Home > housing bubble > The housing bubble and what Greenspan should have done

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.

See article on original website

  1. January 11, 2012 at 5:37 pm

    Why is that once land is built upon it becomes invisible? See Fred Harrison’s Boom Bust: House Prices, Banking and the Depression of 2010. Michael Hudson can see it too but he rarely suggests the solution.

    I guess my comment will be ignored, like all the rest I post.

    • charlie
      January 11, 2012 at 8:06 pm

      not being ignored. I guess I listen, but am overwhelmed by the vast misinformation and propaganda currently driving Fox and rwtr right wing talk radio). My issue happens to be the unfunded spending on military industrial portion of the GDP. The unfunded wars which we borrowed so much from while cutting taxes for the rich. and the huge price in VA for treating our veterans.

    • merijnknibbe
      January 11, 2012 at 11:28 pm

      Well, you (and Fred) did change my mind…

    • January 12, 2012 at 1:48 pm
  2. charlie
    January 11, 2012 at 8:11 pm

    sorry Carol I meant to say that I had contact with the single tax community near Mobile, AL. Fairhope, AL., Part of that community moved to Monteverde, Costa Rica to distance themselves from US militarism

    • January 12, 2012 at 12:07 pm

      @Charlie, we are not all single-taxers. Some of our number are even (dare I say it?) paid-up members of the Communist Party here in the UK. Why throw out the baby with the bathwater?

  3. Tim Knight
    January 11, 2012 at 8:55 pm

    It seems to me that realistic levels of manipulation of interest rates is far too feeble to moderate a debt-funded asset bubble. If the ‘mark-to-market’ value of an asset is expected to rise at a real rate of (say) 10%/y (i.e. over and above the general rate of inflation), and a speculator can borrow (say) 90% of that ‘mark-to-market’ value at a real rate of interest of (say) 5%/y, then the speculator would expect to make a real return of 50%/y on his net investment. That is, a gross investment of 100 would rise to 110 (i.e. by 10%), the associated borrowing would rise from 90 to 95 (i.e. by 5%), and the speculator’s net 10 would rise to 15 (i.e. by 50%). It’s called ‘leverage’. It’s how financial speculators make so much ‘excess’ profit from asset bubbles. If one wished to eliminate the ‘excess’ profit of leverage through manipulation of real interest rates, one would have to increase real rate of interest to more than the expected real rate of appreciation of the assets in the bubble (i.e. to 10%/y over and above the general rate of inflation). That would kill the productive economy stone dead.

    The answer is not to use interest rates at all for moderation of asset bubbles, but to have the value of assets used to secure debt ‘marked-conservatively-to-damped-market’ (e.g. at 80% of the lowest market-valuation in the previous three years). Thus, in the above example, after three years of real appreciation at 10%/y, the investment would be valued at only 52 (i.e. 100 x 0.8 x 0,9 x 0.9 x 0.9) for security purposes, and the arranger would not be able to off-load such a debt at any more than 52 (instead of the nominal 90). If a bank wished to invest in that debt as the ongoing creditor, and to value that debt asset at 90, that bank would have to allocate 38 of equity to cover the gap between the debt asset of 90 and the security of 52. If a pension administrator wished to invest in that debt as the ongoing creditor, and was prepared to pay more than 52, that pension administrator would have to explain to the trustees why he had ‘lost’ the difference.

    In other words, no financial organisation would be prepared to fund the bubble-value. There would be no ‘excess’ profit in it. Home-buyers would have to find 48% of the ‘mark-to-market’ value from their own resources. Most would be unable to do so, and would back out of the market for a while. Speculators with access to 48% of the ‘mark-to-market’ value from their own resources would also back out of the market, because they would be able to see that there would be no bubble, and therefore no ‘excess’ profit.

  4. Alice
    January 12, 2012 at 11:55 am

    You expect such intervention in the economy of Greenspan? He was in the business of being chief economist “Dr Do Nothing”. Thats what libertarianism does. Thats what Ayn Rand suggested he do. Nothing. The market will work it out and it did (GFC). Greenspan, even if he could see it coming, wasnt going to do anything and he still wouldnt do anything now – that is what is so irksome.

