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Generational Dynamics Web Log for 25-Oct-06
Alan Greenspan blames the housing bubble on the fall of the Berlin Wall

Web Log - October, 2006

Alan Greenspan blames the housing bubble on the fall of the Berlin Wall

Meanwhile, the stock market keeps skyrocketing and appears unstoppable to many investors.

I've been wanting for a long time to write a comprehensive exposition of a "Generational Dynamics theory of macroeconomics," and I finally posted it today as "System Dynamics and the Failure of Macroeconomics Theory." I hope any web site readers with an interest in macroeconomics theory will read it and let me know what you think.

The economy is so crazy these days that it's hard to see where any theory has anything to do with it. Just when the market has gone so high up into bubble territory that I think that investors can't possibly be such fools as to buy, they push it up higher. The Dow advanced a huge 114 points on Monday, and 11 more today. On Monday, the long-term trend value of the DJIA was 5074, and the market closed at 12117, which is 238% of the trend value. The figure 238% indicates how high the bubble is. In 1929, the market peaked at 254% of trend value, so maybe that means that the Dow has another 1000 points or so to go before the bubble bursts. Even so, this stock market panic is well overdue, even though it's impossible to predict the exact date of a stock market panic.

On Friday, I heard a TV financial pundit say that the market is doing so well that small investors are coming back in. Maybe that's where all the new investor money is coming from. Isn't that wonderful? Ordinary people who lost big after the Nasdaq crash in 2000 are now betting their pensions and 401k's again, now that the market is near the top of a new bubble.

Greenspan and the Berlin Wall

And now, if things aren't crazy enough, Alan Greenspan is giving a brand new reason for the real estate bubble:

"I don't think that the [real estate] boom came from a 1 per cent Fed funds rate or from the Fed's easing. It came from the collapse of the Berlin Wall," said Alan Greenspan to a private Canadian audience on Friday.

Ten months after leaving the Fed, he appears to want to rewrite his legacy.

Here's a summary of the reasoning that Greenspan used:

The collapse of Communism in eastern Europe and the shift towards more market-based economies in China and other parts of the developing world brought "billions of cheap laborers onto the scene."

Thanks to this flood of cheap labor, manufacturing and other labor costs became much cheaper, and prices of good came down -- in other words, this caused disinflation, rather than the inflation that we usually hear about caused by increasing labor costs.

Because of disinflation, long-term interest rates also came down.

Lower long-term interest rates caused a decline in mortgage rates.

Lower mortgage rates mean that a real estate property is more valuable, since a buyer can afford to pay more for the property and still have the same monthly payment to the bank.

This caused the market value of real estate to grow quickly, creating a bubble.

This represents a substantial evolution in Greenspan's thinking.

Greenspan has solved his 'conundrum'

If you've been following Greenspan for a while, then you may recall the word "conundrum." In a speech early in 2005, Greenspan said that long-term interest rates and bond yields were exceptionally low in countries around the world, and that this "remains a conundrum." Here's what he said:

"There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

Notice this sentence in particular: "But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization."

Well, guess what, folks? Greenspan has changed his mind. He's resolved his conundrum. He's now decided that the long-term interest rate declines that caused the housing bubble were in fact caused by the cheap labor resulting from globalization.

The problem is that this makes no sense at all, for the reason given by Greenspan in this same sentence: "But none of this is new ...."

Cheap labor has been around for decades, even from China, as well as many other countries. There was no significant difference between 1983, 1993 or 2003 with regard to cheap labor, but it didn't cause a real estate bubble in those other times.

(This is the kind of argument that we use all the time in generational theory. Terrorist events and acts of war happen all the time; what changes is the generational era, and that affects the reactions of the population to the events. Cheap labor has been around all the time, but what's different now is America, not the cheap labor.)

There's really little doubt what caused the real estate bubble. It was caused by the Fed's near-zero interest rate policy, which poured money into the economy, and to the fact that other central banks around the world followed the Fed's lead in that regard, leading to a huge money liquidity around the world. It's particularly worthwhile to note that the Chinese currency was pegged to the dollar until recently, and so the Fed's near-zero interest rate effectively became the near-zero interest rate of the People's Bank of China.

