Comment 69: In defense of Alan Greenspan: What is the real cause of the housing bubble? (July 12, 2009)

Major financial media treated Alan Greenspan like a god when he retired as the chairman of The Federal Reserve Board (abbreviated as FED) in early 2006. We wrote Comment 27 at that time to pour cold water on the Greenspan mania, pointing out that as a major steward of the current globalization scheme, Greenspan’s reputation will be tied to the eventual success or failure of the globalization scheme. However, since the burst of the housing bubble and the resulting global financial crises many are now blaming Greenspan’s very low short-term interest rate policy from late 2001 to early 2004 as the culprit of generating the housing bubble. We need to approach this claim against Greenspan with caution since the short-term interest rate controlled by FED is not necessarily synchronized with the mortgage interest rate and the availability of mortgage money both of which define the housing bubble. The key to uncover the real cause of the housing bubble is thus to understand the reasons behind the movement or the lack of it in the mortgage interest rate and the availability of mortgage money. If Greenspan’s very low short-term interest rate policy was indeed the culprit, the avoidance of very low short-term interest rate will be enough to prevent the recurrence of future bubbles. If the greed of Wall Street, another popular thinking about the cause of the housing bubble, is to blame, tighter regulations on Wall Street will be the answer. If neither is the real cause of the housing bubble, casual injection of massive amount of money into the system as currently underway is certain to generate another bubble. Apparently in depth studies of the cause of the latest housing bubble are important for us to understand the future course of the U. S. economy.

FED controls short-term interest rate by targeting the interest rate of the federal funds market. The federal funds market is the facility for major financial institutions to make overnight loans and borrowings among themselves. FED injects liquidity into or withdraws liquidity from the financial system through open market operations, that is, to trade short-term U. S. Treasuries with major financial institutions. When FED wants to inject liquidity into the financial system, it buys short-term U. S. Treasuries from major financial institutions and pay those institutions with cash equivalent dollar credits that are created from thin air, or more accurately by a few computer key strokes. Flush with dollar credits major financial institutions do not need to borrow so vigorously among themselves, and as the result interest rate of the federal funds market falls. If FED wants to drain liquidity from the financial system, it sells short-term U. S. Treasuries to major financial institutions and takes away dollar credits from their accounts kept on FED’s computer. Deprived of those dollar credits major financial institutions are forced to bid more vigorously to borrow in the federal funds market, and push up the interest rate of the federal funds market. The movement of overnight interest rate of the federal funds market propagates quickly to other liquid short-term interest rates like the interest rate of 3 month T. Bill. Throughout this comment we use 3 month T. Bill rate as the representative of short-term interest rate instead of the unfamiliar interest rate of the federal funds market. In the following graph monthly averages of the interest rate of 3 month T. Bill are plotted as the blue curve, and monthly averages of 30 year fixed interest rate mortgage as published by Freddie Mac are plotted as the red curve to serve as the base of following analysis. Also included in the graph are monthly trade deficit of goods and services as the green curve, and monthly trade deficits of goods less food and industrial materials as the purple curve (majority of deficits of industrial materials is due to the import of crude oil).

Let us start from the left most portion of the blue and the red curves in the graph. During the period from the beginning of 1997 to the fall of 1998 the blue 3 month T. Bill curve went sidewise, indicating that FED’s monetary policy was on hold during the period, but the red 30 year mortgage rate curve declined about 1 %. This period was the first part of the second phase of the runaway U. S. trade deficit fueled by the rapid rise of U. S. Dollar vs. Japanese Yen, the result of near-zero interest rate in Japan that unleashed the torrent of yen-carry-trades as discussed in article 1. The runaway trade deficit inevitably generated a credit/debt/stock-market bubble as will be discussed later, and made a lot of mortgage money available so that the mortgage rate declined. The sudden drop of the blue short-term interest rate curve in September, 1998 was due to FED’s emergency easing of monetary condition in order to cope with the near collapse of a giant hedge fund; the trouble of the fund was induced by the Russian currency crisis. After the economy weathered the 1998 Russian currency crisis and 1999 Latin America currency crises, both of them were the after shocks of the Asian Financial Crises as discussed in article 1, FED turned to raise short-term interest rate in order to curb the increasingly overheating stock market bubble. The rush of money into stocks adversely affected the mortgage money at the time when the demand of mortgage had risen following the explosion of stock prices. Thus 30 year mortgage rate had leveled off in the latter part of 1998 and then turned upward following the rising short-term interest rate.

