In this blog post at Pacific Research Institute, I criticize former Treasury Secretary Snow, who in a recent WSJ piece put the blame for the housing bubble on foreign savers. Naturally, I point the finger instead at Greenspan’s Fed. I think this episode is really getting other economists and investors to consider the Austrian business cycle theory.It’s really so obvious that it’s hard for anyone to deny that ABCT at least plays a part in what happened. Consider it this way: We’re trying to understand why there was a stampede of investment in a durable asset (housing) in the early and mid-2000s, and then all of a sudden things blew up.
Well gee, the Fed slashed interest rates to unprecedented lows during the boom, and then steadily jacked them back up right when the market tanked. Could the two be connected?
And even though this is old hat for veteran Austrians, the St. Louis Fed’s graph of interest rates (knowing the timing of the housing boom-and-bust) is powerful:
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Would it be possible to post a longer term chart of these events rather than this one time correlation?
Thank you! I’ve been saying this for years! Keep it simple, stupid. It’s extremely clear if you just go through the decision making process of any normal human being, which is relatively simple.
When interest rates are low, you can afford more house. If they go up, you can’t afford that much house anymore.
People didn’t plan for interest rates to go back up, and if they did plan, they dismissed it because of the rising home prices, and increased equity they would undoubtedly have in their home. What they didn’t realize is that they were part of the group causing prices to go up so much, and that their group was only so large because of historically low interest rates.
Yes, it is the people’s fault for not understanding their own means and planning for the future. But the Fed shares some blame because they seem to have perpetual amnesia about the fact that a people will usually spend up to and/or beyond their means in a society that encourages consumption more than anything else. Doubly true when the Fed is using interest rates for that very reason, to encouragement consumption.
I though the bubble burst because rampant fraud in loan applications came to light and lending practices were tightened up. This reduced the amount people could borrow causing a decrease in home prices and sales. Condo flippers trying to sell in to a down market just made the housing market even worse. People who had kept refinancing their homes while prices were going up and spending their appreciated equity now couldn’t refinance to keep up with mortgage payments. Then the secondary markets wouldn’t trust any of the rating agencies to rate other types of loans and therfore no one was willing to invest in any other type of repackaged loans let alone mortgages.
Is all this foolisness the fault of Alan Greenspan?
Who deserves blame, the fraudlient loan brokers and applicants, condo flippers, reckless borrowers, or Alan Greenspan who lowered interest rates to keep the economy going after the corporate accounting scandals, terrorist attacks, and fear of foreign wars hit the economy right in the middle of a recssion and stock market correction?
Isn’t it more likely that a burst bubble is the inevitable result of irrational exuberance?
Doesn’t the fact that inflation was managed properly indicate Fed policy was correct?
I agree that ABCT explains it but lets look at some other factors.
Low interest rates by the fed and foreign exports to the US (imports by the US) caused the yield for savers to be extraordinarily low – 1% short term and 3-4% mid and long term. So low risk tolerance savers looked for bonds that would pay higher than US Bonds.
Enter cheap computing expense and a couple of MBA financiers/marketers and you have the expansion of securitization which grew exponentially in the past 10 years.
These new products were bought with a vengeance since who in their right mind wants to tie up money for 5 years making 3.25%? As long as there were buyers of these securitized bonds banks underwriting loans would make more and more loans, no skin off their back. Ergo housing went up with easy loan money.
I wouldn’t simply state that lower interest rates cause higher housing prices. There needs to be other factors as well. If (more like when) the fed lowers rates to 3.0% in the next 12 months I am not expecting housing prices to suddenly rise. The reason being similar. I expect the dollar to be weak (as a result of the 1.0% rates era among other things) imports to the US to fall resulting in fewer foreign US bond purchases (demand) resulting in longer term bonds rates to rise. This will affect home purchases in a negative way.
In the same vein, G.Becker writes “Perhaps the Fed did keep the federal funds rate too low for a couple of years preceding the onset of the crisis, but low interest rates were found worldwide. The main reason for the low rates was not the Fed, but the high savings rates in China and other rapidly developing nations that put pressure on interest rates all over the world.”
When Congress changed the tax treatment for the sale of a personal residence in 1997 the demand for credit exploded since the gain was excluded up to $500,000. One could buy and sell every 2 years tax free. Accomodating this new demand for credit fueled the eventual disaster.
adkjwfh: “Who deserves blame, the fraudlient loan brokers and applicants, condo flippers, reckless borrowers, or Alan Greenspan…”
I think the point of Austrians is that mortgage companies would not have made the mistakes of loaning to fraudulent applicants, flippers and reckless people had interest rates not been so low. The ABCT, emphasizes that at any point in time, all the investments that are perceived to be good investments at the current interest rate are taken. Lowering the interest rate makes some investments appear profitable that were too risky at the higher rate.
adkjwfh: “Doesn’t the fact that inflation was managed properly indicate Fed policy was correct?”