Diffusing the bubble

Greenspan made some more news at this meeting.

Greenspan was asked why he didn't raise interest rates to dampen down the stock market bubble of the late 1990s. His answers contain some completely new information.

He said, "we tried that in 1994/1995 and failed," and added that the tightening cycle from 1994 to 1995 was "highly disruptive" but failed to rein in stock prices.

A little history: The year 1994 was a pivotal year for the Fed because the Fed decided to raise interest rates to keep inflation under control at that time. However, something went wrong, and there were some spectacular bankruptcies, the most visible of which was the bankruptcy of Orange County, California. Many people blamed Greenspan for these bankruptcies, and Greenspan is now blaming the 1994 experience for failing to stop the 1990s bubble.

"We didn't diffuse the bubble, we made it worse," he said. "The stock market was flat during the tightening period and when the tightening ended in 1995 the stock market took off. We learned that the Fed could not incrementally diffuse a bubble."

S&P stock prices, 2000 dollars, with long-term exponential growth trend line

S&P stock prices, 2000 dollars, with long-term exponential growth trend line

There's a small surprise here -- that Greenspan appears to be saying that the bubble started in 1994 rather than 1996. It was at the end of 1996 that Greenspan gave his "irrational exuberance" wherein he stated publicly that the bubble was on. Furthermore, if you look at the adjoining graph, you can see that it was in 1995 that stock prices, which had been leveling off, took a sharp upward turn, indicating a bubble. It probably doesn't matter much whether the bubble began in 1994, but was held down by the 1994 tightening, or whether it actually began in 1995, but it's something worth more research.

At any rate, Greenspan is now saying that he was shocked by the 1994 experience, and realized that the stock market bubble could not easily be stopped.

He now says he realized that "unless we tightened aggressively enough to hurt the economy and profitability the market bubble wouldn't diffuse. Rates would have had to go up 10 to 12 percentage points to break the back of the stock market, which would destroy the economy."

He now gives this as his reason for not stopping the bubble, but he gave a quite different reason in his Wall Street Journal interview in November, 2004.

At that time, he didn't think that the bubble was important because it was caused by increased productivity from hi-tech investments. He even got two of his interns to gin up a report supporting that view. But as anyone knows who was in the computer industry, as I was, productivity was way DOWN from information technology (IT) investments. IT was a monetary black hole. IT investments didn't become productive until after the Nasdaq crash in the early 2000s.

However, his new reasoning is consistent with a view that he's often expressed: The Fed decided not to deal with the bubble, but to deal with its aftermath instead. That's why interest rates were lowered to near-zero levels after 2000.

And that's what caused the various bubbles -- the new stock bubble, the bonds bubble, the real estate bubble, the commodity bubble. Greenspan is going to have a tough hill to climb if he wants to now convince people that these bubbles were all due to the fall of the Berlin Wall, especially when he's never mentioned that before.

The agony of Alan Greenspan

As I wrote last year in "Ben S. Bernanke: The man without agony," Greenspan became increasingly agonized over the years about his 1996 decision.

In January, 2004, Greenspan was quite positive and hopeful when he bragged in a speech:

"There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences, rather than the bubble itself, has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession, even milder than that of a decade earlier." -- Alan Greenspan to the American Economic Association's annual meeting.

During the next two years, Greenspan's remarks reflected an increasing level of concern, then alarm -- and agony that he was going to be blamed.

By August, 2005, he warned about the stock market and housing bubbles:

"To some extent, those higher [stock and housing] values may be reflecting the increased flexibility and resilience of our economy. But what [investors] perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

When Greenspan says that "history has not dealt kindly," he's referring to the 1930s Depression. This was one of Greenspan's final speeches as Fed Chairman, and it was his most explicit warning that we're headed for a new Great Depression.

In his new remarks, he now seems to be returning to his January, 2004, position, that everything is OK. At his Friday meeting, he even said that the worst of the real estate bubble correction may be over, something that will be surprising news to home sellers, as the housing bubble bursts, and home prices continue to fall. (25-Oct-06) Permanent Link
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