    An economist paid an enomous amount who advocates doing nothing. He didnt even see it coming. Wasnt he busy giving himself a pat on the back along with Bernanke for taming the business cycle (just before)?

    You wouldnt find a better plot in a hollywood blockbuster but its not unusual. Its only embarrassing for the authors of such comments in hindisght. There were plenty of self congraulatory comments by dignitaries documented just before 1929 as well. Collectively re-inforced blindess by those who are paid to know better in the middle of a bubble is a very interesting phenomenon.

    • January 12, 2012 at 4:06 pm

      Libertarianism does not say “do nothing.” The main cause of real estate cycles is massive subsidies to land values, and a libertarian policy would eliminate subsidies along with punitive taxation. Governmental public goods paid for by the non-landed pump up rents and land values, and constitute the greatest of all subsidies, and a massive redistribution of income from workers to landowners.

      • Alice
        January 13, 2012 at 8:36 am


        I have heard what you have to say in a lot of threads but I really have to disagree with your prescriptions. Economic policy actually started travelling down your road with considerably less punitive taxes to the wealthy and no doubt lack of subsidies also. I simply dont see that the outcome of all these attitude that “the government is the problem” which is at the heart of libertarianism, is the answer. Various governments have been a problem – it is true but generally when the state simply gets too big and too dominant. Having said that, I think we have tried (or Greenspan tried libertarian solutions) and whilst it may not be enough for you, it is more than enough to demoninstrate failure to me. I see both excessive state intervention and excessive libertarianism as likely to cause (and with some history of causing) economics problems. Each situation differs – each market differs – each sector differs. I just pray we have some economists who can switch from libertarianism to intervention (and in between) as the case and circumstances require and who arent bound by any textbook or other source of pure ideology.

        That is, we need people (thinkers) who can respond helpfully and pragmatically and practically to real circumstances (real responses for the real world) not just utopian ideological fixes.

    • January 14, 2012 at 9:23 pm

      The US government has always subsidized land values. During the 1800s much land was given to speculators and special interests such as the railroads. Only a small portion of US land went to small homesteads. Indeed a major push for the US Constitution came from land speculators who wanted a strong army to clear out the Indians. The claim that there was no subsidy to land in early American history is just plain incorrect.

  5. paolo leon
    January 12, 2012 at 1:51 pm

    Both Knight and Alice are right. There is a simple explanation of what happened, and what has already happened before the house bubble many times: neither invidiuals nor Governments are capable, after Reagan, to reason in macro economic terms. The macro effects of easing house lending can only be anticipated by Government if its culture is macro. It was not the case with Greenspan nor with Bernanke, who works on interest rates and finds himself trapped.

    • January 12, 2012 at 4:33 pm

      But it was the economists who removed land from their models, which lays at the heart of the bubbles. Easing lending did not cause inflation in manufactured products. Land is different, it cannot be manufactured to meet demand. Land was further used as collateral for loans for consumer goods, which increased production and growth on an unsustainable basis.

  6. BTU
    January 12, 2012 at 5:52 pm

    The post at http://groups.yahoo.com/group/Glocality/message/71 speaks directly and in some depth to this topic. (If the preceding link doesn’t work for you, I believe you can get to the message through http://groups.yahoo.com/ , “Find Yahoo! Group” Glocality.)

  7. merijnknibbe
    January 13, 2012 at 9:33 am

    I guess we should all read Micheal Hudson on what’s happening:


  8. Dave Taylor
    January 14, 2012 at 12:34 am

    Yes, Merijn, and Michael spells out lucidly what most of us have been fearing; but what are we to DO about it? What should the 1930’s Germans have done when Hitler began to show his hand? What could they have done if he had had a nuclear arsenal?

