Greenspan and His Critics Misread Housing
The public profile of former Federal Reserve chairman Alan Greenspan has risen substantially in recent weeks. Formerly content to remain mostly behind the scenes while globetrotting to all manner of highly paid speaking engagements, Ben Bernanke’s predecessor has materialized quite a bit of late. He has appeared in both television and print to defend a central-banking legacy that is increasingly being called into question.
The controversy surrounding Greenspan involves the alleged real estate “bubble,” and the view of many that his policies early in this decade were the cause. What’s increasingly apparent is that both Greenspan and his critics have misread what drove the nominal gains in home prices in recent years.
Greenspan’s critics conclude to varying degrees that his decision to reduce the Fed funds target to 1 percent, in 2003, where it remained for a year, was the cause of the property boom and that the reversal of this policy was the cause of subsequent house price declines.
For his critics to be correct there would presumably have to exist historical evidence showing that low nominal rates of interest have correlated with vibrant housing markets. Very little evidence supporting such a claim can be found.
Take, for example, the aftermath of President Nixon’s decision to sever the dollar’s link to gold, when the cash rate targeted by the Fed began to rise. Sitting at 5.5 percent in August of 1971, it reached a high of 10 percent by the end of 1973. Despite this substantial increase in the rate target, according to economic historian Allen Matusow’s book Nixon’s Economy, “Housing emerged as the most dynamic sector” in the early 70s.
Moving to Jimmy Carter’s presidency, from a low of 5 percent in 1976, the Fed funds rate rose all the way to 13 percent by the end of the decade. Housing hardly faltered, and as William Greider noted in Secrets of the Temple, the economy of the Carter years “improved the financial status of large classes of ordinary Americans,” and “particularly benefited the broad middle class of families that owned their homes.”
George Gilder arguably chronicled the late 70s housing market best in his 1981 book, Wealth and Poverty. Describing the property boom that occurred amidst skyrocketing interest rates, Gilder wrote, “What happened was that citizens speculated on their homes…Not only did their houses tend to rise in value about 20 percent faster than the price index, but with their small equity exposure they could gain higher percentage returns than all but the most phenomenally lucky shareholders.” Shades of this decade?
To show how this seemingly contrarian rate phenomenon is not unique to the U.S., we can look to Great Britain in the 70s. Although the Bank of England moved the bank rate from 5 to 9 percent in 1972, David Smith noted in The Rise and Fall of Monetarism that the sector which investors “chose above all others was property development.” Reflecting on the pound crisis years later, the June 1978 Bank of England Quarterly Bulletin explained that “There was no other general area of economic activity which seemed to offer as good a prospective rate of return to an entrepreneur as property development.” That was the case owing to the belief “that property was the inflation hedge par excellence.”
That the level of interest rates is somewhat of a sideshow when it comes to home prices—or even a contrarian indicator—raises the obvious question of what drives the property market. The answer is a fairly simple one, and it involves the direction of the currency; in our case, the dollar. While economic vitality is a certain factor when it comes to the health of the housing sector, as my Wainwright colleague David Ranson wrote last August in the Wall Street Journal, “the relationship between housing prices and the prices of highly inflation-sensitive assets such as commodities is much more impressive than the relationship with the economy.”
Notably, empirical evidence produced by Wainwright supports the conclusion that rising rates of interest don’t drive down housing prices in the way that intuition perhaps suggests they might. Indeed, nominal home prices since 1976 have increased the most when T-bill rates have risen over 200 basis points, and they’ve declined the most when those same rates have fallen more than 200 basis points.
This reasoning contradicts the popular assumption today suggesting that low interest rates explain the weak dollar. Instead, as dollar history has shown, the greenback has more frequently exhibited the weakness that’s reflected in the rising price of gold and home prices when rates are rising. If anything, this speaks to non-interest rate and non-Fed factors that have driven the dollar’s direction in recent times including geopolitical events, domestic policy decisions such as taxes and tariffs, and most importantly, the stance taken by the U.S. Treasury when it comes to defining the dollar’s price.
Looking at this from the perspective of Treasury actions in this decade, Secretaries O’Neill and Snow mocked or questioned the importance of a strong dollar, while Secretary Paulson has frequently attempted to use his outsized reputation in China to force a revaluation of the yuan against the dollar. The actions of all three secretaries were an implicit communication to the markets that a weaker dollar was the Bush administration’s true policy, and those policies, combined with 9/11 and the imposition of tariffs on steel, lumber and shrimp in 2002 led to a falling dollar that powerfully drove up nominal home prices.
