US Property & The Fed

Alan Greenspan was chairman of the Board of Governors of the Federal Reserve form 1987 until 2006. A position he held during the terms of four different presidents and possibly more impressively during two asset price bubbles. He has been famously quoted in the past as saying, “We don’t perceive there to be a national bubble, but it is not hard to see that there are a lot of ‘local bubbles’. At minimum there is a little froth in this market.” When discussing US housing prices. He has also come under criticism in the media with Time magazine placing him third on a list of 25 people to blame for the financial crisis. I doubt if his successor, Ben Bernanke, has had a more popular beginning as he has went on record as saying “ There is no housing bubble to go bust.”

It is often too easy, with the luxury of hindsight, to look towards national government and place the blame for any problems or difficulties with the economy. So why has the finger of blame firmly been pointed Mr. Greenspan? Many argue the fact that in response to both the DOTCOM bubble and the Sept 2001 attacks the Fed cut the federal funds rate to 1.00% and by doing so lead to a surge in borrowing and refinancing. In 2004, Greenspan also championed Adjustable Rate Mortgages at a time when the Federal funds rate was still only 1.00%. However the rate was increased in the following two years to a high of 5.25% resulting with many subprime borrowers, who were initially able to meet their payments at the lower rate now being forced to default.

 

I believe that this prolonged period of record low interest rates contributed greatly to the amount of borrowing taken on by subprime lenders.  This resulted with an increase in house prices of more than 70% above the US rate of inflation by the peak of the asset price bubble in 2006. This artificial boom in prices influenced the overall US economy in two ways. Firstly, it fuelled the construction sector which accounted for a large proportion of the economy as new properties where built at near record levels. And secondly, the increase in prices increased the level of wealth for many individuals and household. Property owners felt that this increase in wealth was real and here to stay and therefore borrowed and consumed accordingly.

Any period of time during which the economy is doing well, with both low unemployment and high growth rates, sounds like music to the ears of politicians. This therefore makes it extremely difficult for the central bank to take action which may in any way jeopardise the governments popularity. My next post will discuss if the Fed could have done anything differently under Mr Greenspan and what lessons can be learnt for the future.