the U.S., flattened labor compensation in developed countries, and reduced the rate of inflation expectations throughout the world, including those inflation expectations embedded in global long-term interest rates.

In addition, there has been a pronounced fall in global real interest rates since the early 1990s, which, of necessity, indicated that global saving intentions chronically had exceeded intentions to invest. In the developing world, consumption evidently could not keep up with the surge of income and, as a consequence, the savings rate of the developing world soared from 24% of nominal GDP in 1999 to 33% in 2006, far outstripping its investment rate.

Yet the actual global saving rate in 2006, overall, was only modestly higher than in 1999, suggesting that the uptrend in developing-economy saving intentions overlapped with, and largely tempered, declining investment intentions in the developed world. In the U.S., for example, the surge of innovation and productivity growth apparently started taking a breather in 2004. That weakened global investment has been the major determinant in the decline of global real long-term interest rates is also the conclusion of a recent (March 2007) Bank of Canada study.

Equity premiums and real-estate capitalization rates were inevitably arbitraged lower by the fall in global long-term interest rates. Asset prices accordingly moved dramatically higher. Not only did global share prices recover from the dot-com crash, they moved ever upward.

The value of equities traded on the world’s major stock exchanges has risen to more than $50 trillion, double what it was in 2002. Sharply rising home prices erupted into major housing bubbles world-wide, Japan and Germany (for differing reasons) being the only principal exceptions. The Economist’s surveys document the remarkable convergence of more than 20 individual nations’ house price rises during the past decade. U.S. price gains, at their peak, were no more than average.

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 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.

In mid-2004, as the economy firmed, the Federal Reserve started to reverse the easy monetary policy. I had expected, as a bonus, a consequent increase in long-term interest rates, which might have helped to dampen the then mounting U.S. housing price surge. It did not happen. We had presumed long-term rates, including mortgage rates, would rise, as had been the case at the beginnings of five previous monetary policy tightening episodes, dating back to 1980. But after an initial surge in the spring of 2004, long-term rates fell back and, despite progressive Federal Reserve tightening through 2005, long-term rates barely moved.

In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates.

Arbitragable assets–equities, bonds and real estate, and the financial assets engendered by their intermediation–now swamp the resources of central banks. The market value of global long-term securities is approaching $100 trillion. Carry trade and foreign exchange markets have become huge.

The depth of these markets became readily apparent in March 2004, when Japanese monetary authorities abruptly ceased intervention in support of the U.S. dollar after accumulating more than $150 billion of foreign exchange in the preceding three months. Beyond a few days of gyrations following the halt in purchases, nothing of lasting significance appears to have happened. Even the then seemingly massive Japanese purchases of foreign exchange barely budged the prices of the vast global pool of tradable securities.

In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions. The ability of central banks and their governments to join with the International Monetary Fund in broad-based currency stabilization is arguably long since gone. More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.

Although central banks appear to have lost control of longer term interest rates, they continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created. Thus central banks retain their ability to contain pressures on the prices of goods and services, that is, on the conventional measures of inflation. 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.

Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of “The Age of Turbulence: Adventures in a New World” (Penguin, 2007).

The former Fed chairman walked through some of the basics of the economy, including Stewart’s straightforward question: “Why do we have a Fed? Why do we have someone adjusting the rates if we’re a free-market society?”

Greenspan: “You’re raising a very fundamental question.”
Stewart: “I am? Should I leave?”
Greenspan: “No. Stay for a while. Since you got your Emmy, you’re qualified.”

Stewart quickly forced Greenspan to defend big investors and hedge funds. “It seems to me that we favor investment, but we don’t favor work,” Stewart said. “The vast majority of people work — they pay payroll taxes, and they use banks. And then there’s this whole other world, of hedge funds and short-betting and — it seems like craps. And they keep saying, no no, no, don’t worry about it, it’s free market. That’s why we live in much bigger houses. But it really isn’t. It’s the Fed, or some other thing, no?”

Greenspan: “I think you better re-read my book…. What a sound money system does is to stabilize all the elements in it, and reduces the uncertainty that people confront. And the one thing all human beings do when they are confronted with uncertainty is pull back, withdraw, disengage, and that means economic activity, which is really dealing with people, just goes straight down.”

In a straightforward definition of market bubbles, Greenspan explained how euphoria leads to confidence “that everything is terrific” before a sudden realization that the good times won’t last.