Trade deficit usually lags behind the movement of currency exchange rate by one to two years since the flow and ebbs of factory productions cannot respond to the changing currency exchange rate quickly. U. S. Dollar had suffered a sharp fall vs. Japanese Yen during the 1998 Russian currency crisis, and again in 1999 when the Latin America currency crises hit. Thus in the spring of 2000 the torrid growth rate of trade deficit had started to slow as can be seen from the green curve in the graph. The reduced influx of dollars forced the stock prices to top out around the middle of 2000. With the peaking of stock markets the demand of mortgages waned, and the 30year mortgage rate had started to drop from its peak at May, 2000. Greenspan FED was slow to recognize the changing economic condition and had kept short-term interest rate rising until November of 2000. FED had turned to aggressive lowering of short-term interest rate only when the 2000-2001 recession had already hit the U. S. economy.

According to the definition and characterization of recessions adopted in article 12, the 2000-2001 recession started in the fall of 2000, reached its nadir in the second quarter of 2001 and ended near the end of 2001. The recession was a rare “U” shaped recession, meaning that the recovery was slow and uneven even after the official end of the recession. Greenspan had been lowering short-term interest rate aggressively since December of 2000 to fight the recession, but at the aftermath of 911 tragedy Greenspan lowered the short-term interest rate one more notch. Due to the sluggish recovery from the recession disinflation had turned into no inflation. From the fear that zero inflation will turn into deflation, Greenspan lowered the short-term interest rate further to about 1% and held at that level until the spring of 2004. Greenspan’s very low interest rate policy shrank the difference between U. S. short-term interest rate and the short-term interest rate of Japan drastically. Something like reversed yen-carry trades had occurred, and U. S. Dollar fell sharply vs. Japanese Yen. If not for Japanese Government to come into currency markets and to buy 400 billion dollars from the fall of 2003 to the spring of 2004, U. S. Dollar would have collapsed down further to an uncertain economic consequence. At the spring of 2004 Japanese Government was exhausted and stopped to intervene in the currency market. The burden of defending Dollar was returned to the shoulder of FED so Greenspan had started to raise the short-term interest rate to defend Dollar. Greenspan probably had also started to worry about the gathering heat in the housing market so he raised the short-term interest rate aggressively. By early 2006 when Greenspan retired, the red 3 month T. Bill rate had already moved above 4% level. However, 30 year mortgage rate had stuck at 6% level in spite of Greenspan’s short-term interest rate raising campaign as the red curve in the graph shows. Greenspan dubbed the divergence of long-short interest rates of that period as “interest rate conundrum”. The persistently low mortgage rate in the period from the spring of 2004 to the spring of 2006 became the critical factor that had allowed the housing bubble to inflate to its 2006 pinnacle, but not Greenspan’s very low short-term interest rate policy of the preceding period, that is, from the spring of 2002 to the spring of 2004.

