The current financial crisis has its roots in Greenspan's decision to keep interest rates very low in 2002 and 2003 to head off the danger of a deflation-induced double-dip recession, and his subsequent decision that the costs of cleaning up after a housing bubble were likely to be less than the costs of the high unemployment that would be generated by a preemptive attempt to pop a housing-speculation bubble. Two years ago, I would have said that Greenspan's judgment here was correct. Six months ago, I would have said that his judgment was probably correct. Today -- in the middle of the largest nationalizations in history -- I can no longer state that Greenspan made the right calls with respect to the level of interest rates and the housing bubble in the 2000s.
Arnold Kling replies:
My view of history is rather different from Brad's. I think that the current financial crisis was not the product of Alan Greenspan. I think it was a phenomenon that emerged from a number of subtle factors, the most important of which was the anomaly in capital requirements. See my fantasy testimony and written remarks.
The central bank does not control the risk premium, which is perhaps the most important financial variable in the economy. Had there been no housing bubble, it is possible that the general drop in the risk premium that took place from approximately 2001 through 2007 would have created a crisis elsewhere. Perhaps it indeed did create a crisis in the debts of the so-called emerging-market countries.
I, like Arnold, find it hard to credit the American central bank with this crisis. The disaster in Europe shows that lending standards fell everywhere--in the US, it was the mortgage market, in Europe, emerging market debt. Yet the Bank of England, and especially the ECB, were inflation hawks. Nor do falling interest rates explain the vast influx of foreign capital that unquestionably sustained the bubble; capital is supposed to follow rising rates. The global decline in lending standards seems to support Bernanke's "global savings glut", in which Asian savers recycled export earnings into American and European credit markets with insufficient regard to risk.
Given that Ben Bernanke was appointed in 2005, it should be noted that the worst of the housing bubble took place under Ben Bernanke'.s watch. It should also be noted that Brad DeLong hates Greenspan and adores Bernanke.Until just a few weeks ago, all of macroeconomic theory suggested that inflation targeting was sufficient for monetary policy. In The Economics of the Great Depression, Randall E. Parker interviews the top modern macroeconomists on their view of the 1930's. Ben Bernanke, in his interview, says (p. 65)
A price target that avoided deflation would have de facto forced abandonment of the gold standard and would have eliminated a major channel of depression...So I do agree that stabilizing prices is the ultimate lesson of the Great Depression and also of the 1970s. There really is nothing more a central bank can do for domestic economic stability than make sure that inflation remains low and stable over long periods.
Re-read that last sentence. Ben Bernanke, the Depression expert, or "technocrat-prince," as DeLong hails him, says nothing about the Fed needing to pop financial bubbles or to give Treasury Secretary Mussolini power to buy hundreds of billions of dollars of mortgage assets and then use that power to partially nationalize banks, insurance companies, auto companies, or anyone else of his choosing.
Targeting asset bubbles always seems like a slam dunk--after you know there was a bubble. Prospectively, if you want to do it effectively, you probably need to intervene in the very early stages. The Fed raised interest rates in the late 1920s, to no effect--indeed, it encouraged foreign capital to flow in. Iceland's central bank, too, tried to quiet its financial bubble, but borrowers simply ignored them--borrowed at the higher rate, or stupidly took on currency risk by getting auto loans and mortgages from abroad. Meanwhile, more lenders were attracted by the higher rates. If you think house prices will go up 10% every year, a 1% increase in mortgage interest rates is not really that worrying.
So to squelch asset price bubbles you need to get in early, before the bubble takes off. But in the early stages, an asset price bubble isn't necessarily distinguishable from actual economic growth, or real changes in the relative value of assets. The various indices have fallen since the bubble peaked in 2000--but the S&P is still about twice what it was at the start of 1995, the year the bubble is generally agreed to have taken off. Stomping down on bubbles before they get going will mean accepting higher unemployment and lower economic growth any time that any asset market starts to look the least bit frothy.
At that, we don't know if it is possible to prevent bubbles (and we definitionally won't--if a central bank succeeds, all we'll see is . . . no bubbles. Which is also what we'll see in most cases if the central bank takes no action.) Speculative mania precedes fractional reserve banking, central banking, and quite possibly, the invention of currency. The central problem is that in an asset market, other people's opinions of an asset's future value are meaningful components of the asset's future value. And since guessing other peoples' future opinions about cash flows is even harder than guessing the cash flows, there is a systemic tendency to over- or under-shoot.
Almost everyone attributes the quiescent markets of the 30's, 40's and 50's to FDR's sweeping regulatory changes. But it seems to me that it's at least as plausible to think that investors simply got much more bearish on stocks, because the lesson of 1929 was fresh in their minds. As that memory faded, markets headed north.
Update: Free Exchange adds
When does a bubble become a bubble? While it's certainly sometime before your waiter begins day-trading between courses and your son refinances his treehouse, it's definitely after awareness of the sure-fire profit opportunity in the relevant sector has hit some critical mass. That's really what a bubble is all about, after all--the departure of price growth from fundamentals thanks to a rapid broadening of players in the bubbly market. Before the Ponzi scheme is a Ponzi scheme, it isn't a Ponzi scheme.