I assume you mean price inflation as measured by the federal indexes. The problem with those indexes is that they don’t measure the whole effect of monetary inflation. Monetary inflation has often appeared in the sudden rise in the stock market or other assets, like housing, which those indexes don’t measure. Besides, as the ABCT points out, price inflation isn’t the only problem with monetary inflation. The main problem with monetary inflation is the disruption of the structure of production which leads to massive losses of wealth in the capital intensive industries.
ed: “Low interest rates by the fed and foreign exports to the US (imports by the US) caused the yield for savers to be extraordinarily low…”
That’s true, but where did Americans get the dollars to buy imports? A lot of them came from the Fed’s inflation of the money supply.
ed: “These new products were bought with a vengeance since who in their right mind wants to tie up money for 5 years making 3.25%?”
Again, where did the money come from to buy the new instruments? Much of it came from the Fed.
ed: “If (more like when) the fed lowers rates to 3.0% in the next 12 months I am not expecting housing prices to suddenly rise.”
That’s why Austrians don’t take the quantity theory of money too literally. The ABCT points out that monetary inflation causes massive malinvestment in the real economy. When that malinvestment becomes apparent, no amount of monetary inflation will cause it to disappear. It takes years to liquidate and the Fed can do nothing about it. Monetary inflation, through lower interest rates, only sets the stage for the next false boom that will take place when the malinvestments of the past have been liquidated. Also, the housing market won’t recover as a result of lower interest rates because it’s clear to investors that housing is a bad investment now. But if the Fed continues to lower interest rates and pump money into the economy, that money will go somewhere and it will probably head for another asset class, maybe bonds, stocks or commodities, causing an artificial boom in those markets.
Stephanie quoting G Becker: “The main reason for the low rates was not the Fed, but the high savings rates in China and other rapidly developing nations that put pressure on interest rates all over the world.”
It’s true that Asians have a high rate of savings. But how do their savings get to the US? They purchase US stocks and bonds. How do they get the dollars to buy US stocks and bonds? After all, the Chinese don’t save in dollars, but in the Chinese yuan, or remnimbi. They sell us their goods. How do Americans get the dollars to buy Asian goods? Mostly through work, but a good portion comes from the Fed artificially lowering interest rates. So the Fed plays some role in making Chinese savings available to Americans through imports.
Why do Austrians blame the Fed for the housing bubble? Because it was a bubble, which means it was a false boom; the wealth from rising house prices was illusory. Who has the power to create such illusory wealth? The Fed. Had the rise in home values came about through real savings and not the creation of money from thin air, the boom would have lasted.
Just to add to what fundamentalist said above:
“I though the bubble burst because rampant fraud in loan applications came to light and lending practices were tightened up. This reduced the amount people could borrow causing a decrease in home prices and sales. Condo flippers trying to sell in to a down market just made the housing market even worse. People who had kept refinancing their homes while prices were going up and spending their appreciated equity now couldn’t refinance to keep up with mortgage payments. Then the secondary markets wouldn’t trust any of the rating agencies to rate other types of loans and therfore no one was willing to invest in any other type of repackaged loans let alone mortgages.
Is all this foolisness the fault of Alan Greenspan?”
All of these things can be traced back to loose fiat currency. The Fed provided cheap money to the market through open market bond purchases aimed at lowering the fed funds rate to 1%. The goal was to stimulate productive business activity in the private sector and stimulate consumer demand and employment growth. The problem is that when cheap liquidity is pumped into the economy it doesn’t find it’s way to the most NEEDY area (as defined by the politicians, fed officials and voters) it always finds it’s way to the highest PROFIT area.
The productive economy, and business investment in particular didn’t need or want that liquidity. The stock market had just burst so there was no demand to bid up stock prices – especially with the government on a corporate governance witch hunt (ending in Sarbanes-Oxley). Private businesses had over-bought capital equipment (there are still thousands of miles of un-used fiber optic cable in the ground), had over-staffed (bidding unemplyment down to 3.9%), and in general had expanded their productive capacities way beyond the amount of business they could forecast in the near future. This is referred to as “mal-investment”.
All of this was fueled by the last round of monetary over-expansion that lead to the stock market bubble and it’s eventual crash when people figured out that the prices on worthless stocks for companies with no revenues or hope of profits were way too high. So businesses weren’t hiring people or buying capital equipment no matter how cheap money was.
That liquidity went seeking the highest returns. Most recessions result in a liquidation of the mal-investments, which takes time. The excess liquidity diappears by people paying off their loans or defaulting, and the banks not being able to loan all that money back out. But the Fed and the banking system didn’t want the liquidity to dry up (more on this in a minute). In order to hault that process it had to force interest rates so low that it would change the investment decisions of businesses and consumers.