Much has also been made of the subprime debacle being directly related to low nominal rates along with laws such as the Community Reinvestment Act; the latter forcing lenders to make unwise loans in areas previously “redlined” by banks. While both arguably factored into the lending equation of recent vintage, they arguably whitewash over what really happened.
Put simply, when the unit of account weakens, there’s a flight to the real. Not only is housing an asset that is least vulnerable to a falling currency (compare the slight drop in home prices to the drop in equities over the last year), it’s an asset that in fact thrives in nominal terms in times of currency weakness. So while low rates and unfortunate legislation surely contributed to the property boom and subsequent moderation, the major factor has been dollar debasement that in Ranson’s words led capital “into assets that are invulnerable” to that same debasement.
In short, for Greenspan’s critics to be correct, there would have to be an historical correlation between low nominal rates of interest and currency weakness. That’s there’s very little speaks to criticism of the former Fed Chair that’s either misdirected, or unclear.
Mr. Greenspan’s recent responses to his critics have rightly failed when it came to repairing any reputation lost. More surprisingly, he’s embraced the very supposition about low rates and housing vitality used by his critics.
In Greenspan’s case, he’s pointed to falling rates as the driver of “remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006.” To his way of thinking, a glut of savings worldwide pushed rates downward such that housing was the sure beneficiary.
The notion of a “glut” of savings is something that’s been similarly embraced by Greenspan’s successor at the Fed, but the assumption is a fallacious one. To believe in the concept of excessive saving is to assume a place in time where all human wants are satisfied such that capital would have to find another home; in the present case, property. But since we’ll never reach such a point due to the happy existence of entrepreneurs eager to serve infinite human wants, the idea that we hit nirvana in 2001 seems a bit farfetched.
Greenspan concluded that “the evidence that monetary policy added to the bubble is statistically very fragile.” By his lights, if there was such thing as a property bubble, it was a world event rather than something endemic to the United States.
In defending himself incorrectly, Greenspan missed the chance to prove his critics wrong. Contrary to his suggestions otherwise, monetary policy was at the heart of this decade’s real-estate boom, but not in the way Greenspan’s critics assume.
Mentioned earlier was the falling dollar since 2001, and the combination of geopolitical and policy factors that led to its weakness. Though the nominal level of rates (in particular, low rates) is a not very predictive indicator when it comes to the value of the dollar, exogenous and endogenous factors have historically affected the dollar negatively, and did so in this decade. So in talking about monetary policy, we should say the absence of policy, particularly any policy from Treasury meant to define the greenback’s price, made the dollar’s value vulnerable such that it weakened and fed the property boom.
And when we consider Greenspan’s argument that real estate rallied around the world, it has to be remembered that when the dollar weakens, foreign central banks frequently feel the need to devalue their currencies alongside ours. Indeed, lost in all the modern commentary about the dollar’s weakness versus all manner of foreign currencies is the certain truth that a falling dollar begets world inflation.
Simply put, comparing the dollar against other kinds of money in a floating currency world involves comparing one piece of paper lacking definition to another. When we bring an objective benchmark such as gold into the equation, an entirely different story emerges.
The story is a basic one, and it shows that the oft-chronicled foreign currency strength of recent vintage has been a mirage; one that has obscured the broad currency weakness that the dollar’s even greater weakness has hidden. Since 2001, the price of gold in terms of the British pound, euro and Aussie dollar respectively has increased 151, 101, and 94 percent, while our neighbors in Canada have seen the price of gold in terms of their own dollar rise 122 percent.
Seeking to maintain some level of parity with the dollar with trade in mind, foreign central banks in this decade have added to the U.S. mistake by allowing their own currencies to depreciate relative to gold. And with real estate most correlative with commodities, dollar policy stateside has led to a worldwide commodity boom in nominal terms that drove capital into appreciating real assets including housing. A lot has been said about the recent moderation of home prices, but the real correction will occur if and when U.S. monetary authorities seek to rein in dollar weakness.
There are varying views as to the Fed’s ability to control the dollar’s value with its interest-rate mechanism. But for one to tie this decade’s property boom to the level of rates is to defy history suggesting otherwise. The low nominal rates targeted by Greenspan were decidedly not the cause of the housing boom. Unfortunately, explanations by his critics about what happened proved just as wanting.