But what that means is that by the time a bubble becomes a bubble (and certainly by the time it becomes a recognisable bubble) a lot of amateur investors are involved. A healthy chunk of the body politic will have entered an inflated market believing prices will continue to increase. And Mr Roach and Mr Thoma are saying, correctly, that someone important will need to tell them that they have made a very bad decision and are about to lose their money.
Mr Thoma says that popping such a bubble will take courage. For a politician to do it would take an extraordinary amount of courage--more than we could reasonably expect a politician to display. It's important then to place the bubble popping decision in the hands of officials that are entirely--inhumanly--apolitical and independent.
And frankly, I wonder if the standard of independence necessary for the job is realistic.
The world was awash with US dollars thanks to fed policies. It was coming back thanks to a belief that not only was the US market safe, for once it was proving to be as lucrative as the riskier investments in the third world.
I hope, at the very least, you aren't suggesting that fed rate cuts played no role in the economic bubble.
We do know a few things about decreasing the likelihood of housing bubbles, but no one wants to hear that advice about zoning and land management laws. And we would get bubbles elsewhere, no doubt.
We do know a few things about decreasing the likelihood of housing bubbles, but no one wants to hear that advice about zoning and land management laws. And we would get bubbles elsewhere, no doubt.
Without offering a (completely non-expert and relatively meaningless) opinion as to whether you or DeLong are correct, I would just like to point out that, perhaps more than anything you've ever written, this post demands that you turn in your Libertarian Decoder Ring. DeLong, a liberal, gives you the opportunity to BLAME THE FED for all our economic woes and you respond by saying it's not the Fed's fault?
I'm driven crazy by the kinds of analysis I see here from Delong, Kling, and McCardle. It's perfectly fine to ask what this crisis says about our models of monetary supply, asset bubbles, etc - but not at the expense of almost completely ignoring the obvious recent dysfunction in the basic workings of the real and shadow banking systems. These systems, because of changes to their structure and the advent of new, unregulated financial instruments, were simultaneously making risk far more opaque, and leveraging up. It doesn't take any fancy analysis of global savings gluts or negative real interest rates to predict the dramatic, systematic increases in risk would eventually lead to serious problems, even if the exact pathology could not be predicted a priori.
Greenspan was the only figure who had both the credibility and the authority to stand athwart these dangerous trends and yell "stop". His failure to do so is what he's really responsible for, and even he seems to understand that.
Arnold Kling gets much more of recent economic history more right than most of us. Megan gives us an elegant take on his thoughts.
Following the same line, I doubt if even world wide interest rate policy is a proper or effective way to tackle an asset price bubble. It looks improper because the likely costs of trying to squelch a bubble rise in one sub-set of assets will include reining back presumably desirable expansion in the rest of the economy. I think it is probably ineffective because asset price bubbles are very largely relative price phenomena. Thus house price bubbles in Ireland and Spain could and did co-exist with restrictive euro zone monetary policy.
To tackle asset price bubbles we need other instruments. They are at hand in bank regulation. Bank regulators can and should make clear - the earlier the better - that ratings of risk on an asset class suspect of being the subject of a nascent bubble should be need to be scaled up for the expected future presence of systematic risk. This seems to me to be a natural but as yet undeveloped part of the Basel II framework.
(What is systematic risk? the rational banker asks. Arnold Kling nails that elusive definition:
"I will define systemic risk as follows: whenever individuals make contingency plans that can only be executed if others are not trying to execute similar contingency plans, there is systemic risk.")
As for an economy-wide (or global) savings glut, interest rate policy seems as irrelevant to curing one as it is to curing that other rare phenomenon, an economy-wide liquidity trap. In a saving glut, savers' real options are to spend their surplus savings or eventually lose them. How do we help them see that these are the real options?
I'm a big fan of bubble as a sort of "market discovery process on speed." (Cf. Dan Gross.
What's really frightening is "political lock-in." Think of agricultural subsidies or the public school establishment.
When the political class gets an idée fixe, followed by the death grip of institutionally stable political power . . . that's the death knell.
Problems are bad but the opportunity to work through them is what can be strangled by political interference.
As to squelching bubbles, many commentators have noted that there is terrific political/psychological pressure on a central banker not to recognize a bubble. They argue that if the bubble is popped, no-one will see the situation as one in which a bubble has been popped, but rather as a situation in which growth was squelched.
A reasonable, simple idea (to me, at least): why not adjust leverage requirements counter-cyclically? For example, why not require banks to start raising their tier one capital ratios to, say, 10%, when the previous quarter's GDP exceeds a 3% annual rate, and then let banks lower those ratios to 8% when the previous quarter's GDP clocks in at less than, say, 1.5%. That way, banks would be less likely to get over-levered during boom cycles, and they would be able to extend more credit during slower economic periods.
All the ingredients were in the system before 2001. Ingredients put into the cake by Greenspan and the entire mighty financial world.
