Economics
Bubble spotting
THE FED has just released detailed transcripts of its 2004 meetings, and the dialogues within have gotten a lot of blog attention. Annie Lowrey posts a long, frustrating passage in which FOMC members seem incapable of perceiving that the ratio of rents to home prices has moved well out of normal territory. Calculated Risk posts this quote:
I don't want to leave the impression that we think there's a huge housing bubble. We believe a lot of the rise in house prices is rooted in fundamentals. But even after you account for the fundamentals, there's a part of the increase that is hard to explain.
Prompting Matt Yglesias to ask what exactly a bubble might be if not a rise in prices above fundamentals. And Ryan Grim collects several troubling statements. Here's Chairman Greenspan in March of 2004:
We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand...
Jack Guynn, president of the Atlanta Fed, offered prescient warnings:
[A] number of folks are expressing growing concern about potential overbuilding and worrisome speculation in the real estate markets, especially in Florida. Entire condo projects and upscale residential lots are being pre-sold before any construction, with buyers freely admitting that they have no intention of occupying the units or building on the land but rather are counting on 'flipping' the properties--selling them quickly at higher prices...
The substantial run-up in house prices, which we have followed in Florida and also see in the populous Northeast and West Coast of the United States, may be at least partially attributable to unusually low mortgage rates influenced by our very accommodative policy...
A number of other FOMC members expressed some concern that prices might be moving above levels that could be considered economically justifiable.
Mr Greenspan's point is the most interesting one, I think. It comes across as incredibly arrogant and hubristic in the light of hindsight. As it happens, the FOMC did not understand the trouble that was brewing, and to the extent that it did it failed woefully to act the mitigate the potential damage. And it isn't surprising that the publication of these transcripts have increased the calls for oversight of and transparency at the Fed.
But would such oversight and transparancy have helped? I think many bloggers have rushed through the transcripts looking for smoking guns related to the housing bubble and financial crisis. But the FOMC members spend as much time or more on the employment situation. In March of 2004, economic recovery was more than two years' old, but the unemployment rate was still elevated"”higher than it was at any point during the 2001 recession. The stubborn persistence of unemployment clearly troubles FOMC members, as it clearly troubled many Americans.
By June, the Fed had made up its mind that other risks"”asset price bubbles, inflation, financial instability"”outweighed continued labour market weakness, and it began the long series of quarter-point increases in the federal funds rate target that didn't end until housing markets had begun declining, in the second half of 2006.
So the question is, how would an FOMC with more exposure to American public opinion have acted, or how would it have acted differently? Does it seem likely that a more transparent Fed would have spent more time fretting about financial market instability and inflation and less time focused on unemployment? Or is it more likely that the opposite would have been the case? I think it is highly unlikely that a Fed more exposed to popular pressure would have been more aggressive in diagnosing and deflating a housing bubble.
Apart from that, Mr Greenspan's quotes are taken somewhat out of context. His comment is made, specifically, in the context of the phrasing of the Fed's statement. Several presidents have remarked that the balance of threats to the economy is unpredictable, and the motion has been made that the statement change to reflect a balance of concern between upside (inflation) and downside risks, where before inflation was less of a concern than lingering economic weakness. And Mr Greenspan is saying that with increased transparency, the Fed needs to be more careful about the language it uses lest it give markets whiplash by appearing to veer from one fear to another. Put more simply, if the language were to be changed in the March meeting and subsequent data revealed growth to be more of a worry than inflation (or something else) then the subsequent reversal would not generate a lot of confidence.
I don't want to go out on a limb defending Alan Greenspan. His Fed continues to strike me as disturbingly cultish and woefully complacent. Obviously, the data were showing something amiss and were dismissed far too quickly. But as forehead-slapping as these quotes end up looking, I don't think a rush to open the Fed to significant oversight of monetary policy is necessarily the right response.
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Correct, although I might (before hiding under the desk) point out that a Fed that read this blog last year would also have erred on the side of bubble-inflating. If anything, I'd say the error was too much focus on monetary policy as the sole work of the Fed. I have yet to be convinced by anyone that Greenspan was wrong to think that asset bubbles were beyond the Fed's power to deflate. But some regulatory oversight of the stuff that was accelerating the bubble (at least inside banks) might have helped a lot and his proclaimed opaqueness to the possibility that the principal-agent problem might still apply frustrates me.
By the way, I think the assumption that bubbles are created by global forces beyond the control of individual separate banks might provide some context to the dismissiveness in those quotes.
Articles on the Federal Reserve seem to constantly overlook the fact that the Fed's mandate extends far beyond the mere ability to influence interest rates. The Fed is also charged with regulating and supervising banks, something which it was woefully negligent in doing during the bubble years. One argument the Fed had for keeping rates low, even in the face of a potential housing bubble, was that it did not want to impact the larger economic recovery. This argument is bogus. Had the Fed been truly concerned about a housing bubble, they had many options at their disposal that could have targetted mortgage lending, without impacting overall interest rates.
