By Joshua Holland, AlterNet
Posted on April 7, 2009, Printed on April 9, 2009
http://www.alternet.org/bloggers/www.alternet.org/135507/
In the Wall Street Journal, Steven Gjerstad and Vernon Smith explain a key difference between the crash that followed the burst of the 1996-2006 housing bubble, and earlier bubbles that didn't bring the whole enchilada down with them when they deflated [HT: The Bubble Meter].
Monetary policy is a key part of the story -- monetary policy that created the appearance of prosperity, even as American families were growing more financially insecure year after year.
The Fed, under Clinton and Bush, kept interest rates at very low levels even after the recession that followed the crash of the dot-com bubble in the early 2000s. Combined with the elimination of capital gains for houses sold for less than a half-million dollars, the result was a lot of cheap money out there gravitating to one of the few sectors of the economy that was growing.
In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.
The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.
On that last point, the authors gloss over a key point. As the NY Times reported last year, "Credit rating agencies did not properly manage their conflicts of interests when assigning ratings to structured products such as mortgage-backed securities, a report by the Securities and Exchange Commission said on Tuesday." But that's an aside ...
But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.
How did we get there?
During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.
Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!
Why didn't everyone see it coming a mile away? Some did, of course, but here we have to look at how changes to how we measure inflation played into the "irrational exuberance" of the past decade ...
By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.
How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.
With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.
This was just one of a number of measures to redefine inflation downwards over the past 20 years. Why? In large part to control Social Security spending and other "entitlement" payments that are hooked to the rate of inflation. I wrote about this at some length back in July, in a piece titled, "In a Perfect Storm of Economic Stagflation, the Yachting Set Says: 'Let Them Eat Pizza'." If you missed it then, check it out.
Joshua Holland is an editor and senior writer at AlterNet.
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