The housing bubble and what Greenspan should have done
from Dean Baker
In Washington policy circles, money and influence can be used to make even the most simple and obvious things complicated and confusing. This is certainly the case with the housing bubble and its aftermath. Four years into the housing bubble downturn, much of the country remains hopelessly confused about what happened, why it happened and who is to blame.
First, what happened is very straightforward. We had a huge run-up in house prices that had no basis in the fundamentals of the housing market. After 100 years in which nationwide house prices just kept even with the overall rate of inflation, house prices began to sharply outpace inflation beginning in the late 90s. By 2002, when some of us first noticed the bubble, house prices had already risen by more than 30 percentage points in excess of inflation. By the peak of the bubble in 2006, the increase in house prices was more than 70 percentage points above the rate of inflation.
This was a huge problem because this bubble was driving the economy. It drove it directly by creating a boom in residential housing construction. We were building housing at a near-record pace in the years 2002-2006. This was in spite of the fact that we had an aging population and record levels of vacancies at the start of the period.
The other way in which the bubble was driving the economy was through its effect on consumption. The bubble created more than $8 trillion in ephemeral wealth in housing. Homeowners thought this wealth was real and spent accordingly. The result was a massive consumption boom that sent the saving rate down to zero in the years from 2004-2006.
When the bubble burst, the building boom went bust. Construction fell to its lowest levels since the 50s as the country waits to gradually work off a glut of housing. Consumption fell back to more normal levels as people came to grips with the fact that they had lost tens of thousands or even hundreds of thousands of dollars of equity in their home.
The combined impact of the plunge in construction and consumption spending together with the collapse of a bubble in non-residential real estate is to lower annual demand in the economy by more than $1.2 trillion. This is the reason for the prolonged downturn. There is nothing in the economists’ bag of tricks that will allow the economy to quickly and easily replace $1.2 trillion in lost demand. That is the reason we are still 10 million jobs below full employment four years after the onset of the recession.
The “why” in this story is simple: Businesses were making money. Many people acted poorly in this story — almost everywhere the motivation was money and profit. Countrywide and Merrill Lynch were issuing and packaging fraudulent mortgages because they were making tons of money on them, not because they wanted to make moderate-income people and minorities homeowners.
Fannie Mae and Freddie Mac deserve plenty of blame in this story. Housing is all they do. They should have seen the bubble and tried to stop it. Instead they jumped on the bandwagon. But they were followers, not leaders. The worst loans were securitized by the Wall Street boys. Fannie and Freddie got into junk mortgages late in the game and they did so to regain market share as a profit-making business, not out of a concern to extend homeownership.
The government agency devoted to extending homeownership to moderate-income people, the Federal Housing Authority, became almost irrelevant. Its market share shrank to less than 2.0 percent at the peak of the bubble (compared with around 10 percent in more normal times), as it lending standards were far stricter than those of the subprime mortgage pushers.
Finally, some quick points on what could have been done. First, the Fed has responsibility for maintaining the stability of the U.S. economy. Alan Greenspan should have recognized the bubble and done everything in his power to burst it before it grew to such dangerous levels.
Step one in this process should have been to document its existence and show the harm that its collapse would bring. This means using the Fed’s huge staff of economists to gather the overwhelming evidence of a bubble and to shoot down anyone who tried to argue otherwise. Greenspan should have used his Congressional testimony and other public appearances to call attention to the bubble.
This would have put the bubble clearly on everyone’s radar screen. And, the reality was that there were no serious counterarguments. It is difficult to believe that this action by itself would not have slowed the home buying frenzy and curbed the issuance of junk loans, or at least their repurchase for securitization.
Second, the Fed has enormous regulatory power beginning with setting guidelines for issuing mortgages. They first issued draft guidelines in December of 2007. It was not hard to find abusive and outright fraudulent practices in the mortgage industry, if anyone in a position of authority was looking for it.
Finally, the Fed could have used interest rate increases as a mechanism to rein in the bubble. This should have been a last resort, since higher rates would have slowed the economy at a time when it was still recovering from the collapse of the stock market bubble.
To maximize the impact of any rate increases, Greenspan could have announced that he was targeting the housing market. He could have said that he would continue to raise rates until house prices were brought back to a more normal level.
This surely would have gotten the attention of the mortgage industry and potential homebuyers. Would it have been an extraordinary action from a Fed chair? Sure, but so what. It might have prevented the economic devastation that is ruining tens of millions of lives. If this required Alan Greenspan to deviate from the standard script for Fed chairs, that would have been a very small price.