Sept 4, 2000
A key to appreciating credit bubble dynamics is to recognize that they are acutely self-reinforcing. Here, the focus is on processes and forces not easily characterized and certainly non-quantifiable. Credit bubbles absolutely feed on money and credit excess, which only induces an intense hunger for greater excess. What’s more, this appetite is insatiable. After all, credit bubbles are about financial wealth creation and accumulation. Lending, the creation of additional liabilities, is the mechanism, while the consequences of excess are immediate spending increases and asset inflation. Wealth is, of course, about power and one should appreciate that credit bubbles have everything to do with obtaining and retaining power. Those who control a mechanism for money and credit creation have enormous power. Those who manage vast sums of financial assets on behalf of their clients are immensely powerful. And those who attain discretion to allocate an economy’s resources possess great power. Credit bubbles by their very nature direct enormous power to the financial sector, for the financial sector, by the financial sector. And, as has developed during this historic period, as the financial sector attains sufficient financial power to dictate an economy’s reward system it achieves supreme power. With this achievement, the powerful financial sector garners and relishes in its ability to create its own financial wealth, with devastating consequences to the underlying economy and financial system.
Financial wealth begets greater wealth, and power begets abusive power. Those having attained great power have no intention whatsoever of relinquishing control, of course not. And to the powerful machine the mindset becomes that to give up any control is to commence a process of losing control and relinquishing wealth and influence. Such a development is seen as completely unacceptable, and there is no compromise. The machine knows only expansion, sees only continued expansion, and accepts only the perpetuation of the boom. There is no other way. With this in mind, hopefully a nebulous cloud is becoming clearer as to the intractable momentum and self-feeding characteristics behind this historic boom. Here as well, one discovers the source for the incredible resiliency the financial system and real economy have developed to thwart any force that might temper credit or speculative excess.
http://www.prudentbear.com/index.php/creditbubblearchivedisplay?art_id=8732
Read the entire thing. Every single thing being talked about now was identified by Mr Noland in the year 2000. The GSE's, derivatives, the works.
It's an outrage that this after 2001 thing has taken root. It's a lie.
After seeing people comment about economics, i gradually learnt that knowing what is going on cannot be understood without understanding where money comes from..........It is quite obscene really, money is created by debt!!..........This conjuring trick is obtained through the "FRACTIONAL RESERVE BANKING SYSTEM" first legalised in England..................After seeing the youtube and quite famous video called "Corrupt banking system" or otherwise known as "Money As Debt" the veil lifted since i could never in my unknowing state reconcile how it was that more and more peple were going into debt..........Where was all this money coming from???.....The "fractional reserve banking" system allows all this and more..........quite an amazing "PARTY TRICK" once you know how it is done........
A number of things:
- Freedom Exchange argument about politics making things difficult for monetary policy is an argument against discretionary monetary policy, i. e. for the gold standard.
- The canard about a hawkish ECB stand is ridiculous. It only had an expansive policy as opposed to the demented policy pursued by the Fed. Moreover, conditions were hyperexpansive in Spain and Ireland, countries where nominal GDP growth was way, way above the ECB's intervention rate. I'm writing from Spain, BTW.
- It wasn't only a real estate bubble. There was a commodities bubble starting in 2002. The problem is not to target asset bubbles. The crux of the matter is that it is not possible to leave assets out of the inflation calculus, as Greenspan decided to do.
- The willingnes of foreign money to underwrite the US consumption and malinvestment spree ENABLED the Fed to continue its policy without major disruptions, i. e. a US dollar crash, but was not the source of the problem.
- The issue of risk assessment is the natural consequence of lax money and it's twin sister "moral hazard". Using Taleb's jargon, beginning with the Mexican crisis of 1994/95 the US government (mainly through the FED) chased away any black swans that appeared on the horizon (Asian crisis, LTCM, dot com fall out, Bear Sterns, etc), to the point that market participants were allowed to believe that black swans didn't exist.
- Going back to my home country of Spain, it's going to be very interesting to see how the financial system evolves here (as Tyler Cowen said in a post I can't find right now). The Bank of Spain adopted countercyclical reserve requirements, mainly to offset the fact that, since 1999, we've had German rates with Mediterranean nominal GDP growth, that is, hyperexpansive monetary conditions. A gigantic bubble developed, nonetheless, but Spain is beign held as an example, anyway. Truth be told, no bank failures had taken place yet, but there are very ominous signs. Roughly half of Spain's financial sector is made up of "Cajas de Ahorros", politically controlled thrifts that are terribly opaque and have massive exposure to the housing sector. Our current account deficit comes in double digits, and is made up of medium to long term debt that Spanish financial institutions need to roll over beginning right now. The big banks many people are talking about (mainly Santander) have taken a beating over the past two weeks in the stock market. In short, things dont't look good.
Mr. Noland was doomed to repeat the same arguments for years and years. Obviously the boom was not ready to end. Instead it went into a blowoff phase which was fueled by Greenspan's manic interest rate cuts and subsequent well publicized long period of mini hikes which had no effect on slowing the bubble.
The degree of the correction will now be much worse than if the cycle had ended in 2002. That isn't to diminish the pain that would have been meted out if the country would have rejected the finance centric economic model that had been in force since the early 80's.