Greenspan: “I’ve been dealing with these big mathematical models of forecasting the economy, and I’m looking at what’s going on in the last few weeks. … If I could figure out a way to determine whether or not people are more fearful or changing to more euphoric, and have a third way of figuring out which of the two things are working, I don’t need any of this other stuff. I could forecast the economy better than any way I know.

“The trouble is that we can’t figure that out. I’ve been in the forecasting business for 50 years. … I’m no better than I ever was, and nobody else is. Forecasting 50 years ago was as good or as bad as it is today. And the reason is that human nature hasn’t changed. We can’t improve ourselves.”

Stewart: “You just bummed the [bleep] out of me.”

U Utorak, Greenspan je bio gost poznatom John Stewartu, u Daily Show. Pokušao sam pronaći video toga ali još ga nema na webu. Na kraju razgovora Stewart je rekao Greenspanu, koji je objasnio na svoj tmuran način kako se mi ljudi ne mjenjamo na bolje, “You bumed the s*** out of me now.” No jedan bloger si je dao truda i napisao kratki ulomak iz intervju koji su dvojca imali oko kontradikcije postojanja centralne banke koja kontrolira kamatne stope u slobodnom tržištu. Nadam se da će cijeli razgovor dvojce biti uskoro na webu.

Exclusive Book Excerpt: Alan Greenspan

Greenspan charts our economic course in ‘The Age of Turbulence.’ An excerpt.

Newsweek – Sept. 24, 2007 issue

People have always been enthralled by the notion that it is possible to peer into the future. Ancient Greek generals sought audiences with the oracle at Delphi to guide their military adventures. Fortune-tellers thrive to this day. Modern Wall Street employs phalanxes of very smart people to read what the entrails of market performance say about future stock prices. To what extent can we anticipate what lies ahead? Fortunately for policymakers, there is a degree of historical continuity in the way democratic societies and market economies function. There is indeed much that we can infer about the U.S. economy and the world at large in the decades ahead, especially if we adopt Winston Churchill’s insight: “The further backward you look, the further forward you can see.”

What, then, can we reasonably project for the U.S. economy for, say, the year 2030? Little, unless we first specify certain assumptions. I need affirmative answers to the following questions to get started. Will the rule of law still be firm in 2030? Will we still adhere to the principle of globalized free markets, with protectionism held in check? (By protectionism, I mean not just barriers to international trade and finance but governmental restrictions against competition in domestic markets as well.) Will we have fixed our dysfunctional elementary and secondary school systems? Will the consequences of global warming emerge slowly enough so as not to significantly affect U.S. economic activity by 2030? And finally, will we have kept terrorist attacks in the United States at bay? Unsaid are those possibilities, such as a wider war or a pandemic, that could upset any forecast.

But the long list of caveats does not inordinately tie our forecasting hands. After all, such a list has always existed in one form or another, and yet the record of long-term forecasting of the U.S. economy overall in my experience has been reasonably impressive. What is the most likely level of overall activity we can expect in our arbitrarily chosen 2030 forecast year?

Given our assumptions and the economy’s historical record, it is difficult to imagine the employment rate of the civilian labor force being outside the rather narrow range of 90 to 96 percent (that is, an unemployment rate between 4 and 10 percent). America’s fifty-year average is more than 94 percent, with nonrecession years (the assumption for 2030) near 95 percent. Combining labor force participation rates, population projections, a near 5 percent unemployment rate, and a stable workweek yields an annual growth rate in hours worked in the United States through 2030 of 0.5 percent.

If we smooth through the raw data on output per hour, a remarkably stable pattern of growth emerges, going back to 1870. Annual growth of nonfarm business output per hour has averaged close to 2.2 percent. Even without adjusting for the business cycle, wars, and other crises, the range of overlapping consecutive fifteen-year averages of the annual increase in output per hour stays consistently between 1 and 3 percent. Our historical experience strongly suggests that as long as the United States remains at technology’s cutting edge, annual productivity growth over the long run should range between 0 and 3 percent.

But why not higher—say, 4 percent per year or more? After all, in much of the developing world, annual output per hour has been averaging growth of far more than 2 percent. But those nations have been able to “borrow” the proved technologies of the developed world and have not themselves had to undertake the slow step-by-step effort to advance cutting-edge technologies.

