2007 December 24 Monday
Stephen Roach: Yet Another Asset Bubble Recession

Remember when recessions were caused by the Federal Reserve clamping down on excessive consumer goods inflation? Stephen Roach of Morgan Stanley opines that the United States is headed for its second post-bubble recession in 7 years.

THE American economy is slipping into its second post-bubble recession in seven years. Just as the bursting of the dot-com bubble led to a downturn in 2001 and ’02, the simultaneous popping of the housing and credit bubbles is doing the same right now.

It is very important that the last two downturns are not for the typical reasons. Globalization brought so many cheap goods to market that foreign suppliers kept US consumer prices in check. So excess money supply growth manifested as inflation in housing prices and financial assets. Roach is correct to argue that the Fed made a big mistake by not acting against asset market inflation.

America’s central bank has mismanaged the biggest risk of our times. Ever since the equity bubble began forming in the late 1990s, the Federal Reserve has been ignoring, if not condoning, excesses in asset markets. That negligence has allowed the United States to lurch from bubble to bubble.

Basically when people spend more to buy food or clothes or appliances it feels bad. But when the value of one's house or stocks go up it feels good to a great many people. Never mind that new buyers have to pay more. There are more existing owners than new buyers. Even the new buyers expect to reap gains from ever rising asset prices. So the buyers do not complain about big asset price inflation as much as they ought to.

The Fed basically acts as if only non-durable goods inflation matters. Therefore the Fed lets asset price inflation get out of hand. The Fed claimed soundness of bank lending was not a Fed responsibility.

As housing prices soared in what became a speculative bubble, Fed officials took comfort that foreclosure rates on subprime mortgages remained relatively low. But neither the Fed nor any other regulatory agency in Washington examined what might happen if housing prices flattened out or declined.

Had officials bothered to look, frightening clues of the coming crisis were available. The Center for Responsible Lending, a nonprofit group based in North Carolina, analyzed records from across the country and found that default rates on subprime loans soared to 20 percent in cities where home prices stopped rising or started to fall.

“The Federal Reserve could have stopped this problem dead in its tracks,” said Martin Eakes, chief executive of the center. “If the Fed had done its job, we would not have had the abusive lending and we would not have a foreclosure crisis in virtually every community across America.”

The Fed has decided it really does have the authority to force banks to more carefully qualify mortgage loans. They came to this conclusion a few years too late.

Greenspan acknowledges what happened but argues he was powerless to stop it.

“The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World,” Mr Greenspan argued in an article printed in The Wall Street Journal yesterday.

“The resulting growth of fairly educated low-cost workers in those countries, together with an increase in their exports, combined to keep down wages and inflation in the developed world.

“Interest rates are, in part, designed to reduce the impact of inflation, which erodes an asset’s value in real terms. As the outlook for inflation continued to remain low, so interest rates came down and borrowing for mortgages and other assets went up.”

Interest rates came down in part because he drove them down. He went too far to prevent deflation.

Share |      By Randall Parker at 2007 December 24 10:53 PM  Economics Business Cycle

John S Bolton said at December 25, 2007 2:06 AM:

Interest rates came down because of massive and hugely socialistic dollar support programs overseas,
but Greenspan makes it sound like a natural by-product of capitalism. Free trade in stolen goods, the exports
which arrive here from forced savings in despotic China and elsewhere, is not what should be made to sound like capitalism and free trade.
As always, the downside is an extended period of slow growth, probably including a recession.
Greenspan told us we were in a new era where high growth rates in the world could carry on and on,
but Japan found out over 15 years ago that such policies based on currency interventions, reach their limits, beyond which they can yield no further years of high growth led by export manufactures, just a holding pattern of 1% growth.

Dennis Mangan said at December 25, 2007 7:02 AM:

This quote epitomizes what's wrong with the article: “The Federal Reserve could have stopped this problem dead in its tracks,” said Martin Eakes, chief executive of the center. “If the Fed had done its job, we would not have had the abusive lending and we would not have a foreclosure crisis in virtually every community across America.”

The fact is, virtually no one saw this coming, as Gary Becker pointed out the other day(http://www.becker-posner-blog.com/archives/2007/12/the_subprime_ho.html): "The vast majority of economists, including me, were surprised by the extent of the subprime mortgage crisis. This needs to be recognized when evaluating the numerous proposals about how to prevent the next housing crisis, and also about how to help those who are in danger of having their homes foreclosed." (- Becker.)

The tech bubble was seen for what it was at the time by many people, especially astute investors. In the present case, plenty of people saw that housing was overvalued, but few saw the mortgage crisis. The fixes proposed will be useless (IMO) for the next crisis or bubble, because they're all different.

Wolf-Dog said at December 25, 2007 8:27 AM:

"In the present case, plenty of people saw that housing was overvalued, but few saw the mortgage crisis. "

This is because most learned people are middle class or upper class, and the members of this group do not pay attention to the fact that the more impoverished groups simply cannot pay any debt, because their salaries are lower than their expenses. On the other hand, it is the spending of the impoverished majority by accumulating debt that caused the corporate profits to increase during the last few years. For every loser there is a winner. In the distant past, when the US trade imbalance did not exist (we used to have a trade surplus), the inequality of the lower income groups was not as dangerous as it is now.

