America's Day of Reckoning

The pessimists who have long forecasted that America's 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 Federal Reserve Chairman Alan Greenspan, 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.

In fact, 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 "subprime" 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 Alan Greenspan egged them to pile on the risk by encouraging these variable-rate mortgages. On February 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. But it was only a matter of time before that performance became unsustainable.

Fortunately, most Americans did not 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 has been negative for the past couple of years. With this engine of growth turned off, it is hard to see how the American economy will 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.