U.S. productivity in 2005 was 2.8 times higher than in 1955. That is because we knew so much more in 2005 than a half century earlier about how our physical world operates. Every year, millions of innovations incrementally improved overall productivity. This process has become particularly evident since the discovery of the exceptional electrical properties of silicon semiconductors following World War II. Yet why hasn’t productivity growth been even faster? Couldn’t what we knew in 2005 have been figured out by, say, 1980, thereby doubling the rate of productivity gains (and increases in standard of living) between 1955 and 1980? The simple answer is that human beings are not smart enough. Our history suggests that the ceiling on the productivity growth of an economy over the long term at the cutting edge of technology is at the most 3 percent per year. It takes time to apply new ideas and often decades before those ideas show up in productivity levels.

Which brings us to our bottom line. Coupled with the projected 0.5 percent annual increase in hours worked between 2005 and 2030 that follows from the demographic assumptions cited earlier, a slightly less than 2 percent annual average growth in GDP per hour implies a real GDP growth rate of slightly less than 2.5 percent per year, on average, between now and 2030. That compares with 3.1 percent per year, on average, over the past quarter century, when labor force growth was considerably faster.

Arriving at a credible forecast for the level of real GDP for 2030 is a start, but it doesn’t tell us much about the nature of the dynamic that will be driving U.S. economic activity a quarter century in the future, or about the quality of our lives. For superimposed on these powerful trends will be the consequences of an inevitable completion of major aspects of globalization. At some point, globalization’s vast economic migration—the epoch-making shift of fully half of the world’s three-billion-person labor force from behind the walls of economies that were centrally planned, in part or in whole, to competitive world markets—will be complete, or as complete as it can possibly get. The continuing acceleration of the flow of workers to competitive markets during the past decade has been a potent disinflationary force. That acceleration has depressed wage growth and held down inflation virtually uniformly across the globe. Leaving aside Venezuela, Argentina, Iran, and Zimbabwe, inflation during 2006 in all developed and major developing nations was clustered between 0 and 7 percent. Similarly narrow ranges describe long-term interest rates. Such globally subdued price and interest rate pressures are exceptionally rare in my experience.

The rate of flow of workers to competitive labor markets will eventually slow, and as a result, disinflationary pressures should start to lift. China’s wage-rate growth should mount, as should its rate of inflation. The first signs are likely to be a rise of export prices, best measured by the prices of Chinese goods imported into the United States. Falling import prices from China have had a powerful ripple effect. They have suppressed the prices of competing U.S.-made goods and contained the wages of the workers who produce them—as well as the wages of any who compete against the workers who produce the goods that vie with the Chinese imports. Accordingly, an easing of disinflationary pressures should foster a pickup of price inflation and wage growth in the United States. It should be noted that import prices from China rose markedly in spring 2007 for the first time in years.

How the federal reserve responds to a reemergence of inflation and expected falling world saving propensities will have a profound effect not only on how the U.S. economy of 2030 turns out but also, by extension, on our trading partners worldwide. The Federal Reserve’s pre-1979 track record in heading off inflationary pressures was not a distinguished one. In part, that earlier history was a consequence of poor forecasting and analysis, but it also reflected pressures from populist politicians inherently biased toward lower interest rates. During my eighteen-and-a-half-year tenure, I cannot remember many calls from presidents or Capitol Hill for the Fed to raise interest rates. In fact, I believe there was none. As recently as August 1991, Senator Paul Sarbanes, in response to what he considered intolerably high interest rates, sought to remove voting authority on the FOMC [the board that controls the federal funds rate, the primary lever of monetary policy] from what he perceived were the “inherently hawkish” presidents of the Federal Reserve banks. Interest rates declined with the 1991 recession, and the proposal was shelved.

I regret to say that Federal Reserve independence is not set in stone. FOMC discretion is granted by statute and can be withdrawn by statute. I fear that my successors on the FOMC, as they strive to maintain price stability in the coming quarter century, will run into populist resistance from Congress, if not from the White House. As Fed chairman, I was largely spared such pressures because long-term interest rates, especially mortgage interest rates, declined persistently throughout my tenure.

It is possible that Congress has observed the remarkable prosperity that emerged in the United States and elsewhere as a consequence of low inflation and has learned from this happy circumstance. But I fear that containing inflation through higher interest rates will be as unpopular in the future as it was when Paul Volcker did it more than twenty-five years ago. “You’re high on the hit parade for lynching,” Senator Mark Andrews told Volcker bluntly in October 1981.

This brings us back to globalization. If my suppositions about the nature of the current grip of disinflationary pressure are anywhere near accurate, then wages and prices are being suppressed by a massive shift of low-cost labor, which, by its nature, must come to an end. A lessening in the degree of disinflation suggested by the upturn in prices of U.S. imports from China in spring 2007 and the firming of real long-term interest rates raise the possibility that the turn may be upon us sooner rather than later. So at some point in the next few years, unless contained, inflation will return to a higher long-term rate.