Bob Badour said at December 25, 2007 2:15 PM:


American economists must be very stupid then. The moment I heard about sub-prime lending a decade or more ago, I knew it would come home to roost. Randall is right: If the Fed had actually exercised control over the money supply, the sub-prime market would never have developed. One or two sub-prime groups would have been burned by defaults 10 years ago, and nobody else would have entered that fool's market.

The truth is: The Fed basically allowed the money supply to grow uncontrolled as long as China sopped up the extra cash to mask the more immediate impact of that uncontrolled growth.

Not to rub their noses in it, but: Bad Fed! Bad!

averros said at December 25, 2007 3:05 PM:

The only correct reaction from the Fed in order to prevent bubbles and recessions is to go out and shoot themselves.

Before we do that to them.

It is a well known (to anyone but the establishment "economists", I guess) fact that the business cycle is caused by the central banks and their emission of fiat money resulting in systemic malinvestment. Asking Fed to fix the business cycle makes about as much sense as asking a fox to guard the henhouse.

Randall Parker said at December 25, 2007 5:05 PM:


I've argued for years that asset price inflation is as real and as important as consumer price inflation. I got this from reading Murray Rothbard on the Great Depression. Asset price inflation makes people feel good. But it still is inflation.

I've also seen the arguments made a few years ago that the real estate price run-up was a bad thing. Maybe those arguments were not getting made by the big mainstream economists. But those guys are not good at calling market shifts. For that you have to look at the great traders. But they don't make public pronouncements when they see some big bubble building up. They wait for the bubble to get as big as possible and then bet on a big correction.

Look at Goldman Sachs. They made a lot of money this year. Why? Some of their traders saw it coming and for the most part kept to themselves about it as they placed beds on the sub-primes going sour. They started betting on this correction even as the company continued to sell debt instruments to customers that ended up not being worth much.

Dennis Mangan said at December 25, 2007 8:12 PM:

Randall, Sure, Goldman made a ton, and more power to them, but Morgan Stanley, Lehman, Bear Stearns, Countrywide, Citigroup, Washington Mutual, all lost a ton and some of them are within inches of their lives. So I'd say the fact that Goldman saw this (actually, a couple of traders saw it and convinced the company to go along) means little, because so few others did.

Bob Badour: So, with your prescience, how much did you make on the meltdown? Subprime worked well for a long time; it was only the last two years, with RE prices falling, that everything went to hell. Caused by a charming combination of greed and ignorance.

m said at December 26, 2007 8:35 AM:

Easy money+cheap credit=boom,bubble,bust.

What's new here?

"but Morgan Stanley, Lehman, Bear Stearns, Countrywide, Citigroup, Washington Mutual, all lost a ton"
"So, with your prescience, how much did you make on the meltdown?"

You miss the point,we live in a "social construct society"(wishing makes it so)with a greater fool economy(but denying it's any such thing).REmember the New Economy/New Paradigm nonsense of a decade ago?
This just shows the degree that even Randal's high IQ folks are subject to wilfull self delusion.

We are also beginning a necessary and unavoidable economic restructuring,to wit,$800 billion trade deficits are unsustainable,the dollar tumbles,as we see,and overpriced asset bubbles pop OR Americans accept a much reduced standard of living(politcally unacceptable).

America,Inc. earns a profit or else,borrowing huge sums from aging Japanese and Euro's to build day spa's is no longer an option.

Get ready for a grim decade,led by Boomers with heads firmly stuck in 1968.To paraphrase the wit who satirized the Brit Labour party back in the day,the Boomers have come to power in the 21st century prepared to solve all the problems of 1960's.

Bob Badour said at December 26, 2007 4:44 PM:


I have never learned how to make money off other people's misery. While perhaps imprudent, I have no desire to either.

I did, however, divest myself of the stock markets in January 2000. I lacked the balls, though, to step in and buy up high-dividend stocks at that time so I missed a big opportunity for large capital gains.

Nevertheless, I immediately recognized the long-term stupidity of sub-prime lending and I stayed away. Apparently, the folks who created that market skimmed the short-term gains while shopping the losses out to suckers. Because the Fed allowed the shell game to go on for as long as it did, we (ie. taxpayers) will probably have to bail at least some of the suckers out -- making suckers of us all.

Randall Parker said at December 26, 2007 5:03 PM:


I think the signs were there to see and that some of the people inside the Fed who were complaining were wise to what was going on.

I'd really like to see the yearly breakdowns behind this trend:

The Federal Bureau of Investigation says the share of its white-collar agents and analysts devoted to prosecuting mortgage fraud has risen to 28%, up from 7% in 2003. Suspicious Activity Reports, which many lenders are required to file with the Treasury Department's Financial Crimes Enforcement Network when they suspect fraud, shot up nearly 700% between 2000 and 2006.

I think these numbers suggest the mortgage fraud didn't just get out of control in the last couple of years:

Reports of suspected mortgage fraud have doubled since 2005 and increased eightfold since 2002. Banks filed 47,717 reports this year, up from 21,994 two years ago, according to statistics from the Federal Bureau of Investigation and the Financial Crimes Enforcement Network of the Treasury Department. In 2002, banks filed 5,623 reports.

“I don’t think any law enforcement agency can keep up with mortgage fraud, because it’s such a growth industry,” said Chuck Cross, vice president of mortgage regulatory policy for the conference of state bank supervisors, an organization of regulators and bankers. “There’s too many cases, not enough agents.”

Okay, so that tells me from 2002 to 2005 the rate of mortgage fraud went up by a factor of 4. That's a big bright flashing red light.

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