Post 9/11 Greenspan made 40 or so visits to the White House. We can assume he was told to goose it because the fate of the world depends upon it and thus you. He fell for it but he didn't have far to fall. By that time he believed in the model of unlimited credit expansion and asset inflation as the key to wealth and economic health. He was a fool. The worst central banker in history.
rapier has it exactly right.
Megan: You should make a distinction between asset bubbles and credit bubbles. Asset bubbles are caused by true irrational exuberance -- the Internet is the classic case -- and these are hard to spot and hard to pop.
But credit bubbles are a different matter altogether. Credit bubbles are caused by excessively loose monetary policy, and since this is within the purvue of the Fed, the Fed is responsible for it. Isn't the job of the Fed (and Treasury) to control money supply? And isn't a credit bubble -- by definition -- a consequence of money supply out of control?
-winterspeak
winterspeak, credit bubbles create asset bubbles (inflation, in general). The dot com bubble came on the heels of the interest rate cuts in the fall of 1998, following the LTCM affair.
I hope I'm not the first to consider the obvious...
But, popping bubbles requires limiting legitimate growth in other sectors of the economy. Since (usually) the fed simply controls the blunt object known as the fed funds rate, it is impossible to target one sector of the economy.
And in response to Winterspeak:
Perhaps in a closed economy credit bubbles are caused by loose monetary policy. But people from around the world send their money here for our vastly superior safety and rates of return. They also like our fancy derivatives, which seem to make money appear from nowhere.
Megan, you really are amazing. Your utter lack of self-awareness, coupled with a truly amazing ability to create strawmen, has made reading your posts on the financial crisis a true joy (in a sick, twisted, hitting-head-on-desk, kind of way).
frex: 10/23 Anyone with any sort of expertise in the field knows that no one understands this crisis very well
10/23 (in the same post!) CDS's (credit default swaps) are not the main cause of the crisis
10/23 A little knowledge is a dangerous thing
10/23 many liberals have a common theory of how all this happened: Alan Greenspan dunnit.
10/27 All of this seems like a pretty stinging rejoinder to the notion that the problem is simply a failure of regulatory stringence
10/28 I, like Arnold, find it hard to credit the American central bank with this crisis.
Now, you could write a post that points out current conventional thinking, to wit, that when Greenspan kept rates very low there was tremendous pressure on the investment banks to do something, anything, with the money washing around looking for safe higher returns. And in a truly regrettable series of coincidences (or, alternatively, as a predictable result of the Republican party mindset), the IBs found that securitizing mortgages with incredible leverage did just that. And as a result of those returns, ever more money flowed into mortgage lenders, resulting in a death spiral of ever-higher housing prices coupled with ever-riskier borrowers. And since there was no willingness to pull away the punchbowl, a multi-trillion dollar housing bubble, worsened by even more trillions in leverage, was created.
No, you'd rather demonize "many liberals".
As BdL puts it so eloquently, why oh why can't the Atlantic have a better economics writer?
Why not try popping commodity bubbles by increasing the supply, where possible - instead of treating oil companies like pariahs, encourage them to drill and expand even when the price of oil is low - the cost of exploration will be lower and supplies will be expanded. You cannot "just in time" oil reserves.
The credit bubble was the mother of the asset bubbles.
The credit bubble arose because systematic credit creation escaped the bounds of the banking system and moved to Wall Street, and the GSE's. through the mechanism of securitization.
That doesn't let Greenspan or the Fed off the hook. For the great money center banks, and the investment banks which were it's partners, being the Feds 'primary dealers' provided virtually all the short term funding for the credits which were securitized. It wasn't a true honest arms length arrangement. Greenspan et al knew, as Noland in that article and many others alludes to, knew that they were creating their own liquidity in the process.
The GSE's were out of the Fed's purview but let it be known that it was with full knowledge aforethought that Greenspans second great rate cutting period in the early 90's was aimed at getting mortgage rates low. There is no question Greenspan and Wall Street by that time fully understood the golden egg for them that lay in an explosion in credit issuance, even if it wasn't done by them.
To say the least Democrats did not cover themselves in glory in the GSE story but that's a side issue.
Ah, holdfast. The commodity bubble burst already. The supply has not moved a bit in oil, platinum, cooper or wheat. Why did it burst? Because it was a speculative bubble driven by leveraged speculation mostly in their derivatives, ie futures.
Keyah: it's true that the internet bubble came after the LTCM disaster (and on the heels of Y2K) but I was alive then and remember is clearly -- internet stocks were not going up because money was cheap, they were going up because everyone thought the internet was great and was going to revolutionize everything. The internet boom was fueled by equity, both private (VC) and public (IPO and post IPO).
By contrast, the housing boom, and credit bubbles in general, and fueled by credit.
I am not a fan of either bubbles, but have sympathy for the position that it is hard for the Fed to deal with asset bubbles, but no sympathy for the position that it is hard for the Fed to deal with credit bubbles. Controlling credit -- also known as money supply -- is why we have a Federal Reserve.
"Since (usually) the fed simply controls the blunt object known as the fed funds rate, it is impossible to target one sector of the economy."
The Fed does have some other levers, e.g., via Reg T it has the authority to set margin levels on brokerage accounts. During the 90s I wondered why Greenspan didn't use this authority to tighten margin requirements after his "irrational exuberance" speech.
