Fault Lines: How Hidden Fractures Still Threaten the World Economy (20 page)

The Fed did worry about the deteriorating quality of lending and made some supervisory noises over time. But with its foot pressed firmly on the interest-rate accelerator, the supervisory measures were ineffective. Ultimately, it was probably also Fed actions that brought the party to an end. Higher short-term interest rates raised the payments on adjustable-rate mortgages as well as prospective payments on mortgages with rate resets. With demand for housing falling off (and Fannie and Freddie eventually tempering their purchases of mortgage-backed securities), house prices stopped rising. As a result, overextended borrowers found it hard to refinance before the initially low “teaser” rates on their mortgages expired, and households began to default on payments. Foreclosures caused house-price declines, and the whole momentum of the boom was reversed. The Fed, as we now know, intervened too late. The bubble had inflated enormously, and the ensuing bust has been extremely painful.

With the benefit of hindsight, it easy to suggest that the Fed made mistakes even in the traditional conduct of monetary policy: for instance, it may well have overestimated the risk of deflation. In some ways, though, the threat of deflation seemed to be a low-probability red herring, put forth to explain why the Fed kept rates on hold. The true problem was unemployment, which made raising rates politically impossible. In the past, when economic growth and job recovery coincided, this was not an issue. With jobless recoveries though, growth and jobs became somewhat divorced. The Fed would have to be on hold for a long time if it wanted to see jobs reappear.

For those who believe the Federal Reserve is too independent, the notion that it is subject to political pressure may seem unthinkable. Yet, as Fed governors admit in private, pressure is applied all the time by Congress. Powerful politicians, in off-the-record conversations with Fed governors, frequently make veiled and not-so-veiled threats to scrutinize Federal Reserve activities and reduce its independence unless the Fed complies with their wishes. Although typically they stay off monetary policy, their desires are not hard to read when unemployment is high. Ironically, the Federal Reserve’s desire to remain independent is the lever with which Congress makes it compliant.

At this time, however, the Fed needed little convincing to keep interest rates low. The prevailing orthodoxy suggested that Fed policy makers should worry only if inflation was getting out of hand. And it was not: inflation in the prices of goods (like cars and milk) and services (like haircuts and laundry) was quiescent, and indeed, if anything, the Fed feared deflation. So the Fed was free to focus on the second part of its mandate, full employment. Yet even while the Fed attempted to convince unwilling corporations to invest through ultralow interest rates, the prices of financial assets and housing were skyrocketing. But the orthodoxy suggested asset prices could be ignored.

Rapidly rising asset prices should have sounded alarm bells. They were driven by a number of forces other than the traditional ones: increased risk taking, more foreign money looking for debt claims, and expanding credit.

Low short-term interest rates pushed investors to take more risk, for a number of reasons.
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Some institutions, like insurance companies and pension funds, had contracted long-term liabilities. At the low interest rates available for safe assets, they had no hope of meeting those liabilities. Rather than falling short for sure, they preferred to move into longer-term riskier bonds, such as mortgage-backed securities, that paid higher interest rates. In addition, as long-term interest rates fell and the value of stocks, bonds, and housing rose, households felt wealthier and may have felt the confidence to take more risks. Some of these choices may have been irrational. As my colleague Richard Thaler has argued, when gamblers win money, they take more risks, because they treat their earlier winnings as “house” money—not their own—and therefore less important if lost. Whatever the reason, with investors more willing to take risks, the risk premium on all manner of assets came down.

One effect of the search for yield was that money moved out of the United States into other countries, especially into the high-yielding bonds, stocks, and government securities in developing countries. But many of these countries were fearful of losing out in the race to supply goods to the U.S. market. Their central banks intervened to hold down the value of their currency by buying the U.S. dollars that were flowing into their countries from the domestic private entities that had acquired them and reinvesting these dollars in short-term U.S. government bonds and agency bonds.
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Thus, even as the Fed pushed dollars out, central banks in developing countries pushed them back in. In a number of industrial countries, private entities recycled the dollar inflows: German banks and Japanese insurance companies bought seemingly safe U.S. mortgage-backed securities with the dollars their customers deposited. The money leaving the United States looking for riskier assets around the world thus came back to the United States, looking for seemingly safe but higher-yielding debt-like securities. In some ways, Federal Reserve policy was turning the United States into a gigantic hedge fund, investing in risky assets around the world and financed by debt issued to the world.
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Credit also expanded. Rising asset prices themselves gave households and firms the collateral with which to borrow—a channel that Chairman Bernanke himself had pointed out when he was a professor at Princeton University.
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Indeed, much of the financing of low-income borrowers was predicated on house prices rising and borrowers refinancing once the low teaser rates ran out. Thus a higher house price, rather than increased income, was the means through which borrowers would keep themselves current on payments.

In addition, the promise that liquidity would be plentiful over the foreseeable future meant that bankers were willing to make longer-term illiquid, and hence risky, loans.
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But with firms unwilling to invest, banks went looking for deals that would create demand for loans.
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One option was for private equity investors to acquire firms, relying on banks to finance the deals. Banks, in turn, packaged the loans they made—creating collateralized loan obligations (CLOs)—and sold debt securities against them, thus obtaining the funds to make yet more loans. The result was that larger and larger leveraged acquisitions were proposed to satisfy the seemingly insatiable investor hunger for debt claims. As the rush to lend increased, lending standards declined rapidly: the classic signs of the frenzy were “covenant-lite” loans, bereft of the traditional covenants banks put in to trigger repayment if the borrower’s condition deteriorated, and pay-in-kind bonds, schemes by which borrowers who could not pay interest simply issued more bonds. As I argued earlier, the recent crisis was not caused only by lending to the poor!

