Day Of Reckoning For Americans Who Lived Beyond Their Means
By Joseph Stiglitz
15 August, 2007
pessimists who have long forecast that the US economy was in for trouble
finally seem to be coming into their own. Of course, there is no glee
in seeing stock prices tumble as a result of soaring mortgage defaults.
But it was largely predictable, as are the likely consequences for both
the millions of Americans who will be facing financial distress and
the global economy.
The story goes back to the
recession of 2001. With the support of former Federal Reserve chairman
Alan Greenspan, US President George W. Bush pushed through a tax cut
designed to benefit the richest Americans but not to lift the economy
out of the recession that followed the collapse of the Internet bubble.
Given that mistake, the Fed
had little choice if it was to fulfill its mandate to maintain growth
and employment. It had to lower interest rates, which it did in an unprecedented
way -- all the way down to 1 percent.
It worked, but in a way fundamentally
different from how monetary policy normally works. Usually, low interest
rates lead firms to borrow more to invest more, and greater indebtedness
is matched by more productive assets.
But given that overinvestment
in the 1990s was part of the problem underpinning the recession, lower
interest rates did not stimulate much investment. The economy grew,
but mainly because American families were persuaded to take on more
debt, refinancing their mortgages and spending some of the proceeds.
And, as long as housing prices rose as a result of lower interest rates,
Americans could ignore their growing indebtedness.
Even this did not stimulate
the economy enough. To get more people to borrow more money, credit
standards were lowered, fueling growth in so-called "sub?prime"
mortgages. Moreover, new products were invented, which lowered upfront
payments, making it easier for individuals to take bigger mortgages.
Some mortgages even had negative
amortization: payments did not cover the interest due, so every month
the debt grew more. Fixed mortgages, with interest rates at 6 percent,
were replaced with variable-rate mortgages, whose interest payments
were tied to the lower short-term T-bill rates.
What were called "teaser
rates" allowed even lower payments for the first few years. They
were teasers because they played off the fact that many borrowers were
not financially sophisticated and didn't really understand what they
were getting into.
And Greenspan egged them
to pile on the risk by encouraging these variable-rate mortgages. On
Feb. 23, 2004, he pointed out that "many homeowners might have
saved tens of thousands of dollars had they held adjustable-rate mortgages
rather than fixed-rate mortgages during the past decade."
But did Greenspan really
expect interest rates to remain permanently at 1 percent -- a negative
real interest rate? Did he not think about what would happen to poor
Americans with variable-rate mortgages if interest rates rose, as they
almost surely would?
Of course, Greenspan's behavior
meant that, under his watch, the economy performed better than it otherwise
would have done. But it was only a matter of time before that performance
Fortunately, most Americans
did not follow Greenspan's advice to switch to variable-rate mortgages.
But even as short-term interest rates began to rise, the day of reckoning
was postponed, as new borrowers could obtain fixed-rate mortgages at
interest rates that were not increasing.
Remarkably, as short-term
interest rates rose, medium and long-term interest rates did not, something
that was referred to as a "conundrum."
One hypothesis is that foreign
central banks that were accumulating trillions of dollars finally figured
out that they were likely to be holding these reserves for years to
come, and could afford to put at least some of the money into medium-term
US treasury notes yielding -- initially -- far higher returns than T-bills.
The housing price bubble
eventually broke and, with prices declining, some have discovered that
their mortgages are larger than the value of their house. Others found
that as interest rates rose, they simply could not make their payments.
Too many Americans built
no cushion into their budgets, and mortgage companies, focusing on the
fees generated by new mortgages, did not encourage them to do so.
Just as the collapse of the
real estate bubble was predictable, so are its consequences: housing
starts and sales of existing homes are down and housing inventories
are up. By some reckonings, more than two-thirds of the increase in
output and employment over the past six years has been real estate-related,
reflecting both new housing and households borrowing against their homes
to support a consumption binge.
The housing bubble induced
Americans to live beyond their means -- net savings have been negative
for the past couple of years. With this engine of growth turned off,
it is hard to see how the US economy would not suffer from a slowdown.
A return to fiscal sanity will be good in the long run, but it will
reduce aggregate demand in the short run.
There is an old adage about
how people's mistakes continue to live long after they are gone. That
is certainly true of Greenspan. In Bush's case, we are beginning to
bear the consequences even before he has departed.
a Nobel laureate in economics, is professor of economics at Columbia
University and was chairman of the Council of Economic Advisers under
US president Bill Clinton and a chief economist and senior vice president
at the World Bank. Copyright: Project Syndicate
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