"Ah, holdfast. The commodity bubble burst already."
Jim Rogers, who knows a thing or two about commodities, believes this is a cyclical correction in the continuing secular bull market for commodities. I wouldn't bet against him.
Credit bubbles are easier to detect than asset bubbles, as several commentators have noted. When the investment banks and homeowners were operating on 97% leverage (this was average for homeowners a couple of years ago), and CDOs and credit default swaps were similarly leveraged, a 5% drop in prices would (and did) cause the whole house of cards to collapse. Yet Greenspan refused to regulate subprime loans or swaps, just as he refused to impose increased margin requirements during the dotcom bubble. (Not clear how much the dotcom bubble was fueled by margin, though.) You can have decent rules of thumb for leverage, requiring higher reserves for everything above 70 or 80%, and barring some loans. (Was there ever a reason to allow homeowners to do 100% loans?) That won't be sufficient to pop a bubble, but it will limit it.
Oh come on. There were people predicting that we were in a housing bubble before Ben Bernanke was even appointed. I don't mean the sort of stock-picker predictions that are right by chance, but actual reasoned arguments. Here's one by Benjamin Wallace-Wells:
http://www.washingtonmonthly.com/features/2004/0404.wallace-wells.html
Kling needs to own up that Greenspan is not Always Right. One of these days somebody is going to edit a collection of essays by people walking back their youthful commitments to this particular strain of market-idolatry. They can call it The God That Failed.
When times are good, the real money was made in the sort of speculation which eventually caused the crash. Now that the crash has come, the productive suffer along with the speculators. Hell, it's nothing that a top 90% tax rate on unearned income wouldn't have prevented.
Winterspeak: I pretty much agree with you. Only that we should not underestimate the monetary component of the dot com bubble. Again, what allowed the monetary expansion not to have currency implications (in fact the US$ went up in 1999) was the policy changes in East Asia in favor of large current account deficits as a result of the Asian crisis. The whole thing manifested itself in the form of a large US current account deficit, even in the face of budget surpluses and record low commodity prices (a consequence of the Asian crisis).
Rapier: You emphasize the role of securitization and off-bank financial activity on credit creation. As I've been saying, in Spain we have a bubble that, if anything, is even bigger than that of the States. Still, securitization plays a far smaller role here and the Spanish economy is heavily bank-centric. The common link: lax money.
keyah, The credit bubble and the resulting liquidity flood was a world wide phenomenon. Easy credit and too low interest rates were the engine which doubled the worlds money supply from 01 to 08.
That doubling of total money comes from a World Bank study and what they used to count as money, as in M1 or M3 I don't know but the huge scale of money creation cannot be denied. Bubbles arose in different sectors in different ways in each country.
Ideologs of the right made a fetish of Freidman's monetarism in the 70's and 80's then promptly forgot it. Remembering only, sometimes, that government deficits were a bad thing. They remebered that any time giving money to citizens was involved. If say a war, say in Iraq cost 3/4 trillion but much of the money flowed through the companies of your friends, well then never mind about deficits.
The rise of asset bubbles was a monetary phenomenon. However the money flood bidding up assets was mostly the more abstract measures of money like M3. Money is debt.
Money is created by the issuance of credit. Unless you know that, really know it down to your bones, then you don't know.
Rapier: good thing that you bring out monetary aggregates. Is there a study somewhere correlating asset prices and M(X) in the US and globally since 1996? We know that the final phase of the commodities bubble (September 07-July 08) was closely correlated to M3 growth.
Winterspeak:
There is a difference between the two bubbles, but the dotcom bubble was not purely an asset bubble. The venture funds that fueled it were provided through cheap liquidity created by the Fed to lubricate the transition through Y2K. That bubble started bursting at the end of 1999 when the Fed started cutting off that flow to banks (look for the failure of industrial companies after their Chase lines of credit were cut in Dec. 1999 as an early warning of the Nasdaq pop).
But yes, there are difference. One is that the real estate bubble was far bigger than the dotcom bubble so the deleveraging is that much more painful.
IMO, the cake mix for this bubble includes easy money ingredients dating to the 1998 Long Term capital bailout that set the stage for The Globe IPO and subsequent dotcom bubble which scared many investors into real estate when it burst in 2000.
Other ingredients were:
Those are just some of the main ingredients. There were more.
Good post by dcpi. That last point is really important and a example of how loose monetary conditions distort investment decisions.
There will always be bubbles, but this time around excess leveraged made everything much worse. Watching for and limiting leverage can help moderate bubbles, in this era of explosively increasing amounts of capital as more and more people (and their savings) join the modern world.
The responsibility for preventing excess leverage is distributed around the financial system. The Fed's interest rate control is one piece, but there are many others. One move of doubtful political appeal would be to consolidate this responsibility.
Of note: one place where leverage has increased massively in recent years is among homeowners. The old convention was 20% down (4:1 leverage) with decreasing leverage as the mortgage payments piled up and the home value rose. As Congress pushed the GSEs into "expanding homeownership", downpayments declined and homeowner leverage went up. 10% down is 10:1. 5% is 20:1. 3% down gets you into Lehman territory at 33:1. But we went all the way to 0% down, or infinite leverage. How much leverage is too much for homeowners?
