Blaming Greenspan

Business Times - 09 Aug 2007

Critics rap Greenspan for housing mess

They blame former Fed chief's rate policies for creating a false boom in sub-prime loans

AS the US housing market weakens and interest rates on adjustable mortgage rates rise and more and more borrowers are falling behind, the consensus among economists is that a sector that was once considered vulnerable is now on the verge of suffering a collapse in many regions in the country.

Some analysts warn that the real estate in certain expensive bubble areas could drop by as much as 40 or 50 per cent. Daily newspapers as well as television news shows are covering the widespread defaults on sub-prime mortgages and the sad personal stories involving home foreclosures.

It's still possible that the real estate bubble will not burst completely (in Manhattan you'll be lucky to get a studio apartment for US$500,000), but Americans, led by their lawmakers and pundits, are already looking for someone to blame.

On one level, what is happening in the US real estate market, and by extension, the pressure operating on the entire credit market, are a few more chapters in the boom-and-bust story of capitalism.

Rampant speculation may have caused real estate markets around the United States to overheat and it is quite possible that some dealers had exploited the fuzzy sub-prime lending practices.

But since it's not so easy to blame the complex and hidden forces operating in the free-market for the current mess in the housing market, a lot of the criticism in Congress and the media has been directed at former Federal Reserve chairman Alan Greenspan, and in particular, the low interest rates policies that were practised by the central bank in 2002-2004 for creating the artificial boom in mortgage lending.

Indeed, if and when the housing market bubble bursts and brings down with it hedge funds and major lending institutions, pundits will probably recall an address that Mr Greenspan made before Credit Union executives in 2004. He pointed out then that 'recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade' and contended that 'American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage'.

Some of the recent attacks on Mr Greenspan have been quite harsh. 'Fed intervention in the economy, through the manipulation of interest rates and the creation of money, caused the artificial boom in mortgage lending,' according to Republican Representative Ron Paul from Texas who is also running for the presidential nomination of his party.

Mr Paul, an enthusiastic proponent of the free-market, argues that the Fed under Mr Greenspan had roughly tripled the amount of dollars and credit in circulation since 1990.

'Housing prices have risen dramatically not because of simple supply and demand, but because the Fed literally created demand by making the cost of borrowing money artificially cheap,' Mr Paul told US Congress. 'When credit is cheap, individuals tend to borrow too much and spend recklessly.' Hence, as Mr Paul sees it, the actions of lenders are directly attributable to the policies of the Fed.

He goes on to explain the behaviour of some lenders: 'When credit is cheap, why not loan money more recklessly to individuals who normally would not qualify?' Even with higher default rates, lenders could make huge profits simply through volume.

Sub-prime lending is therefore a symptom of the housing bubble and the cheap credit created by the Fed and not the cause of it.

Another critic, Dean Baker, the co-director of the Center for Economic and Policy Research in Washington, points out that Mr Greenspan was going out of his way 'to insist that there was no housing bubble' in a Congressional testimony the former Fed chairman had given in 2002.

The Fed and 'its pack of sycophantic economists have spent much of this decade patting themselves on the back for keeping inflation under control', Mr Dean suggests, adding that 'while none of us want hyperinflation, the economic costs associated with the inflation rate rising by half a percentage point are dwarfed by the impact of the rise and demise of an US$8 trillion housing bubble, or a US$10 trillion stock bubble'.

And he notes that, in addition to the losses to tens of millions of homeowners, crashing property values and soaring foreclosures will mean plummeting property tax revenues for state and local governments as well as school districts and that the debt unwinding is likely to hit many already under-funded public pension funds, which turned to hedge and private equity funds as a desperate measure to raise returns.

Interestingly enough, one of the more subtle criticisms of Mr Greenspan's policies came from inside the Fed. William Poole, President of the Federal Reserve Bank of St Louis - in a speech before real estate dealers - suggested that both the lenders and the Fed had failed to grasp that the low interest rates could not be maintained and created an environment in which sub-prime borrowers were indeed provided with incentives to take out adjustable rate mortgages.

There is no doubt that low interest rates helped stimulate a housing boom by encouraging individuals to take out loans and purchase homes they otherwise might not have been able to afford, as well as encouraging aggressive borrowing by private equity firms.

With fixed interest rates rising above 6 per cent, people who took out adjustable rate mortgages are now suffering and defaulting.

But that is the nature of the beast; free-market capitalism also provides an opportunity - in the form of those much maligned sub-prime mortgages - for members of the lower middle-class to buy their first home.

Indeed, it's important to remember that the majority of those home buyers have not defaulted on their mortgage loans. As Mr Poole suggested in his speech: 'The bottom line is that more people have access to mortgage credit than ever before.' And he noted that 'despite its limitations and flows, the non-prime market has served a large number of borrowers very well'.