I confess to being puzzled by the Federal Reserve’s actions in recent weeks, as well as by the assumptions of even most of the Fed’s public critics that we are not likely to go into a recession. Without an economics degree, I may well be misunderstanding the evidence or the Fed's duties. I had begun writing a series of long posts on the Fed two weeks ago, but decided to wait to publish them to see if the Federal Reserve would lower interest rates before I waded into such a difficult policy thicket.
I had always thought that part of what turned financial hardships into recessions and recessions into depressions was severe restrictions in the willingness of financial institutions to lend and borrow money. For example, after the 1929 stock market crash, banks and brokerage houses reformed their excessively easy lending practices, leading to a massive contraction in the supply of money and its velocity.
Over the last year, we have had four straight quarters of lower prices on the sale of existing single-family homes. While price declines so far have been modest, the rising inventory, tighter lending standards, increasing foreclosures, and substantial non-price seller concessions suggest that nominal prices may not fully reflect the extent of the price decline and that things could get much worse in the housing market before they get better.
Since World War II, there have been three sharp housing price declines (in real dollars):
the 1947-48 housing price drop, preceding the Nov. 1948 – Oct. 1949 recession,
the 1979-82 housing price drop, preceding the July 1981 – Nov. 1982 recession (and also coincident with the Jan.-July 1980 recession), and
the 1989-91 drop, associated with the July 1990 - March 1991 recession.
With the ridiculously easy lending standards of the housing boom in the 2000s, an impending housing crisis was almost unavoidable, as Robert Schiller argued in March 2006.
Schiller presents housing price data through 2005 in real, inflation-adjusted dollars:
The Federal Reserve, therefore, was and is faced with an extremely difficult challenge: to prevent a severe housing crunch from having its usual effect: driving the US economy into a recession, as the three biggest housing crunches since World War II have done.
For more on Federal Reserve policy, go to The Fed: Part II: What’s Goin’ On?
Related Posts (on one page):
The Fed seems out of touch with who demographics and the idea that some people should be careful with credit.
Some people will be hurt, just as a lot of nice people were hurt by the internet stocks. Today, folks will lose their homes and have to rent again (and probably learned they need more savings before becoming a homeowner). in the tech bubble, many a person had to put off retirement another year or two or three, and probably learned the meanings of risk and diversification better.
I think the misunderstanding is in the Fed's duties. The relative importance of combating inflation and promoting economic growth differs across Central Banks. The ECB, like the Bundesbank before it, only cares about economic growth to the extent that growth promoting actions do not cause inflation. The Bank of England has a more balanced approach. Especially since the 1980s, the Fed cares first and foremost about combating inflation. Since inflation in the US is still in the 2% - 3% range, instead of 1% - 2% where they would like it to be, there will be no reduction in interest rates, so the only remaining instrument available is the quick fix of the money market intervention.
The difference is is that this time people who had no interest in playing the game (i.e., frugal hardworking homeowners who saved and bought houses they could afford with traditional mortgages) are going to be hurt because of the greed, ignorance and stupidity of the borrowers, lenders, and yes even the Fed (especially Alan Greenspan) who created this artificial bubble. As housing prices collapse and homes are foreclosed upon and abandoned, it will hurt responsible and innocent homeowners who will see the value of their investments suffer. They will find it difficult to sell their houses, which may be an inconvenience, but for some people (e.g., if they are relocating for a job) might be a real hardship.
Doesn't it depend on the reason for the housing decline? If the housing market is part of a larger trend and is itself more of a symptom than a independent reality than I could see the recession argument as valid. However, from my perspective the housing bubble and burst isn't dependent on broader economic signs, but is, in this case, part of a huge spree of overbuilding. Construction over the last years has been nonstop in my neck of the woods (literally in the woods) and even more in the more open parts of Southern California.
There is an oversupply of high scale housing. In urban centers this is represented by luxury condos. In suburban by mcMansions.
Can we see the housing market, then, not as representative of the broader economic realities, as in times past, but as in this case experiencing its own rightful market balancing of supply and demand?
There are just too many homes to expect prices to be sustained at a under supply rate. Why should the Fed step in?
Sorry for my lack of economic terminology and knowledge.
It wasn't just banks and brokerages doing it on their own. The Fed doubled the reserve requirements for banks, to try to maintain control over them. Prices were controlled through fiscal policy, unions' political powers were growing exponentially and they maintained control over wages. Tight monetary policy combined with rigid prices, and that is what deepened and lengthened the downturn into a full-blown depression.
First, do no harm.
If the Fed can manage not to turn this into a recession, that would be a start.
You can hardly be blamed for that in predicting a recession. After all, as Paul Samuelson famously said, economists have correctly predicted nine of the last five recessions. You can feel free to have that same rate of correct recession predictions.
