Alan Greenspan and the Housing Market

Alan Greenspan and the Housing Market: Is the Former Fed To Blame For the Real Estate Meltdown?

by Dr. Mark Skousen, Advisory Panelist, Investment U
Monday, August 20, 2007: Issue #703

Last week, AOL polled its readers to place the blame on the mortgage meltdown that has brought Wall Street to its knees. According to the poll, 55% of subscribers blamed the banks, 17% blamed the homeowners, 15% blamed investors, and only 13% blamed the housing market issues on Alan Greenspan and the Federal government.

To understand the real culprit for this “market failure,” I am reminded of an old parable in the Bible

In the parable of the wheat and the tares (Matthew 13:24-30), Jesus tells the story of a wheat farmer whose crop comes under attack by an unknown assailant. In the middle of the night this enemy sows tares (weeds) in his wheat fields.

Soon the farmer’s servants discover that the farmer’s crop appears to be twice the normal size. Yet the master realizes that half the crop is fake – weeds instead of wheat. But he warns his servants not to tear out the weeds for fear of uprooting the good shoots; they must wait and let the wheat and the tares grow up together until harvest time.

Months later, the wheat produces good grain, while the tares are merely weeds and provide no fruit. The servants pull out the weeds and burn them, and store the grain in the barn.

The parable is imminently applicable to the recent wild ride on Wall Street

Real vs. Artificial Growth

In today’s robust global economy, the wheat represents genuine prosperity – the new products, technologies, and productivity generated by capitalists and entrepreneurs. It represents real economic growth, and when harvested, reflects a true higher standard of living for everyone. Under such conditions, stock prices are likely to rise.

On the other hand, the tares represent artificial prosperity that bears no fruit in the end and must be burned at harvest time. Where does this artificial growth come from? The central bank’s “easy money” policies! The Fed artificially lowers interest rates and creates new money out of thin air (through open-market operations).

This new money, like regular savings, is invested in the economy and stimulates more growth and higher stock prices – higher than sustainable over the long run.

Since the 9/11 terrorist attacks, investors put most of the new money in real estate, and the banks and financial institutions encouraged them with their easy terms.

Is Today’s Financial Devil Former Fed Chairman Alan Greenspan?

Who is the enemy who sows artificial prosperity in real estate and stocks? Alan Greenspan. (Or, to be more accurate, the Fed and central bankers.)

Starting in 2002, Greenspan & Co. aggressively expanded the money supply and lowered interest rates far below the normal market. Greenspan himself admitted (wrongly, it turned out) that he feared that the U.S. would go the way of deflationary Japan. His Fed gradually cut rates to 1% by 2003.

Not surprisingly, the new money went into risky mortgages. The banks and investment companies found it extremely profitable to encourage profligate homebuyers to buy bigger and bigger homes with little down and less financial background checks.

Look at the following chart, courtesy of Jerry Bowyer.

As Greenspan & Co. lowered the Fed Funds Target Rate from 6% to 1%, banks borrowed cheaply from the Fed window, and invested in risky mortgages. The subprime mortgage market took off like a rocket, from 2% to 14% of all mortgages over a five-year period (2000-2005). In 2003, the year of the great money flood, when the Fed cut rates to only 1%, the subprime lending went from 4% of total lending to more than 10%. That’s in one year!

But there is no free lunch, as sound economists have warned repeatedly. At some point, the harvest time comes and the wheat must be separated from the tares. This is the crisis stage, where the boom turns into the bust. Now it’s harvest time, and we are weeping the effects of the Greenspan era.

Our Current Housing Market The Greenspan Blunder?

On August 7, The Wall Street Journal did a major front-page story on “How Credit Got So Easy And Why It’s Tightening.” The authors quoted Greenspan saying in 2003/04: “I don’t know what it is, but we’re doing some damage because this is not the way credit markets should operate.”

Moreover, at the time, Greenspan brushed off an idea to boost scrutiny of subprime mortgage lenders. A former Fed governor told The Wall Street Journal that he proposed to Greenspan in or around 2000 that the Fed should start sending examiners into the offices of consumer-finance lenders that were units of Fed-regulated banks. But the Fed official said, “He [Greenspan] was opposed to it, so I didn’t really pursue it.”

The lesson is clear: There is no market failure here. The collapse in the subprime lending market and the subsequent credit squeeze can be laid at the feet of our Fed officials, primarily Alan Greenspan, the so-called “maestro.” And now we are paying the price.

Only the Fed can extricate out of this mess, and not surprisingly, it is working in concert with the other central banks to inject massive liquidity to bail out the banking system. But it hasn’t been enough to forestall a financial crisis. Last Friday, it wisely cut the Discount Rate by half a percentage point, but it will probably need to do more before the credit and stock markets show a solid recovery.

When will we learn? Globalization and supply-side, free-market policies have justified genuine economic growth and higher stock prices over the past two decades. But “easy money” policies have at the same time created an artificial boom and “irrational exuberance” on Main Street and Wall Street.

Ignore this lesson at your own peril. Remember the parable of the wheat and the tares.

Good trading,

Mark Skousen

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