Beware what you wish for

An economy awash, almost drowned, in liquidity and tripping over stimuli being thrown all over the place. Government interference everywhere. As if the problems the US and world economy are going through had nothing to do with previous government meddling.

Over the last eight or nine years, the “Great Moderation”, which dates to about 1984, was “discovered” and ascertained. It´s worth reminding that Walter Heller, Kennedy´s head of the CEA, thought in the early sixties that economists had learned to control the business cycle. According to his group of friends and advisors, which included future Nobel winners such as James Tobin, Paul Samuelson and Robert Solow, the business cycle was “dead”. Soon after, the “Great Inflation” took off! From the “Great Inflation” to the “Great Moderation”; what´s next? According to President Obama, if a series of drastic interventionist measures are not undertaken, the recession will turn into a “catastrophe”. More likely a “catastrophe” will happen if he and his advisors don´t “stop to think things through”.

The popping of the house price bubble is said to have been the trigger. But the run up in house prices is not disconnected to all the “incentives” offered for homeownership, especially for minorities (lower income) that was cooked up by Congress and HUD in the early 1990´s and made operational by Fannie Mae and Freddie Mac with the help of “financial innovations”.

As the figure below shows, the significant run up in real house prices (from Case Shiller) took place in the first few years of this century, a fact that many relate to the slash in the Funds rate that began at the start of 2001 and went on for over two years. But as the figure also shows, this was not true everywhere.

image001_512_09.jpg Why didn´t Dallas, Charlotte, Atlanta or even Chicago, show the same “exuberant” behavior as Los Angeles, San Diego, Phoenix or Las Vegas? Going deeper, why, for example, Las Vegas which had record population growth in the 1990´s showed stable real house prices during those years then suddenly took off like a rocket?

Maybe we have to look to supply restrictions. In Nevada, for example, most of the land is federally owned and was regularly sold to developers. After 2000, environmentalist groups were successful in their objections to the practice. Only then did house prices shoot up.

California had lived with supply restrictions since the 1970´s (with house prices being much higher there than in most other areas of the country). No wonder it was more affected than others by the S&L debacle of the 1980´s, with prices falling halfway through the 1990´s before taking off again.

It appears that describing house prices as a “bubble” is not appropriate, unless we subscribe to the “selective bubble” view, where a “bubble” is present only in some residential markets and not in others. The same is true for the so called “stock market bubble” of the late 1990´s. The figure below illustrates that only the technology (NASDAQ) sector showed bubble-like behavior.

image002_24.jpg In the case of houses, low interest rates, creative financing and incentives for subprime mortgages were available to all. For the differing price behavior, supply restrictions are a good candidate. In the case of the stock market, the second half of the 1990´s was all about the “technology revival” and tech companies the “wave of the future”. The psychology of human nature turned many into suckers for the Nasdaq.

Many, maybe most analysts blame Greenspan for the house bubble and ensuing credit crisis. In their view, in the words of Marc Faber, “the complete mispricing of money, combined with a cornucopia of financial innovations, led to the housing boom…”.

To Greenspan, monetary policy was mostly “art”. The “art” aspect of monetary policy explains the deviations from a “Taylor Rule”. The figure below illustrates.

In the early 1980´s Volker was trying to gain credibility, so the effective rate was above the rate indicated by the rule (10.8% unemployment rate was not going to sway him). Just prior to the 1990 recession effective rates were higher than required by the rule and Greenspan, through what came to be known as “opportunistic” disinflation, managed to engineer a step decrease in inflation. As the economy slowed down in 1990/91, rates were brought down to 3% and stayed there between mid 1992 and early 1994, helping the mop up after the S&L debacle.

image003_05.jpg In the period 1995-2000 effective and rule rates were the same. Both inflation and unemployment decreased and GDP growth was robust. During this period there were many, notably Paul Krugman and Steven Roach, that accused Greenspan of being “behind the curve”.