Many main stream economists and Wall Street analysts have missed the importance of “interest conundrum” in the inflation of the housing bubble, and have erroneously blamed Greenspan’s very low short-term interest rate policy of the previous period as the culprit. Those experts have missed the momentous implications of the “interest rate conundrum”, too, because the divergence of short-long term interest rates means that the potent monetary tool of FED to use the control over the short-term interest rate to influence the outcome of the U. S. economy has lost its effectiveness! Why is the “interest rate conundrum”? Why had FED’s monetary weapon lost its effectiveness at the very moment of need to control the runaway housing bubble? The answer in short is the runaway trade deficit. As early as article 1 of December of 1998, followed by article 2 and article 2A, evidences that runaway trade deficits create bubbles and the wane of trade deficits burst the bubbles have been presented in those writings. The mechanism how runaway trade deficits induce creit/debt/stock-market bubbles is analyzed in article 10, and those findings are summarized in Sections 4 and 5 of article 12. Furthermore in article 10 it is pointed out that FED’s monetary weapon of controlling the short-term interest rate loses its effectiveness during the bubbles generated by the runaway trade deficits. The bitter fruit that Greenspan had tasted in the form of “interest rate conundrum” was a typical realization of the observation of article 10.

The next question that arises from the discussion so far is what have happened in the trade deficit front. Earlier we have mentioned the sharp drop of U. S. Dollar vs. Japanese Yen during Greenspan’s very low short-term interest rate period. Why the sharp drop of Dollar vs. Yen did not curtail the third phase of runaway trade deficit earlier so that the housing bubble could be prevented to inflate to its full capacity? At the time of FED’s attempt to control the housing bubble, China and India have been rising rapidly in the supply chain to the consumption boom of U. S.. Their currencies are pegged to U. S. Dollar and are not influenced by the devaluation of Dollar vs. Yen so the effect of dropping Dollar vs. Yen on U. S. trade deficit was damped substantially. Developing countries like China and India are by definition not efficient users of raw materials, especially crude oil. As the result the booming productions in those developing countries translated to the demand pressure on crude oil price. Higher crude oil price meant larger U. S. trade deficit as the rapid rise of the green trade deficit curve in the graph shows. Another bizarre twists of this whole matter appeared during the period of our concern. Runaway trade deficit of U. S. means runaway trade surplus of developing countries, especially China. Bt 2005 China’s official dollar reserve has already rival that of Japan. Japanese Government manages its vast dollar reserve in close cooperation with FED, so its dollar reserve was directed toward buying of short-term U. S. Treasuries when Greenspan was raising short-term interest rate in order to push up the mortgage rate and rein in the housing bubble. China managed her vast dollar reserve alone, and continued to buy long-term U. S. Treasuries and Fannie Mae papers issued with the aim to provide more mortgage money to the housing bubble. Thus the miscommunication between Greenspan and China enhanced the “interest rate conundrum” further. Apparently if the runaway trade deficit goes to extreme, both U. S. monetary and economic policies will be controlled by foreign governments that hold enormous dollar reserves as depicted in article 7. Utilizing the information about currency exchange rates, trade deficit and bubble, we have been able to project in Comment 21 of June 23, 2005, titled "Dissecting the conundrum of long-short yield difference", that the current recession will start at the end of 2007. Later on, following the definition of recessions adopted in article 12 it has been determined at the end of October of 2008 that the current recession has started in the first quarter of 2008, whereas National Bureau of Economic Research, the official arbiter of recessions, has dtermned at early December of 2008 that the current recession has started at the end of 2007.

Looking forward into the future, we need to ask whether the runaway trade deficit and the accompanied bubble will return. The major reason of the runaway U. S. trade deficit is the highly inflated Dollar due to the persistent currency market interventions in the hands of the governments of exporting countries in order to prevent rapid appreciation of their own currencies against Dollar. At the present there is no sign that this problem of government interventions in the currency market will be addressed. If a robust economic recovery comes, we should expect that the runaway U. S. trade deficit and another bubble will reemerge. According to the analysis of article 12, the magnitude of the new phase of runaway trade deficit and the size of the next bubble will exceed the magnitude of the third phase of runaway trade deficit and the size of the latest housing bubble respectively. Ironically the only way to prevent the recurrence of the runaway trade deficit and the bubble under the current set up of the globalization scheme is not to allow U. S. economy to grow strongly. Let us hope that the global community has the wisdom to address the problem of highly inflated Dollar in time so that both the U. S. economy and the global economy are allowed to grow at a steady but measured pace without further runaway U. S. trade deficits and bubbles.