What is the investment decision most affected by interest rates? Housing. As anybody who has a mortgage understands a 30 year mortgage is almost all interest (i.e., pure profit for the banks) until way into the out years. Interest rates, not the inherent value of the property, are the single biggest drivers of house prices. The way the banks keep mortgages in the all-interest phase, and thus keep their profitable interest income up, is by allowing mortgage holders to take money out and pay interest on it again. As long as the liquidity party keeps going this is a win-win for everybody: the banks make money, consumers have more to spend, and at the low interest rates you’d be crazy to let all that equity sit un-used in your house. The smart people used that cheap money to invest in things that returned more money than they paid in interest, like real estate. The dumber ones spent it on big screen tv’s and vacations.
At the end of this frenzy the banks run out of people to lend to who pay their debts, but they still have all this cheap money available that isn’t making them any money. So they go looking for people who they wouldn’t have lent to in times of tighter money, but when there’s nobody with a good credit record to lend to they had to find deadbeats. Why would they do that? Because the Fed and the government (i.e., the taxpayer) ALWAYS bail out the banks when they make bad loans – it’s the sole reason why the Fed was created in the first place.
A side note on how the banking system works: The banks make money primarily by the credit spread – the difference between the rate at which they acquire funds from the Fed and the amount of interest they can charge tehir customers. The Fed member banks are the only ones who get this priviledge. In return the Fed “regulates” the amount of reserves they have to keep for normal depositor withdrawals. This sounds like a restriction but it is actually just the opposite: It limits competition between banks. There is no reason whatsoever (with FDIC insurance, the Fed and the government backing up the banking system with taxpayer funds) for any bank to loan out less than the reserve requirement. SO every dollar pushed into the system by the Fed is garaunteed to end up in an interest producing loan, regardless of how low they have to go into the poor credit risk pool.
But why would banks risk lending money that won’t be paid back? Because NO bank wants to be paid back their principal, charging interest on it is their primary way to make money AND the reserves they are required to keep at the Fed are eaten away by inflation if they don’t. Leaving a single dollar un-lent that they are not required to is a losing proposition. And if the loans go bad, so what? It didn’t cost the bank anything to create the money for the loan in the first place so losing a small percentage is OK, they still come out ahead.
The problem comes when too many of their loans go bad because bad loans come straight off their bottom line (as long as a loan isn’t in default it’s just an asset and a liability on their balance sheet, when it goes bad they have to write it off and take a profit hit. That’s why they’ll never call in your credit card balance even if you fail to pay for a while – they’ll just have a collection agency call bother you, but the goal is not get you to pay off your balance, just start paying interest again). But, because all banks have the same motivation to lend all the way up to the reserve limit, they can be assured that their competitors have made the same amount of bad loans. If they have all been equally reckless won’t that take the whole banking system down? YES! So now the Fed and the government will HAVE TO find a way to use taxpayer money to keep the banking system from collapsing (i.e., get the banks money to make up for their losses on bad loans). This is why the Federal Reserve system was set up in the first place. It’s not really even a secret – the Fed is there to protect the banking system from collapse.
Have you seen any of this play out recently?
This is all perfectly rational behavior in an asymmetric system where the banks get to keep all of the profit they make from loaning money but are insulated from loss when they make bad loans. Who pays for it all? the taxpayer/citizen – both in taxes and drop in purchasing power.
Suppliers of credit (Banks mostly) found a stream of cheap money coming in from the Federal Reserve. So to keep profitable for their owners (stock holders mostly) they lent money to everybody and anybody. This is rational looking at the process:
1. Bank buys money from FED at 1%.
2. Bank loans money to high risk borrower on 5 year balloon mortgage going from 3.5 to 7.5% with a healthy fee for its trouble.
3. Bank sells mortgage to Freddie or Fannie and dumps the whole mess on tax payers.
The best part is that this is COMPLETELY LEGAL and there is no fraud involved.
If you take out steps 1 and/or 3 then the rational bank can no longer make the loan and stick the tax payers with the default.
Whose fault is it? 1. Fed, 3. Congress. Maybe we should get rid of both?
A reply for: DS and Fundamentalist Your comments are welcomed contributions to efforts which clarify the real function of the Fed in this economy, or for that matter of central banks around the world.
Below is a letter to me from Senator Leahy thanking me for my support of the legislation signed by the President which authorizes investigaton of the financial meltdown.
My implied skepticism in my response to Sen. Leahy, is based on much of what you both imply concerning the Fed’s power over this nation’s political and economic decision making processes. Any Congressional investigation is likely to take the deminimus path by looking only at accounting and implimentation procedures rather than fundamental authorities of the Fed Act of 1913.