For instance they might have clamped down on the rise in stated income loans, so called "liar's loans", which were often egregiously fraudulent. They might also have done something to stem the moral hazard involved in issuing negative amortization sub-prime mortgages and repackaging them for third party buyers. There were a host of regulations they might have passed that could have limited the worst excesses of the bubble, yet they did nothing. Instead they acted like a driver who after refusing to touch the steering wheel, seemed perplexed as to why the accelerator pedal alone did not provide enough control to avoid a crash.
In 2006 few people were aware of a housing bubble.
We can see it in hindsight.
It seems the Fed doesn't want to pop bubbles that might be forming, else they get blamed for a recession.
It seems the Fed's policy is to let the bubble pop then flood the economy with liquidity, then mop up.
Regards
A Young: "they had many options at their disposal that could have targetted mortgage lending, without impacting overall interest rates."
You're right that such regulation would have deflated the housing bubble to some degree. But where would all of the money that the Fed was pumping into the economy via cheap credit go? The Fed opened the floodgates on credit in order to reduce unemployment. The money has to go somewhere or it doesn't help reduce unemployment. Had the Fed cracked down on housing, the money would have gone into another industry and created a bubble there and we would be talking about it instead of the housing bubble.
The current Fed is about to face the same problem. It looks like a bubble is developing in the stock market. But the Fed won't want to raise rates because unemployment is so high and the cpi has remained tame. However, due to high spending by the guv, this time the Feds will face an equity bubble, higher cpi, and high unemployment. Too bad no one remembers the 1970's.
Some valid points are made here - but let's not forget that there are sectors of the economy that are cash-strapped. Too much cash being pulled into a housing bubble is bad for other sectors of the economy that struggle to raise funding for potentially far more worthy causes. Most startups are still self-funded (on a shoe-string) and most small businesses pay exhorbitant fees and interest rates to borrow the working capital to expand. Our financial markets may work ok for the fat cats on Wall Street - but they definitely don't work for Main Street.
Our nation's laws and regulations impact the flows in our economy - lets fix them so that they stop causing flows into unproductive investments. In 2005 while S&P 500 firms had record profits and cash balances - our bridges were falling and schools were crumbling. How much more obvious do the signs have to be?
So let me see if I have this right. The Fed was unwilling to raise interest rates in 2004 because the jobs weren't coming back during the recovery from the previous (tech) bubble bursting. This led to the real estate bubble.
And where are we now, in 2010? The Feds are unwilling to raise interest rates, because the jobs haven't come back during the recovery from the previous bubble bursting.
Oh, dear. I think I see what's coming...
Regulation of mortgage origination and securitization practices would have been far more effective than monetary policy. But we mustn't interfere with the all-seeing, all-knowing market.
rewt66 -
Exactly. This is a structural, not cyclical issue. The massive foreign capital inflows have papered over the simple fact that we have been building an unsustainable economy since the '70s.
Actually, let me rephrase that. We have been busily dismantling the American economy, with the richest in the country dismantling it piece by piece and selling it as scrap to foreign creditors. The Fed CAN'T raise the rate today, and they won't be able to substantially raise it in 5 years either. In the meantime, the financial industry will continue its crusade to suck up any value left in America and hoard it for itself.
Case in point - recent article that having a college degree may hurt your chances for employment in the current climate, as employers have to pay you more. So, can't get a job without a degree, can't get one with a degree. I did enjoy Beijing, although nothing Tsing Tao and Carlsberg gets old...
"The substantial run-up in house prices, which we have followed in Florida and also see in the populous Northeast and West Coast of the United States, may be at least partially attributable to unusually low mortgage rates influenced by our very accommodative policy..."
It makes my head explode when I read statements like those above and consider the comments section of some blogs (not necessarily FreeX, but Brad DeLong's blog is a major offender). They consistently vomit anytime someone mentions Hayek, Mises or any opinion inconsistent with Keynes.
Back to the point, Greenspan's career as a business economist began at a time when only industry insiders would likely know the price of major commodities like steel. It must be a hell of a power trip to see state-by-state, weekly data breakdowns from many industries simultaneously. You could call it *The Fatal Conceit*.
OneAegis,
Framing the argument in that way will only lead to protectionism. Finance's role has always been to allocate capital most efficiently; for the last thirty years, that has meant away from the US. The answer isn't to throw up trade barriers and retreat, its to become more competitive. We can reform our institutions to better align reward with success and we can reduce inefficiency. We can develop game changing technologies that make it more advantageous to do business in the US. Even if we fail to do these things, we'll get more competitive in the long run once our real wages resemble Bangladesh's.
In this blog, our correspondents consider the fluctuations in the world economy and the policies intended to produce more booms than busts.
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