Wednesday, November 13, 2013

Mr. Greenspan's Feet of Clay

Alan Greenspan is now doing the talk show circuit, promoting his new book "The Map and the Territory: Risk, Human Nature and the Future of Forecasting".  Within its pages, the former head of the Federal Reserve attempts to explain how economic risk works and how we can better forecast what lies ahead economically.  It provides us a glimpse into the mind of the world's head banker and how it is that he failed to see the coming signs of doom during his tenure.  To that end, I think that it is important to look at the "sage's" own words and let them determine his real contribution to the current economic malaise affecting the world's economy.

Let's open by looking back to a Federal Reserve Board Discussion authored by Alan Greenspan and James Kennedy back in March 2007 entitled "Sources and Uses of Equity Extracted from Homes".  Here is the opening paragraph:

"The rise in the market value of homes since the early 1990s has led to a substantial increase in the level of housing wealth (figure 1). However, since the mid-1980s, mortgage debt has grown more rapidly than home values, resulting in a decline in housing wealth as a share of the value of homes (figure 2)."

Here is figure 1 showing the rise in the level of the value of housing, mortgage debt and housing wealth:

Here is figure 2 showing that the rate of mortgage debt growth exceeded the equity that home owners had as a share of the total market value of housing:

Here is a graph from another paper by Mr. Greenspan showing how much overall home equity extraction grew from 1991 to 2005:

In 1991, $262.2 billion worth of free cash was generated from home equity loans, this grew to $1428.9 billion in 2005.  Between 1991 and 2000, an average of $299.6 billion in home equity loans were generated annually; this rose to $997.4 billion between 2001 and 2005, more than triple the rate of the 1990s.

Mr. Greenspan and Mr. Kennedy estimated that extraction of home equity accounted for 80 percent of the rise in home mortgage debt from 1990 to 2005, a rather staggering share.  What is even more interesting is that the equity cashed out of homes was mainly used to repay non-mortgage debt, mainly in the form of credit card loans, a form of bridge financing for consumers.  Between 1991 and 2005, home equity loans were used to repay an average of $50 billion annually in consumer debt or about 3 percent of the total outstanding balance every year.  Annually, over the same time period, about $66 billion was used to fund personal consumer expenditures so, when we sum the two, home equity extraction funded an average of $115 billion of consumer expenditures annually between 1991 and 2005.   

Let's step away from Mr. Bernanke for a moment.  A 2006 paper "How Large is the Housing Wealth Effect" by Carroll, Otsuka and Slacalek in 2006 stated the following:

"...about half of the decline in the fraction of income that Americans save, from 6.5 percent in 1995 to 1 percent by 2001, is attributable to increases in real estate and financial wealth. Virtually all of the decline in consumption occurring from the stock market decline of 2000-2001 is offset by rising consumption from real estate wealth. Real estate smooth and stabilizes consumption when other assets are performing poorly."

Economists in the early 2000s were puzzled about why consumer spending kept growing in spite of the drop in the stock market seen as one of Mr. Greenspan's bubbles burst.  The authors of the paper suggested that a one dollar change in household wealth (in this case, from housing values) would have a two cent immediate impact on the marginal propensity to consume and a long-term nine cent impact on consumption.  The authors also stated that:

"This large estimate of the housing wealth effect suggests that markets and policymakers do need to pay careful attention to property prices. But the sluggishness of the estimated adjustment process also suggests that policymakers typically will have plenty of time to react to housing wealth effects as they make their way through the pipeline." (my bold)

Apparently, that was clearly not the case.  Bankers did not pay attention and they did not have plenty of time to react to housing wealth effects that, seven years later, are still rippling through the economy.

Now, let's go back to Mr. Greenspan's musings on the housing market, particularly as it related to the level of personal savings:

Personal savings (the dark line) dropped into negative territory in early 2005 and remained there until the time that this paper was released in 2007.  Yet, this did not seem to overly concern Mr. Greenspan and his band of fellow merry central bankers.

So, despite the fact that mortgage debt was growing faster than the rate of home equity growth, that home equity extraction in the early 2000's was at three times the level of the 1990s and that the savings rate was negative, Mr. Greenspan was unable to contemplate the possibility that the housing market was about to implode and that the entire house of cards built around the housing bubble that his policies created was about to collapse.  Even when presented with less than robust housing data from his Federal Reserve Bank Governors at his last meeting as Fed Chair on December 12, 2006, his comment to those present at his last FOMC meeting was:

"In the first part of the economy— the goods economy, housing and manufacturing—there seems to be some softening since the last meeting but not a large change. Housing remains the center of the weakness. There are some indications that demand for housing may be stabilizing, but a few people noted that there are probably still some downside risks in that sector."

This is what happened to housing prices after his "there are probably still some downside risks" in the housing sector comment:

From the first quarter of 2006 until the first quarter of 2012, the average real price of a home in the United States dropped from $284,403 to $162,940, a drop of 42.6 percent.

Let's move ahead to the present and future of central bank policy making.  Now that it's more than obvious that central bankers have feet of clay, it will be interesting to see how long it takes before they figure out that this:

...and this:

for which they are solely responsible, are going to create the next economic crisis.


  1. Great article, in the defense of Greenspan he did on occasion raise interest rates and often near the end spoke of "conundrums" that indicated he did not have all the answers or was declaring smooth sailing ahead. Many people lay the blame at the feet of Greenspan because of his long stay at the Fed from 1987 to 2006. I contend Bernanke is responsible for much of our problems today because he picked up a shovel and started digging at a faster rate when he discovered we were already in a hole.

  2. What makes your article great is that it highlights what drove our economy forward for so many years. It also points out why this "false" growth was unsustainable. Central banks have tried to address the situation by printing money and adding liquidity. This is their equivalent of a band-aid, and they have been putting one band-aid on top of another, but our wounds are not healing. More on the current situation below,