TheGlobe.com -- that brings back memories. That was the biggest one-day move for an IPO ever, right? There was also a restaurant in San Francisco named The Globe that I went to a few times when traveling on business in there. I remember a desert they served there -- a personal-sized peach pie in a small skillet with a big scoop of ice cream on top.
That digression aside, it's clear that, given the enormous bubble we had in the late 90s, the brief, mild recession we had after the dot-com bust was in no way proportional to it (thanks to the flood of liquidity that helped inflate the next bubble). So more excesses built up and we seem to be paying the price now.
Megan -- you state that "lending standards fell everywhere." What's your response to this papers, which argues that lending standards in the subprime market were actually higher after 2004 than in 2001-02? Is the idea that we shouldn't have a subprime market for housing at all?
http://research.stlouisfed.org/wp/2008/2008-036.pdf
Nor do falling interest rates explain the vast influx of foreign capital that unquestionably sustained the bubble; capital is supposed to follow rising rates
Umnnnnhhhh.....
The Fed also had fiscal-policy control, and Greenspan pumped more $GaZillions into the system than anyone ever thought possible. The availability of pure cash pumped the bubble--and cash chasing little return eventually turned to cash seeking larger returns: lousy loans.
I ask this in all seriousness - has there ever been an increase in prices that wasn't a bubble? Didn't Julian Simon teach us that the price of anything that bears on human welfare goes down? Except for the huge increase in stock prices from '95-'98, even the stock market hasn't really seen much in the way of sustained price increases (after inflation). And Bob Shiller claims that the price of houses - except for the recent now-receding bubble - have been basically unchanged for a century. Is there any major asset that has gotten more expensive with time?
This is not a very big planet. It isn't hard to think globally when we need to.
Savings gluts (surpluses of saving over investment) have existed from time to time in a lot of individual countries' economies over the past 150 years or so. Usually, they have got invested in other economies - such as pre-1914 USA. Those investments either yielded profits or losses to the investors: profits were possible because the receiving country invested more as a result of the inflow; losses happend in general because of bad investment decisions, though some losses were caused or accentuated by receiving governments diverting the cash flow to consumption.
This time, the savings glut is exceptionally large. The receiving economies, as managed, provided less than matching investment opportunities, and insufficient investment opportunities were found elsewhere. So the bulk of the savings cash flow was taken up by consumption in the receiving economies; particularly in the USA. This consumption was financed on credit; and the power of the regulatory authorities to raise the price of credit was limited by the sheer mass of money seeking lending opportuniies. The result was a lot of consumption debt which had and has limited prospects of repayment. The banks which borrowed the incoming savings and lent them on are therefore on the hook.
In other words, Greenspan's and Benanke's Feds could (and probably should ) have raised base rates somewhat, but that would not have prevented the main mess we are now in. To have prevented the problem required action on a wider scale than just the USA. We needed to create invetment uses for the excess savings (e.g. massive spending to raise energy efficiencies and cut CO2 emissions? building and maimtaining an infrastructure for Africa? improving transport infrastructures, in the USA and elsewhere) with clear lines of who took the loss when investments tanked. But we didn't (and do not) realise that type of action was what the global economy needed; and we didn't know how (and have scarcely begun to search for ways) to take such action.
Accept that the world as a whole blundered into this mess. The priority now is to find the least costly way out of it. That is sure to include the savings glut counyries increasing consumption. Depending on how much debt we do not find ways of wriggling out of, the rest of us will have to cut some consumption. To keep our economies in some sort of balance, we will need balance that cut with increases in investment and some transitional increases in other forms of consumption. The only way to finance that will be borrowing on public account.
David Heigham: you get the causality relationship wrong. The "savings glut" in East Asia and petrostates is a consequence of the overconsumption in the US (and other countries), along with the political decision made by those countries to hoard up massive current account surpluses in the form of US securities (in order to avoid seeing themselves, again, in the position Thailand was in the spring of 97).
Keyah: Again, I remember the dot com boom very clearly, I was profoundly involved in it, and it was not a credit bubble.
VCs are not funded by debt, they are funded by equity, and low interest rates did not play into anyone's thinking about the value of Pets.com or Kozmo.
When you say "cheap liquidity" i'm guessing you mean low interest rates, which made it easy for VCs to borrow at low rates. This is simply not true. Private equity relies on "cheap liquidity" so it can pile on cheap debt, but not VC. When Netscape IPOd, that was real equity flowing into the sector, and it was simply not credit backed.
I'm not saying that cheap money has not been a problem, but it was not the problem behind the internet bubble. If you can show me a venture fund, or venture backed startup with significant debt financing, I will change my position and admit I was wrong.
There is more of a difference between the two bubbles than "one was bigger".
Let me ask you: do you think there is a difference between an asset bubble (internet stocks, comic books, baseball cards, beanie babies etc.) and a credit bubble (any instrument where financing is a key component of price, such as housing, but also private equity etc.)?
