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Bonds Are a 'Safe' Investment: A Big Lie Gets Even BiggerYou can't say he didn't try, but Alan Greenspan finally agrees that monetary policy can't be used to safely defuse an asset bubble [subscription required]. In today's Wall Street Journal, Greenspan writes, "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." He compares our recent mortgage meltdown to the Dutch Tulip craze of the 17th century and the South Sea Bubble of the 18th century.
He also admits some of the Fed's actions may have helped to fuel this bubble, such as lowering the federal funds rate to 1% in mid-2003 and keeping it there for a while. He things teaser rate ARMs also contributed, but the biggest blame can be placed on the expectation of ever rising prices, which is, of course, what inflates most asset-price bubbles.
Greenspan said he and his colleagues at the Fed believed the threat of corrosive deflation in 2003 after the Internet bubble burst needed the temporary 1% federal-funds rate to fend off that deflationary crisis, but he added, "I did fret that maintaining rates too low too long was problematic." It wasn't until mid-2004 that the Fed started raising rates again but by then the current asset bubble was already inflating and impossible to stop.
Lots of people took advantage of those low interest rates and drove prices higher and higher as they flipped homes to make even more money. Driving prices higher and higher until they could not be sustained realistically because fewer and fewer people could afford the homes at bubble-inflated prices. Finally the bubble burst when the sources of funds to fuel the bubble dried up as more people defaulted on their homes. As the subprime market imploded banks were stuck with mortgage securities of unknown valuation in off-the-books structured investment vehicles and other mortgage security products.
Greenspan concludes that "central banks appear to have lost control of longer term interest rates" but he does think the central banks "continue to be dominant in the markets for assets with shorter maturities, where money and near monies are created." We saw a bit of that today with the newest of the bailout attempts by the Fed and other central banks, including European Central Bank, Bank of England, Bank of Canada and Swiss National Bank, to add cash to the tight marketplace and hopefully free up enough cash to bailout the banks who are overwhelmed by the mortgage and credit mess.
Will what happened today work? Possibly for a little while, but Greenspan does think we'll only see an end to the current credit crisis "when the overhang of inventories of newly built homes is largely liquidated" and home prices stop falling. If foreclosures continue to mount, as is expected with various types of ARMs resetting through 2010, putting many people caught up in the buying frenzy over the edge, the glut of homes on the market will take a while to clear. Even if people with resetting ARMs want to refinance to lower rates there may be nothing available because by then their mortgage may be underwater in many areas of the country as prices continue to drop.
I wish I had better news, but don't expect to see any easy fix to the mess we're in. Do expect to see continuing price weakness in many areas of the country. Anything that can be done to clear up the glut of homes on the market and start stabilizing real estate will help to ease the pain, but probably won't speed the end of this crisis. If Greenspan is right that this housing bubble is like the Tulip bubble of 1634 to 1637 and the South Seas bubble which started inflating in 1711 and then burst in 1718, we're in for some serious pain. The Dutch Tulip bubble sent Holland into a prolonged depression from which no one was spared, even those not at all involved in the bubble mania.
The South Seas bubble in England was handled differently. Parliament overreacted and passed the Bubble Act, which forbade issuing of stock certificates by companies. For more than a century, until the act was repealed in 1825, there were very few share certificates in the British market.
Will the U.S. and global market responses be any better? Probably not. As Greenspan says monetary policy just can't help. The markets will have to correct themselves.
Lita Epstein has written more than 20 books including the "Complete Idiot's Guide to the Federal Reserve."
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Reader Comments (Page 1 of 1)
12-13-2007 @ 5:53AM
Pat Kenmir said...
Houses over-appreciated by 100 and sometimes 150% in 2 to 3 years. No one can afford these houses at these highend prices. The market will have to depeciate these overpriced homes back to affordable prices. I see deflation as the correcting factor. By the way, I now rent. I wouldn't own a home in todays market. If I did, I would probably see it depreciate by 30 to 50%, but it will take at least 3 to 5 years for this situation to run its course. Is there hope? No, the market must correct itself. Until it does, there will be a lot more of walking away from the current downward housing market.