    Surely I shouldn’t be discussing this with you, but trying to talk sense to the directors of it, whose judgement is being warped by economic warfare, sycophants and promotion of pre- and anti-Christian philosophy – from Judean “chosen race” thru Aristotle’s aristocracy thru Renaissance self-promotors to Nietzschean “supermen”. (The “unacceptable” part of the Christian message being that, on our own, none of us is perfect). As individuals, it seems impossible to get to talk to the likes of Greenspan and Bernanske. In light of this, the WEA web conference on Economics and Morality begins to seem very important indeed.

    Carol @ #1. I’m entirely with you on the economic significance of land, but it is not obvious what you think of legislatures permitting absentee foreign and corporate ownership of it – or indeed what you think of “ownership” at all, when this is understood as a right rather than a steward’s responsibility. My take is that some economic entities shouldn’t be legally saleable, i.e. people, their work and their land, but also their money and their debt, for which we, as family members and participants in communities and enterprises, should be on the one hand personally responsible and on the other forgiving of “water under the bridge”. This evidently goes beyond the need for a renewal of economic morality to the need for a new economic paradigm based on giving credit rather than enforcing debt.

    • Dave Taylor
      January 14, 2012 at 12:44 am

      @ Carol. Another slant at line 4 above: “respecting” a steward’s responsibility?

    • January 14, 2012 at 8:53 pm

      “Judean “chosen race?” Jews don’t are not a race. Is this forum going to degenerate into religious defamation?

    • January 16, 2012 at 9:45 am

      The solution – as has been known since Henry George’s time, if not before – and is well known to such economist as Michael Hudson and Fred Foldvary (though they differ on many other issues), is a high or even 100% Land Value Tax, while UNtaxing almost everything else – wages, sales, and fixed capital like actual buildings.
      The land, unlike the buildings, is not creatable like, say buildings or factories, it is fixed in quantity, and given value by demand (i.e. location in populated areas that are doing well). Return the rent to public hands instead of private ones via a tax (which can be easily calculated based on comparable sales figures or well-controlled assessments) and you will have “enough (revenue) and to spare” as George first said in the late 19th century, including his opus and best-selling economics book, “Progress and Poverty” (1879). George didn’t have the tools to calculate the portion of the economy that goes to rent, but today, economists like Mason Gaffney and others have figured out it is at least one third of GDP and maybe as high as 1/2, when every location/resource is factored in. This is all one needs to run a reasonably sized government and untaxing labor would encourage labor and job-creation, whereas privatizing and financializing the Commons only encourages speculation, hoarding, and the run-up of asset prices and further land-based crashes as liquidity sloshes in and out of the system.
      The bank withdrawal of credit is only the surface cause. The underlying cause is the REASON for credit withdrawal, which is a crash in Land prices (and the reasons for not having a debt-based money system are worthy of another discussion, and also well-known to George, who was an original Greenbacker, living when debt-free U.S. Notes were THE major portion of the money supply, albeit briefly).

      • January 16, 2012 at 12:07 pm

        Although LVT uniquely meets all the criteria for a good tax, what georgists ignore is that taxation has other purposes apart from revenue raising, e.g. repricing of goods and services in pursuit of social objectives ; redistribution of income and wealth. And just asserting that LVT would achieve the latter does them no favours.

        We need a debate.

  9. Dave Taylor
    January 16, 2012 at 7:03 am

    Dear Fred, I’m sorry if I’ve disturbed your sensibilities, but in the context of Hitler’s infamy my comments were hardly either racially or religiously defamatory – quite the contrary.

    Come on, folks. Don’t let this defender of the “1%” poison the discussion. I referred – perhaps too summarily – to philosophies of rulers (religious or not) down the ages, and there is not much between them. Long before Christ’s time the people of Israel had been enslaved by their lawyers and financiers in much the same way as we are being now. Whether or not Christ was God he is on record as offering the “99%” (of his own and every race) concepts of leadership and economics which were relevant then and so are relevant now. Their forgiveness of debt and making up for each others’ deficiencies are conceptually the inverse of even the virtue-seeking Christianised Aristotelianism swept aside by the scorched earth policy of the “1%” within a few years of Machiavelli’s advice to princes. Their being potent enough for the”1%” to want to suppress them suggests they are potent enough to be worthy of discussion.