I think this distinction is important because 1) asset bubbles do not cause contagion the way credit bubbles do, 2) asset bubbles are much harder to spot than credit bubbles, 3) asset bubbles are much more benign than credit bubbles and 4) the government, which controls money supply both through the Fed and through credit regulation and the Treasury, can (and should) do something about credit bubbles.
I agree with you that the dramatic increase in money supply (around Y2K) did not show up in CPI was in large part because of China: not only did they make things very cheaply, but they were also eager to trade those for our dollars.
Winterspeak:
- Remember that the willingnes of VC firms to invest large amounts of money in increasingly ridiculous startups was driven by the stock market. They expected to make a splash come flotation day. I remember that 1:10 success ratio was deemed acceptable, since the payout at the time was so huge. And stock market valuations were indeed fueled by cheap money, since leveraged institutions and the search for alpha returns (given the paltry interests paid by traditional instruments) were already playing a very important role. Greenspan recognised that as early as 1996 (the "irrational exhuberance" speech) but decided, because of political reasons and in order to congratiate himself with the I-banks (who were reeling after the 1994/95 bloodbath), not to move rates, a choice for which he was criticied (although not enough). Later, in what was to become his trademark modus operandi, he ended up retroactively rationalizing his politically motivated decissions.
- As for the distinction between credit and asset bubbles as I see them: credit bubbles generate inflation, or to be more precise, credit bubbles ARE inflation, that is, the debasing of the currency. Inflation manifests itself through different symptoms, depending on structural factors that vary from time to time. In a simplified manner inflation can cause classical CPI growth and/or asset bubbles. Monetary authorities can stop inflation at any time by hiking short term rates by a large enough amount (although there is always a time lag). I agree with you that asset bubbles, unlike CPI growth phases, are hard to spot, because agents perceive them as fundamental changes in the economic structure, instead of the temporary illusions that they are. Politically, there will always be enourmous pressure to avoid ending an inflationary bout that causes asset bubbles, because, in the short run, there are many winners and barely any losers. This is where Fed chairman William McChesney Martin's aphorism comes in handy: "the job of the Federal Reserve is to take away the punch bowl just as the party gets going". Greenspan failed this test miserably, both in the 90's and in the 00's.
Skynet, anyone?
Keyah: if I understand you correctly, you are saying that leveraged equity investments in the stock market (through alpha seeking funds) drove high equity prices, which in turn drove VCs backing internet companies, which caused the bubble.
That's funny, I remember all kinds of individual investors piling into Pets.com also. I also have no recollection of people piling into Pets.com because treasury yields were just so darned low. People honestly thought the internet would change the world (which it is) and make everyone very rich (which has worked out in some cases, but not in others).
We may simply agree to disagree here. 1998 was not a long time ago, and people were simply not jumping into internet shares because the Fed was keeping interest rates low. The fact that there are investors out there with leveraged money does not change anything. Internet shares were priced where they were because of "irrational exuberance" or "animal spirits" or whatever you want to call it. They were not priced where they were at because financing was cheap. If you want to disagree feel free.
We would agree that with MBS and CDOs there was a real search for yield going on.
Given your definition of "inflation", please tell me what you would consider to be an asset bubble. We certainly agree on what constitutes a credit bubble, but I'm still not sure what, if anything, would constitute a pure asset bubble to you.
Winrespeak: we might indeed have to agree to disagree. As i see it, leveraged institutions did play a very important role in the formation of the stock bubble (especially those I-banks trying to make up for the losses in fixed income during the 1994/95 Fed hiking campaign). Moreover, lax monetary conditions distort the perception of risk of market participants, and hence you had run of the mill investors joining the party (and, again, had the 30-year T-Bond yielded 9% instead of somewhere around 6% the number of middle class families willing to invest in stocks would've been smaller). The opposite holds true as well, as excesively tight money distorts risk perception the other way (which is what we have experinced since early September). Sure, people believed that any stock with a dot com in its name would make them rich, because the Internet was going to change the world (which, as you say, it is). Investors also believed that condos in Miami would never fall in price, since there was going to be such a big demand for second homes and from retirees; they also believed that Mexican Tesobonos would never default, since Mexico had made so much progress in reforming it's economy; or that Japanese stocks and real estate would only go up, since the Japanese economy was so awsome; or that junk bonds were the equivalent of AAA bonds, since very smart people were behind them; or that Peruvian bonds were a sure bet, since, by the early 80's, sovereign defaults were things of the past; by that time, oil patch wildcatters thought that oil would never fall below 35$, since everybody knew that oil was very scarce, and so they went on a (mal)investment spree; etcetera. There's always a seed of fundamental reality underlying any asset bubble. But fuelling all of them there's always an excessive relaxation of monetary conditions (late 60's and 70's; Plaza Accord - 1988; 1990-1993; 1996-1999; 2001-2005).
I have been reading the comments on this thread and am confused about not be able to spot an asset bubble. I remember the late 90's very well and wanted to get in on the dot com frenzy. However, when I tried to apply conventional stock analysis to these companies there was nothing to analyze. The companies were all losing money and the business plans really did not make sense to me. I think when conventional analysis fails to explain price then there is a bubble. However, predicting when it will burst or how much damage it will do is very difficult. Part of the bubble problem is the herding by investors.