Then along comes the Nasdaq bust, the 2001 recession and the terrorist attacks on the heels of the Asian crisis three years before, and a wiff of deflation is in the air. According to the FOMC the deflation risk is small, but the consequences are big. The “risk management approach” calls for rates below “normal”. For different reasons they had also been below normal in 1991-94 and nothing untoward happened. Interestingly (see figure below), the stock market (S&P, Dow) surge only began after rates rose in 1994-95!

image004_11.jpg But “deflation” is Bernanke´s “prefered habitat”. A few months after being appointed Fed Governor he made the famous November 21, 2002 speech at the National Economists Club in DC titled Deflation: Making Sure “It” Doesn’t Happen Here, for which he got the nickname “helicopter Ben”. It´s  a speech well worth rereading because it provides the blueprint for the Fed´s actions since September 2007 when it began to decrease the FF rate.

Before that, in the 1999 annual Jackson Hole gathering which debated “New Challenges for Monetary Policy”, Bernanke (with Marc Gertler) presented a paper  with the apt title: “Monetary Policy and Asset Price Volatility” where they write:

In this paper we address the question of how central bankers ought to respond to asset price volatility, in the context of an overall strategy for monetary policy. To be clear, we agree that monetary policy is not by itself a sufficient tool to contain the potentially damaging effects of booms and busts in asset prices. Well-designed and transparent legal and accounting systems, a sound regulatory structure that helps to limit the risk exposure of banks and corporations, and prudent fiscal policies that help instill public confidence in economic fundamentals, are all vital components of an overall strategy to insulate the economy from financial disturbances. However, our reading of history is that asset price crashes have done sustained damage to the economy only in cases when monetary policy remained unresponsive or actively reinforced deflationary pressures”.

It appears Bernanke was well aware of what was needed to sustain stability, both economic and financial. But the key underlined ingredients were missing before the crisis hit. More than “excessively” low interest rate, the absence of the underlined conditions from Bernanke´s paper must shoulder the blame for our present predicament.

But why such neglect? Greenspan was the boss at the time and in chapter 19 of his memoirs he spells out his views. Just one example illustrates his philosophical tone: “The marketplace itself regulates hedge funds through what´s known as counterparty surveillance…”. According to this view, the Madoff fiasco shouldn´t have happened!

As Bernanke indicates in his 1999 article; if push comes to shove, monetary policy becomes the “cavalry”. Being a dedicated student of the Great Depression he immediately surmised that the economy was once again in the throes of a liquidity crisis, something the Fed could avert. But as Professor John Taylor has argued, if you have the wrong diagnosis you will prescribe the wrong medicine, in which case the outcome might even be counterproductive. And “liquidity problem” was the wrong diagnosis for an economy caught in the vise of a “lack of trust” that spells rising risk.

So the uncertainty remains and is being compounded by an almost trillionaire Federal Government “shopping list”.  The longer the uncertainty remains the more likely the infection will spread. As usual, big slumps or depressions are the result of BIG mistakes that follow from bad decisions taken in haste and which don´t consider, in the words of Thomas Sowell, “thinking beyond stage one”.

2 Responses to "Beware what you wish for"

  1. Anonymous   February 21, 2009 at 2:06 pm

    firstGreat article. I live in one of the areas that did not have a price bubble largely in part from an excessive supply of cheap new no down payment housing competing with older homes. However, we are still experiencing substantial deflation in housing prices and bank repos dot the landscape competing with homeowners for sales. Many people refinanced and unknowingly took all their equity out of their homes because the bank appraisers gave appraisals that were way over market price. Homeowners believed the bank/mortgage company’s appraisal was what their home was really worth. The Inner city also had a scam going on where homes were appraised for way over market price and then sold to unwitting victims. These homes were sold primarily to low income black and Hispanic families who trusted the appraisals of what they thought were honest professionals. This all occured during the peak of the bubble that while my town may not have graphically experienced a bubble according to charts like the above, we are still experiencing the effects.Key sentence:”But as Professor John Taylor has argued, if you have the wrong diagnosis you will prescribe the wrong medicine, in which case the outcome might even be counterproductive. And “liquidity problem” was the wrong diagnosis for an economy caught in the vise of a “lack of trust” that spells rising risk.”However I would add that there would be no lack of trust if this trust had not been so grossly violated.