Rising asset prices would not be a problem if markets were well behaved and kept asset prices tied to fundamentals. In the case of housing, prices should be a function of interest rates, local demographics, household incomes, and local zoning regulations constraining the supply of housing.

Unfortunately, asset price growth can be self-reinforcing. For instance, higher house prices give existing homeowners home equity that they can borrow against to make the down payment for better houses, leading to a rise in prices for those houses as well. And a history of house price growth can lead naive new home buyers to swallow their real estate agent’s sales pitch and put their money down expecting the price appreciation to continue. Indeed, for a while such expectations may be logical, because there are many more existing homeowners with enough home equity to move up.

In most markets, savvy investors can take a contrarian position when prices depart too much from fundamental value. In the housing market (as well as in the market to take firms private), few opportunities exist for investors to take a short position—that is, sell houses they do not have so as to make a killing when prices fall. This typically means that the optimistic, who buy housing, tend to have undue influence.
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So house prices, and more generally, asset prices, can rise excessively, and their reacquaintance with reality can be brutal indeed.

Central bankers argue that they really should not be in the business of figuring out when asset prices are too high: after all, do they really know that much more than market participants? This not a silly argument. Many markets work well by themselves, and introducing the whims and fancies of the central bank governor into the way prices are determined could create more problems than it solves. But history warns that markets such as housing, which are driven by bank lending, are different: not only are they very thin (relatively few house sales determine the value of housing for the whole country), but they also do not allow for investors to take short positions. Prices in these markets can run away from fundamentals. And the adverse spirals associated with house-price busts can be very damaging indeed : as prices fall, lending vanishes, and people cannot repay their mortgages; thus foreclosures increase, and prices drop further.

The key warning signal of unsustainable growth in asset prices is an accompanying growth in credit.
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Before the crash of 1929, the warning signal was the growth in margin loans against shares even as stock prices increased. Before the most recent recession, alarm bells should have sounded in every central bank meeting as a boom in real estate lending accompanied house price growth, and lending to private equity grew with ever-higher transaction prices. Indeed, credit growth has historically been one of the factors determining how central bankers set policy interest rates; but in recent years, academics have persuaded many of them that such behavior is archaic. To their credit (no pun intended), the European Central Bank and some developing-country central banks, like the Reserve Bank of India, have continued to pay attention to credit growth in determining their monetary policy.

Rapid credit growth was deemed of importance in the past partly because it was thought to presage inflation and partly because it reflected a possible deterioration in the quality of credit. Academics argued that the links between credit growth and inflation were tenuous (here they were right) and that credit problems were a historic curiosity in industrial countries because of improvements in bank management and supervision (here they were obviously wrong).

A second argument central bankers offer is that in the midst of a frenzy, when investors expect double-digit rates of price growth, raising rates by a fraction of a percent is ineffective.
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There are two difficulties with this argument. First, the key issue is expectations. If the central bank can convince investors that it is serious about fighting asset-price inflation—in the same way as it convinces them it will fight goods-price inflation—expectations about price growth can deflate fast, especially in the early stages of a bubble. Put differently, small changes in the central bank interest rate can affect expectations about price growth considerably. The fact that asset prices are growing at double-digit rates does not mean that policy rates have to be raised commensurately. Second, bubbles develop based on a kind of “greater fool” theory—that even if an asset is already trading at an inflated price, someone will be willing to buy it at an even more inflated price. By signaling that it will tighten liquidity conditions, and thus constrain financing and trading, the central bank can signal to investors that there will be fewer fools out there with the capacity to buy, making it more difficult for the bubble to grow.

Indeed, instead of discouraging the development of bubbles, the Fed encouraged it through an implicit commitment, which might have done far more damage than any other Fed action. This commitment, the so-called “Greenspan put,” essentially said that the Fed could not really tell when asset prices were building up into a bubble, and so instead the Fed would ignore asset prices but stand ready to pick up the pieces when the bubble burst. To understand why this commitment was made, we need to go back to 1996.

In late 1996, the Fed chairman, Alan Greenspan, an astute and experienced (though somewhat ideological) economist, became concerned about the high level of the stock market. In a famously brave speech at the American Enterprise Institute, he wondered whether the central bank should also worry when the prices of real estate, equities, and other earning assets were rising rapidly. And in the opaque language that he had perfected, he came as close as a central banker can to saying he thought stocks were overvalued:

In his autobiography, Greenspan admits wondering whether the market would understand what he was getting at.
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It did—and ignored him! The stock market opened substantially lower the next day but regained its losses in a day. And it was right to ignore him, because the Fed did not follow up Greenspan’s concern with an increase in interest rates, even though he had hinted at such action in his speech. Greenspan never explained why he did not act: quite possibly his hand was stayed by the furious reaction he engendered when market participants realized he was trying to talk the market down.