What needs to be debated are the advantages and disadvantages of a Fed operating a fractional reserve banking system and the Treasury managing a system that issues debt free currency.
All of the bubbles of the past 97 years would have to be examined in the context of these two alternative systems. Intuitively, we can agree that a debt free currency would have massive advantages for the public weal compared to the status quo.
Nonetheless, there should be a debate to educate the 98% of Americans who know too little about how money and crushing debt are created and the effects on their lives and those of all of their progeny for the next several centuries.
Dear Senator Leahy,
Congratulations on passage of the “Fraud Bill.” I, like millions of Americans, need to see those responsible for our current economic distress punished to the fullest extent of the law. It is my fondest hope that this legislation will finally have the authority to investigate the policies and actions of private banks like the Federal Reserve.
I assume that is what will happen given the fourth objective of this legislation;
• Establishing a Financial Crisis Inquiry Commission to investigate the root causes of the economic and financial crisis.
As you well know, the Fed has, since 1913, usurped the sovereignty of this nation by controlling the issuance of currency and therefore, control of inflation and deflation, debt and interest rates.
According to Milton Friedman, the Fed has been the source of all economic decline in America since it refused to provide sufficient liquidity to avoid the devastation of the Depression.
It has used the fractional reserve policy to enrich the private owners of the Fed while making debt slaves of 98% of American’s and jeopardizing the very foundation of our society by its ruinous lending policies that force the government to borrow in order to payoff its principal plus interest debt to the Fed. There is no end to that scenario.
“The real truth is…that a financial element in the large centers has owned the Government ever since the days of Andrew Jackson.” President Franklin D. Roosevelt, 1933
“The sack of the United States by the Fed is the greatest crime in history. Every effort has been made by the Fed to conceal its powers, but the truth is the Fed has usurped the government.” Charles McFadden, Chairman, House Banking Currency Committee, 1932
You and others in the Congress and indeed
the President have an obligation to protect this nation and uphold the Constitution. It is incumbent upon our leaders to unravel the deception and the clear and present danger to this society posed by the Fed and its policies of ensuring perpetual debt and sending this nation into a financial abyss.
You and others in Congress know that we could, as a nation, finance all of our public needs by having the Treasury issue debt free currency similar to that of “Colonial Script” or President Lincoln’s “Greenbacks.”
Senator, what happens when the government can’t pay the interest on the debt?
According to David Walker former Director of the U.S. GAO, “…just the interest will be more than taxpayers can afford to pay. When the government can’t pay interest, it will have to renege on the debt, and the economy will collapse.”
Please Senator Leahy, tell the American people about the ultimate fraud perpetrated by the Fed and sanctioned by time and convenience so much so that the Fed has become a wolf in sheep’s clothing and we the people have become debt slaves in the nation of our forefathers who fought for our sovereignty.
Please have someone on your staff let me know how you plan to deal with the issue of initiating efforts to repeal the Fed’s authority to issue debt currency, and restore to the Congress that authority so that we can move to a debt free currency.
Thank you,
+++++++++++++++++++++++++++++++++++
Dear Robert,
It’s time to crack down on the financial fraudsters who have wreaked havoc on our economy and America’s hard-working families — and now we have the tools to do it.
Yesterday I joined President Obama at the White House as he signed the Fraud Enforcement and Recovery Act into law, a bill I wrote to provide federal law enforcers with the resources they need to go after white-collar criminals.
Thanks to the support of more than 20,000 people who emailed their Senators and Representatives through the LeahyForVermont.com website, Congress passed a strong, bipartisan bill to tackle the scourge of fraud and recover taxpayer money lost due to illegal financial dealings.
The Fraud Enforcement and Recovery Act will protect Americans by:
• Increasing resources for federal investigators and prosecutors to go after cases of financial fraud,
• Modernizing fraud and money laundering statutes to deal with the growing wave of fraud,
• Strengthening the False Claims Act to better equip the Justice Department to recover the proceeds of fraud, and
• Establishing a Financial Crisis Inquiry Commission to investigate the root causes of the economic and financial crisis.
Now that President Obama has signed this important bill into law, the LeahyForVermont.com community can chalk up yet another legislative victory for the American people.
Thank you for all that you have done to put the Fraud Enforcement and Recovery Act on the President’s desk — and on the books.
Sincerely,
Patrick Leahy
U.S. Senator
Robert Bostick,
“You and others in Congress know that we could, as a nation, finance all of our public needs by having the Treasury issue debt free currency similar to that of ‘ Colonial Script’ or President Lincoln’s ‘Greenbacks.’”
I looked, I looked and I looked again. I can’t find the Article or Section of the U.S. Constitution that grants Congress the power to print any kind of money. Maybe I am blind?
Ed Waggoner Sr.
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