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Alan Greenspan and His Bubbles


Alan Greenspan now says that we are seeing a housing bubble. He expects a large single-digit price decline “as a minimum” and would not be surprised by a double-digit decline in house prices nationwide.

This is a huge deal. A 15 percent fall in prices over the next three years implies a loss of almost $3 trillion dollars in housing wealth. After adjusting for inflation, the loss would be close to $4 trillion, more than $50,000 for every homeowner in the country.

Since the bubble was unevenly spread across the country the impact will be much worse in some areas. A 15 percent nationwide decline in house prices almost certainly means declines on the order of 30 percent in the most affected markets. People who paid $600,000 for a home last year will find that it’s worth $400,000 next year.

And, house prices are not coming back. The meaning of a bubble is that the bubble prices don’t make sense. The Nasdaq may have regained some ground from its 2002 lows, but its not going back to its bubble peak of 5000 any time soon. Once home prices stop falling from their bubble peaks, they can be expected to rise in step with inflation, just as they did for the hundred years prior to the bubble.

This decline in prices will have a huge impact on the economy. Most immediately, the housing sector will continue the contraction it has already begun. We will likely lose more than a million jobs in construction, real estate, mortgage banking and other housing related sectors.

Collapsing house prices will also lead to more turmoil in the huge secondary mortgage market and the market for mortgage backed securities. The crisis will go far beyond the subprime sector. We have only seen the beginning of the financial turmoil from the collapse of the housing bubble.

However, the biggest effect will be the impact that the loss of housing wealth will have on consumption. As the bubble expanded, people borrowed against housing equity almost as rapidly as it was created. The Fed estimated that a dollar of housing wealth translates into 5 cents of additional consumption. This story works in reverse also. A loss of $4 trillion in housing wealth will lead to a reduction of approximately $200 billion in annual consumption. This drop in consumption, coupled with the downturn in the housing sector, virtually guarantees a recession, and quite likely a very severe recession.

In short, by acknowledging that we face a housing bubble, Greenspan is acknowledging that we face some extremely difficult economic times ahead and that tens of millions of homeowners will lose much of their life’s savings.

This raises the obvious question, if Greenspan saw this train wreck coming, why didn’t he do anything to stop it while he was chairman of the Fed. Greenspan’s position seems to be that there was nothing that the Fed could have done to contain the housing bubble or the stock bubble before it.

In fact, the Fed has enormous power to reign in financial bubbles. First, it has regulatory authority. For example, it could have written regulations that prohibited the banks under its control from writing predatory mortgages, as it has actually done this year. The Fed also can raise interest rates, a policy that would hurt growth, but is likely preferable to the dangers of a housing bubble, if not a stock bubble.

Most importantly, the Fed and its chairman can provide information. If Greenspan had carefully documented the evidence that there was a housing bubble when he was Fed chairman, rather than dismissing those of us who made this argument, it is likely that the bubble never would have grown to such dangerous levels. Clear warnings from the Fed chair might have made potential homebuyers more careful and made investors less anxious to throw away money making bad mortgage loans.

Perhaps Greenspan really could not have prevented the housing bubble, as he seems to believe. But the fact that he never tried was an enormous failure, which more than offsets all the successes of his tenure, which will become clear as the meltdown continues.

 

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. (www.cepr.net).

 

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