A real estate bubble?

COMMENT
BLOWING BUBBLES
New Yorker, Issue of 2004-07-12 and 19
Posted 2004-07-05

Next March, Alan Greenspan will turn seventy-nine. Sound health
persisting-he plays tennis and golf regularly-he will be well into his
eighteenth year as chairman of the Federal Reserve Board and, depending
on what happens in November, will be serving his fourth or his fifth
President. Greenspan's lugubrious face and nasal monotone are as
familiar and as comforting to ordinary Americans as Prozac and "The
Simpsons," both of which débuted in 1987, the same year President Reagan
appointed him to office. Greenspan's absence, like that of Lord
Palmerston in Victorian Britain, has come to seem unthinkable.

But, in our system of checks and balances, Greenspan's position is an
anomaly. The Fed is at once an independent institution and part of the
government. Its chairman is Presidentially nominated and senatorially
confirmed, but he takes orders from no one. The Fed's decision last week
to raise short-term interest rates by a quarter of a point cannot be
appealed-not to the White House, not to Capitol Hill, not to the Supreme
Court. Although Congress obliges the Fed chairman to report to it twice
a year on the conduct of monetary policy, politicians rarely challenge
his authority. Last month, when the Senate Banking Committee endorsed
Greenspan's nomination for a fifth four-year term, Senator Jim Bunning,
Republican of Kentucky, cast the only vote against him. (Bunning
objected to Greenspan's voicing opinions on subjects such as tax cuts
and the budget deficit, which he believes are outside the Fed's
jurisdiction.)

Given Greenspan's role in promoting and prolonging the stock-market
bubble that burst in 2000, the deference that surrounds him seems a
little overdone. A few months ago, he argued that the unusually mild
recession in 2001, and the subsequent recovery, however uncertain, had
vindicated the Fed. "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,"
Greenspan told a meeting of economists. Perhaps. It's true that he has
quashed fears that post-bubble, post-9/11 America would resemble
post-bubble Japan, which experienced a decade of economic stagnation
following the 1991 collapse of the Nikkei. He has also done his best to
boost the election prospects of George W. Bush. With four months left
until Election Day, employers are finally creating jobs in significant
numbers-more than a million of them in the past four months, according
to the Labor Department. The rise in business productivity that began in
1995 appears to have accelerated since 2001, with the annual growth rate
approaching five per cent. Since productivity ultimately determines
wages and living standards, this is an important development.

Nevertheless, Greenspan's claim of vindication is premature. Although
the recovery looks genuine, there are serious questions about its
sustainability. Between the start of 2001 and the middle of 2003, the
Fed cut its target interest rate from 6.5 per cent to one per cent, the
lowest level since the Eisenhower Administration. With the cost of
borrowing lower than the rate of inflation, the Fed was essentially
giving money away. At the same time, the Bush Administration cut taxes
by trillions of dollars. This one-two dose of stimulus boosted spending
throughout the economy, as such a stimulus usually does, but it left the
nation's finances chronically unbalanced, with consumers and the federal
government both spending well beyond their means.

The President's fiscal policy, most of which Greenspan publicly
endorsed, has been widely criticized, but the consequences of the Fed's
cheap-money policy have largely escaped attention. Tempted by
unprecedentedly low interest rates, Americans have taken on
unprecedented levels of debt, particularly in the realestate market,
which has replaced the stock market as the favored vehicle for
get-rich-quick schemes. For many families, the soaring value of their
home offset the slump in their stock portfolio, but, with one-bedroom
apartments in Manhattan selling for more than half a million dollars,
and with California banks being forced to introduce forty-year mortgages
so that their customers can afford to buy a house, even some of
Greenspan's colleagues are concerned that one bubble has given way to
another.

In addition, over-all inflation is rising, albeit from a low base, with
prices for some middle-class staples, such as gasoline and health-care
premiums, increasing especially sharply. Most worrying of all is the
prospect of a currency crisis-a phenomenon practically unknown to
Americans but familiar to citizens of many other countries whose
governments have pursued irresponsible economic policies. For years,
Americans lent more money to foreigners than they lent us. Now we owe
the rest of the world about two and a half trillion dollars, and the
debt burden is rising every day.

History demonstrates that countries can increase their foreign borrowing
only so far before creditors start to lose confidence that they will be
repaid in full. The limit tends to come when the trade deficit reaches
about five per cent of G.D.P., which is about where the United States'
trade deficit is now. Once lenders' confidence disappears-as it did in
Britain in 1967, in Mexico in 1994, and in Russia in 1998-panic selling
ensues, precipitating a collapse in the currency. Interest rates rise,
the stock market plummets, and the economy enters a severe recession.

Greenspan refuses to contemplate such a catastrophe. On Capitol Hill
recently, he insisted that the economy "seems to be on track," while
conceding that the task of weaning it from its addiction to cheap money
is "not a gimme putt." Last week's interest hike will probably be the
first of many, as the Fed raises the federal funds rate to a more normal
level. Since Greenspan prefers to move slowly, the process of policy
tightening will almost certainly extend into the second half of next
year, and maybe into early 2006, when, around the time of his eightieth
birthday, he is expected to retire. By then, it will be easier to judge
whether Greenspan deserved all the plaudits he received or whether he
was ultimately more of a cheerleader than a responsible central banker.

- John Cassidy