From 1939 to 1989, the year of the fall of the Berlin Wall and before the onset of the post-cold war wage-price disinflation, the CPI rose ninefold, or 4.5 percent per year. The 4.5 percent inflation rate, on average, for the half century following the abandonment of the gold standard is not necessarily the norm for the future. Nonetheless, it is probably not a bad first approximation of what we will face.

An inflation rate of 4 to 5 percent is not to be taken lightly—no one will be happy to see his or her saved dollars lose half their purchasing power in fifteen years or so. And while it is true that such a rate has not proved economically destabilizing in the past, an inflation projection in that range assumes a generally benign impact of retirement of the baby boomers, at least through the year 2030. Today’s relative fiscal quiescence masks a pending tsunami. It will hit as a significant proportion of the nation’s highly productive population retires to become recipients of our federal pay-as-you-go health and retirement system, rather than contributors to it. Over time, unless this is addressed, it could add massively to the demand for economic resources and heighten inflationary pressures.

Thus, without a change of policy, a higher rate of inflation can be anticipated in the United States. I know that the Federal Reserve, left alone, has the capacity and perseverance to effectively contain the inflation pressures I foresee. Yet to keep the inflation rate down to a gold standard level of under 1 percent, or even a less draconian 1 to 2 percent range, the Fed, given my scenario, would have to constrain monetary expansion so drastically that it could temporarily drive up interest rates into the double-digit range not seen since the days of Paul Volcker. Whether the Fed will be allowed to apply the hard-earned monetary policy lessons of the past four decades is a critical unknown. But the dysfunctional state of American politics does not give me great confidence in the short run. We could instead see a return of populist, anti-Fed rhetoric, which has lain dormant since 1991.

My fear is that as Washington strives to make good on the implicit promises made in the social contract that characterizes contemporary America, CPI inflation rates by 2030 will be some 4 percent or higher.

The “higher” is meant to reflect whatever inflation premium might arise as a consequence of the inadequate funding for health and retirement benefits for baby boomers. In the end, I see a positive fiscal outcome. But I suspect it is likely that to restore policy sanity we will first have to trudge through economic and political minefields before we act decisively. I am reminded of Churchill’s perception of Americans, who “can always be counted on to do the right thing—after they have exhausted all other possibilities.” The trip through the minefields is a major source of risk for my forecast, and it could be manifested in higher paths for interest rates and inflation.

As awesomely productive as market capitalism has proved to be, its Achilles’ heel is a growing perception that its rewards, increasingly skewed to the skilled, are not distributed justly. Market capitalism on a global scale continues to require ever-greater skills as one new technology builds on another. Given that raw human intelligence is probably no greater today than in ancient Greece, our advancement will depend on additions to the vast heritage of human knowledge accumulated over the generations. A dysfunctional U.S. elementary and secondary education system has failed to prepare our students sufficiently rapidly to prevent a shortage of skilled workers and a surfeit of lesser-skilled ones, expanding the pay gap between the two groups. Unless America’s education system can raise skill levels as quickly as technology requires, skilled workers will continue to earn greater wage increases, leading to ever more disturbing extremes of income concentration. Education reform will take years, and we need to address increasing income inequality now. Increasing taxes on the rich, a seemingly simple remedy, is likely to prove counterproductive to economic growth. But by opening our borders to large numbers of highly skilled immigrant workers, we would both enhance the skill level of the overall workforce and provide a new source of competition for higher-earning employees, thus driving down their wages. The popular acceptance of capitalist practice in the United States will likely rest on these seemingly quite doable reforms.

It is not an accident that human beings persevere and advance in the face of adversity. Adaptation is in our nature, a fact that leads me to be deeply optimistic about our future. Seers from the oracle of Delphi to today’s Wall Street futurists have sought to ride this long-term positive trend that human nature directs. The Enlightenment’s legacy of individual rights and economic freedom has unleashed billions of people to pursue the imperatives of their nature—to work toward better lives for themselves and their families. Progress is not automatic, however; it will demand future adaptations as yet unimaginable. But the frontier of hope that we all innately pursue will never close.

From “The Age of Turbulence” by Alan Greenspan. To be published by The Penguin Press, a division of Penguin Group (USA) Inc. © 2007 by Alan Greenspan.

URL: http://www.msnbc.msn.com/id/20789997/site/newsweek/