At winterspeak, keyah, and rapier:
Would a 100%-reserve banking system--with merchant banks, capitalized by selling shares and issuing subordinated debt, providing all credit--mitigate against malinvestment resulting from loose monetary policy?
http://cato.org/pub_display.php?pub_id=9759
I recall Ms. McArdle dismissing such an idea as being silly. Is it?
I don't agree with this:
"Nor do falling interest rates explain the vast influx of foreign capital that unquestionably sustained the bubble"
A low USD interest rate makes the dollar carry trade more attractive, pushing down the value of the dollar and making foreign investments in U.S. real estate cheaper.
Andy: I'm with you -- you can spot them pretty easily. I also think it's easy to tell when one's being driven by easy money, and the other is pure herding. Keyah thinks easy money is behind all of them, but I do not, and to me internet stocks fall clearly in the same category as beanie babies.
Clay: There are different issues at work. Firstly, I don't think *anything* can prevent asset bubbles. People are people. (Keyah thinks there are no such things as pure asset bubbles -- other probably do too.)
Credit bubbles can easily be prevented by having the Fed (who controls credit) actually control credit. FRB has nothing to do with credit bubbles because FRB does not create credit. If we changed reserve requirements, it would make no difference to the amount of credit in the world. Since FRB is not the problem, I don't see how 100% reserve banking can be the solution.
Read the Mosler piece linked to in the link below -- his explanation is good, but hard to get through:
http://www.winterspeak.com/2008/10/red-vs-blue.html
The biggest problem I've found is the contagion and amplification effect that is unique to credit bubbles (and also why I keep harping on about credit vs. asset). This contagion is driven by maturity transformation, ie. borrowing short term money to make long term loans. If you turn that off you see non-artificial long term interest rates, and you also avoid this global bank run problem. Some people call this "liquidity risk" but "liquidity" is used in totally sloppy ways, so maybe we should call it "roll-over risk". And you are 100% correct, predicting when the bubble pops (MT turns off) is impossible. Roll-over risk is impossible to hedge against or model.
Eliminate roll-over risk by matching maturity, and credit bubbles may still happen (depending on how the Fed manages money supply) but when it unwinds it will not be a disaster.
Jonathan: Low USD rates pushed Treasury investors into things that were USD like, but offered a little better yield-- basically GSE instruments, MBSs, and CDOs. That certainly fueled the credit bubble.
"This contagion is driven by maturity transformation, ie. borrowing short term money to make long term loans. If you turn that off you see non-artificial long term interest rates, and you also avoid this global bank run problem."
Interestingly, a client of mine owns a firm that does the exact opposite: his firm borrows long and lends short (at higher rates) to provide short-term working capital to small businesses. Not surprisingly, it's a much lower-risk enterprise. His company remains stable and profitable today.
"when does a bubble become a bubble?"
When my house doubled in price in 2 years and my income went up 5%, it was pretty obvious to me (at the time) that we were in a bubble.
I would say it was obvious to many with a shred of common sense - we were just too happy pretending we were wealthy.
Let me modify somewhat what i said yesterday about asset bubbles always beign caused by easy money (and, to a certain degree, concede a point to Winterspeak).
Market participants always make guesses about the future yields of existing assets. And always will tend to show "herd" behavior (as Andy says). And always will make mistakes (along with instances of getting it right) that end up causing price corrections. The problem with easy money conditions is that it takes a lot longer to spot those mistakes. During a process of inflationary growth, pretty much any scheme appears to be potentially successful for a significantly long period, whether it's Pets.com or the indiscriminate use of CDS's a la AIG, because the environment is so (misleadingly) bening. To put it another way, the process of "creative destruction" gets lopsided: there's a lot of "creativity" and not enough "destruction". The market stops self-regulating properly (this is, I believe, a critical point to be made in the debate about deregulation, and the nexus between that debate and the one about monetary policy), and only returns to normalcy through a violent crisis. Abnormaly tight money, the environment we have been in since early September, has, obviously, the opposite effect.
As Ian and Andy say there's a point in any long running bubble where it becomes apparent, by mere common sense intuition, that price levels are unsustainble (Joe Kennedy getting stock tips from a shoe-shine boy before the crash of 29 is a good illustration). The problem is that by the time most people become aware of the "frothiness" (as Greenspan would have it) the damage is already done.
I agree with Winterspeak when he says that the abolition of the FRB would not solve the problem of asset bubble formation, since the central bank could create inflationary conditions all by itself.
The main goal of Hanke's plan that Clay refers to appears to be the suppresion of the risk of bank runs and their nasty consequences (bailouts). It appears to me to be like Glass-Steagall on steroids, in this case, separating credit from deposits. The flaws I see with this plan are:
- You already have the kind of "deposit" banks the plan creates: they're called money market funds (as Hanke himself says).
- The "credit" merchant banks would be the second comming of the, now deceased, independent I-banks (originally created as a result of Glass-Steagall), which, as we have seen recently, are tremendously vulnerable to worsening credit conditions and are thus a source of instability (and bailouts). The only difference is that they would be even bigger (and hence more dangerous), since they would handle all credit.
What evidence is there that Brad DeLong "hates" Alan Greenspan?