    So I did myself read and appreciate the excellence of Michael Hudson’s statement of the problem. As I’ve just suggested, the Christian solution, like the Copernican, Newtonian and many other examples of scientific breakthrough, involves an inversion of preconceived ideas. It is like printing a photographic negative: a mystifying pattern suddenly becomes an intelligible picture; however, others have to see the print for themselves before you can discuss its details in a blog. The new paradigm in this analogy is not the picture but the printing process, the effects of which we can learn to understand by contrasting the before and after of details, as when one can become able to see the imperfections of supposedly perfect rulers who can be barely identified on the negative. I’m far from perfect myself, so it is best I point you to primary sources. Scan the Gospels for their economic stories and language, the Acts of the Apostles for accounts of their primitive practice, I Cor 12 for a model of social interconnectedness which over two thousand years has improved with our growing understanding of the human body, e.g. of the circulation and functions of the blood which (unlike money today) freely supplies our interdependent cells, from shared resources, with what they need to stay able to perform their local functions.

    Ah well: I live in hope rather than expectation. As my mother used to say, “You can lead a horse to water but you can’t make it drink”.

    • Alice
      January 16, 2012 at 8:22 am

      I agree Dave – the actual poisoning is coming from Fred with his base attempts to caste your comments as a smear against a race. A low tactic – I agree given the broader context of what you actually wrote at post 17.
      Yes that post was relevant to the discussion – for it is the elite 1% who are kicking and screaming against an orderly reduction (haircut – call it what you like) by the holders of greek debt.
      Well they can have it orderly if they want it or disorderly because Greece cant pay. Its that simple and there is no further ability to pay even with further austerity (it will just be a worse default). Its quite clear that the wishes of a minority; the hedge funds with their fancy risk shuffling tactics, are blocking major banks from accepting the orderly version. The disorderly version on the other hand will lead to debt blow outs in other countries as yet unknown. But such is the lack of regulation over the nature of financial activities currently – that these guys are prepared to cannibalise whole nations first and their rivals second.

      So be it. They wont stop at bankrupting firms, governments and nations – they will bet, using complex algoriths, against their rivals soon enough and well… let the rich eat each other (could be a good idea).

      Well thats what we got when we all voted for deregulation and market magic and minimum intervention (courtesy I have to say of mainly conservative parties – but also of left leaning parties who also put just too much faith in the whole idea that small government was best.
      Too small government gets corrupted so easily as we have seen… and stripped of its power too easily…. but too large government oppresses all.
      I know sitting somewhere on the fence gets boring for the utopia seeking amongst us (including Fred) but there has been many a disaster directly inflicted on people by the seekers of utopia when it comes to economic policy. (yes that includes all those groups that Dave mentioned in post 17).

      • Dave Taylor
        January 16, 2012 at 10:13 pm

        Thanks, Alice. As I see it, though, the choice is not just between too small government and too large government. The options include multi-layered government and/or functionally sub-divided government (something like isolated ministries subject to direct review by concerned parties, as when in the old guilds the manufacturers set fair prices to eliminate both undercutting of rivals and monopoly rent).

    • January 17, 2012 at 12:11 am

      The persecution of Jews by Christians and Muslims was historically based on religion. In contrast, the Nazis categorized Jews as a race, to be exterminated no matter what an individual’s religious belief or practice. Jews refer to the “chosen people,” not the “chosen race,” and it is usually opponents of Judaism who invoke the label “chosen,” maliciously. Any labeling of Jews as a “race” is inherently defamatory, invoking the Nazi definition, although this may well have been inadvertent here. Hatred of Jews is so ingrained in Western culture that many people invoke anti-Semitic terminology without evil intentions. This warrants pointing it out when it occurs.

      • Dave Taylor
        January 17, 2012 at 3:55 am

        Okay, Fred, but we’re talking history and different constituencies here. What I was taught as a Christian was “Love the sinner, hate the sin”, and even allowing that for historical reasons (Christians allowing Jews to lead their own lives in co-existence) banking and finance have been dominated by Jews, our objection is to the misuse of finance, not the financiers, and the the desire I expessed was to talk to them, not to exterminate them. In any case, your etymology seems to be wrong: “race (2): “people of common descent,” c.1500, from M.Fr. razza “race, breed, lineage,” possibly from It. razza, of unknown origin (cf. Sp., Port. raza)”.

