But the biggest single cause was Federal Reserve policy in the wake of September 11 and the collapse of the dot-com bubble. With business investment and confidence imploding, the Fed made a bet on the consumer to keep the economy afloat. Former Chairman Alan Greenspan and his mates drove short-term interest rates down to 1% and kept them there for a remarkable 12 months. Even when the Fed started to move rates up again, it did so at a slow and too deliberate pace.
The strategy worked in the early going, as the housing market remained strong and the mighty American consumer kept on spending despite terrorism fears, a war and weak job creation in the early years of the decade. The 2001 recession was one of the mildest on record. The trouble arose as the Fed maintained its easy money policy into 2004 and 2005, well past the time the Bush tax cuts of 2003 had helped to revive corporate spending and investment incentives.
One result is what now looks to have been a classic asset inflation in housing values. Mr. Greenspan never got around to using the word "bubble" himself, preferring the more elegant "a little froth." But that's about as close as any Fed chief gets to conceding a mistake. We agree that as a rule the Fed shouldn't target asset prices (housing, stocks) as it makes monetary policy; its core job is maintaining an overall stable price level. However, when housing prices climb as rapidly as they did in late 2004 and throughout 2005, something more than rational exuberance is going on. At one point, some 10% of all home purchases were estimated to have been for "investment" reasons, not for an actual residence.
This speculative buying was bound to break as the Fed eventually corrected its easy-money mistake. The current slump is in part the product of that correction, and it seems likely to continue for some time as the Fed's interest rate increases have an impact. For many Americans whose monthly mortgage payments are now rising, or who still hope to sell at last year's prices, this may be painful.
The housing slide is already leading to the inevitable calls for the Fed to reverse course immediately and cut rates once again. But this is precisely the wrong lesson to learn from the housing market rise and fall. The Fed's mistake was staying too easy for too long. Re-establishing the Fed's anti-inflation bona fides would help the entire economy, including the housing market.
WSJ agrees: Greenspan sucks!
I've been saying for quite some time that Alan Greenspan was a horrible Fed chief. Now the Wall Street Journal is starting to agree. On the causes of the currently bursting housing bubble ($):
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