But in the absence of high interest rates, I believe people buy houses if they feel that they are financially secure. For example, the drop in bay area housing prices circa 93 was triggered by Clinton's peace dividend, which threw hundreds of local government contractors (Lockheed, Loral, etc.) out of work. In contrast, area housing prices held up and even increased after the dotcom recession. But apartments went vacant, even after rents decreased and "move-in bonuses" increased. I believe that survivors who had kept their jobs, or who had cashed in their dotcom gains, felt secure enough to stop renting and buy a place of their own.
Under the assumption that it was deleted out of ignorance, here is the actual data:
http://www.newyorkfed.org/markets/omo/omo98.pdf, pg 7. covering 1981-1998
http://www.newyorkfed.org/markets/omo/omo2006.pdf, pg 21.
Let me explain what these graphs mean: when the Fed Funds Rate target is below the 'natural-rate', the Fed must continually inject money through Open Market Operations to hold the interest rate-down.
When the Fed Funds Rate target is above the 'natural-rate', the Fed must continually sell the bonds held in the SOMA, to maintain an artificially higher-rate of interest.
We can thus conclude from the balance sheet of the SOMA that the Fed has been pretty much continually holding the short-term interest rate below the natural-rate.
Now, I have to tell you that the Fed describes the SOMA activity as (merely) covering the reserve requirements of the banks. Anyone with a good background in control theory (the engineering of feedback systems) will tell you that this does not contradict the explanation I gave. The reserve balances are merely a way of observing whether more or less money needs to be injected.
I have deleted no comments on any VC threads in the last few months and I doubt that another VC contributor would have deleted anything from another blogger's thread (except for an extremely outrageous comment by a racist troll).
Rest assured that it must have been a computer glitch.
Jim Lindgren
The following is a graph of the fraction of excess reserves. This reflects the money that banks could lend but have not.
Graph of Excess Reserves
That was Schiller's point in the interview linked in the post--that in real dollars home values did not climb much until the 2000-2005 boom.
Jim Lindgen
Say what you will about the Fed, but they are more responsive than my county assessor's office.
You are largely correct, in that the bust is the result of people making bad investments during the boom, and is therefore just a case of market economics working exactly as it should.
To clarify, though, the boom was driven not by overbuilding, so much as a combination of low interest rates and increasingly lax underwriting standards - interest only mortgages, 100% financing, etc. This easy financing made it possible for more people to buy more house, often under terms that would not be sustainable in the long run, and this artificially high demand drove a lot of speculative building.
The problem that most people are worried about, and what the Fed is addressing, isn't the supply of housing per se, it's the question of just how much money people sank into investments that will crash in value as a result of the drop in housing prices, and what that will mean for the broader economy. We're concerned about the ripple effect (which may be more of a wave than a ripple). If some banks lose their shirt in the subprime mortgage market, that's fine, except that if the banking system as a whole loses enough, they won't have any money left over for other sorts of loans, and that makes business difficult for everybody else.
The general uncertainty about exactly what will happen is making investors reluctant to invest in any kind of debt, even in sectors where the underlying fundamentals are relatively good.
The question, then, is how to let the necessary corrections happen without killing the rest of the economy. Not an easy task.
I live in San Diego, and I got a notice of an emergency downwards reassessment about a month ago. It'll save me a ton on property taxes. The "temporary" part is a loophole to allow the county to jack the assessment back up faster than would be ordinarily be allowed under CA law.
Now, Bernanke has had the job for some time, and I hear he knew a lot about econ even before he started, so he's probably better prepared than I was. Also, I've never heard anything about his personal life or lack thereof, but the Fed chair is treated like a movie star to some extent, so if he was a zombie we'd probably hear of it. That said, we all have our limitations, and this has got to be a stressful time for him.
All of the shreiking you see on CNN, Fox News, etc. about how the decline of the housing bubble will bring about a recession are simply all of the weasels trying to get the FED to bail them out by lowering the interest rates.
Is it not ironic that the "supersmart" people running these hedge funds (like Jim Cramer), who claim that their huge compensations are justified by their ability to "create wealth" are now the people crying the loudest for a bail out? That the rest of us should have to pay the price of inflation so that they can have their funds rescued? Can anyone honestly think that this is justifiable?
The rate of growth in the money supply should NEVER, EVER be different than the natural economic growth rate. If the money supply is allowed to increase faster than the economic growth rate, the result is inflation (either price inflation like the 1970's or asset inflation like 1995 until now). Regardless of what anyone says, inflation is actually the debasement of the currency, which is never acceptable under any circumstances, what so ever.
Greenspan was a parasite who increased the money supply (credit bubble) way beyond anything that was rational, given the economic growth rate, since 1993 simply to make his job easier. He is almost as bad as Arthur Burns, who did much the same thing in the 1970s.
The 60's and 70's was the time of kaynesian fiscal policy and the 1994 to now period was the time of keynesian monetary policy. When are we going to learn to bury the ghost of Keynes once and for all? Keynes was one of the worst economists to ever walk this planet (Krugman is getting up there as well) and we need to ditch him once and for all.