      • Alice
        January 17, 2012 at 11:33 am

        Any self labelling of a race as a “chosen peoples” seems to me to be a fundamenatlly racist view anyway ie viewing their own kind as “insiders” whilst all else are outsiders. That is frequently a problem of religious groups no matter what religion they are.

  10. Dave Taylor
    January 17, 2012 at 5:28 am

    Scott @ #20, Carol @ #21, Fred @ #9, #11.

    Yes, Carol, we NEED a debate about the pros and cons of Land Tax. May I chip in with a couple of thoughts?

    In Britain we do have a land tax, but it is for local rather than national government. (That is perhaps relevant, Scott, to the American sitution at the time of Henry George). The problem with it being a monetary tax is that those who own valuable land don’t necessarily have any (or enough) money with which to pay it. (Bureaucratic enforcement has in Britain bankrupted businesses, led to mortgage foreclosures and sent pensioners to prison). If the tax is only taken when property is sold or actually produces its rated monetary value, then it will not necessarily provide government with a reliable income stream.

    The other thought concerns the endowment of land and shares for communal and charitable purposes. It seems to me this is a sort of right of private taxation for functions that might in a different culture be the responsibility of government. The problem with leaving it to government is lack of what is called in cybernetics “requisite variety”: if the government fails so do all the charies too. That seems to me a major objection to financing central and even local government by means of tax, while entirely accepting the other uses of tax pointed out by Carol.

    How else to finance government? Fred quite rightly says “The US government has always subsidized land values. During the 1800s much land was given to speculators and special interests such as the railroads”. So the US government subsidised money-making by giving away land which wasn’t actually theirs to give. much as Henry VIII did in the UK. Let’s try reversing that, producing something like Lincoln’s Greenbacks. His government made and gave away money, thereby subsidising its own work and that of developing the land. In other words, authorised credit can subsidise (underwrite) the work of producing next years’ harvest by enabling workers to share what we have left from previous harvests.

    • January 17, 2012 at 1:52 pm

      The only land taxes we have in Britain are Section 106 agreements and the Community Infrastucture Levy which apply to developers. We have property taxes: stamp duty land tax on transactions (which greatly hobble the market), National Non-Domestic Rates (i.e. business rates, an ad valorem tax payable by occupiers) and Council Tax which bears little relationship to value and is also paid by occupiers, not owners. This is the most odious of all British taxes and results in a single occupant of the most valuable apartment in the world being liable to a tax of £1200 pa – considerably less than that paid by the average family.

      • Dave Taylor
        January 18, 2012 at 5:12 am

        I had been thinking of Council Tax and Business Rates, the one loosely based on property value and the other on rental value, both of which are influenced by location, which is the point, I thought, of land tax. I say ‘loosely’ because, having followed up what you say (and very interesting that was too), it is lumping the land tax in with building value and payment for council services. I agree about the distorting effect of the top end cap on Council Tax, which is only USUALLY required to be paid by occupiers (who are the users of council services). The Business Rate adds insult proportionate to the injury of inflated rents for struggling businesses. The whole “odious” system is in any case designed for simplicity of administration, not fairness.

  11. Dave Taylor
    January 17, 2012 at 1:03 pm

    Going back to what Dean Baker says Greenspan could have done, i.e. recognise the housing bubble and use his authority to publicise and regulate it by attacking fraud and raising costs, he would not be much of an economist if he didn’t recognise the bubble.

    As I recall, the problem he had was a conflict of interests. At the time he was limiting damage due to collapse of stock exchange bubbles by making it easier to convert their energy into real estate. In Britain at least, housing has gone back from becoming largely occupier/local government owned to having no well-maintained, affordable government housing and a large proportion of money-making property portfolios increasingly financed by welfare payments.

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