Nipping the Bubble in the Bud

Greenspan has finally admitted that there might be some "local" bubbles in housing…which is a big step for him. So what does this possible shift from the Fed’s bubble blindness to bubble awareness mean for the U.S. economy? Justice Litle explores…

And the beat goes on: Existing home sales for April hit a record high, while home prices saw the biggest gains in over two decades.

The cover of FORTUNE features the words "REAL ESTATE GOLD RUSH" in bold caps. Meanwhile, The Washington Post reports that even Playboy Bunnies are turning in their tails for real estate licenses and one out of every four houses bought last year was, ahem, investment property ("speculative purchases" is just too crass for polite company).

As the piece de resistance, adjustable-rate and interest-only loans represented close to half of all mortgages in the second half of 2004.

Greenspan says, "At minimum, there’s a little froth in this market." At a New York luncheon, he went on to say, "We don’t perceive there to be a national bubble, but it’s not hard to see that there are a lot of local bubbles."

On surface inspection, there isn’t much to see in these remarks. The maestro seems to grudgingly acknowledge the housing bubble issue, now that it’s too big to be denied, while simultaneously downplaying its importance.

Local Housing Bubbles: Spotting Bubbles Ahead of Time

Dig deeper, though, and things start to look more interesting.

It wasn’t so long ago that Greenspan adamantly denied the possibility of bubbles, or at least the ability to spot them with foresight. He argued that it’s impossible to recognize a bubble before it bursts, and that even if you could recognize a bubble in the making, there’s not much to be done until it pops.

This "hindsight is 20/20" defense was used to justify the Fed’s response to the dot-com debacle, or rather, its utter lack of response. In the days of the late great tech boom, Greenspan essentially cheered on the way up and wrung his hands on the way down, waiting until the stock market imploded – to the tune of $7 trillion – before taking emergency measures.

The Fed’s long-standing bubble-blind stance was rooted in the efficient-market hypothesis, or "random walk" theory, which is dying a slow but sure death.

For many decades, academics have believed that markets are perfectly rational and accurately priced at all times, making foresight worthless and the very existence of bubbles an impossibility.

The efficient-market hypothesis is a silly and stupid belief, for a wide number of reasons; but like many other dumb ideas, it has managed to stick around and hold otherwise intelligent people in thrall.

Only in recent years has the dogma been successfully challenged on academic grounds. (Successful traders and investors, making good money for centuries, never saw reason to care about egghead theory in the first place. That would be like the bumblebees packing it in on notice of being grounded by the aerodynamics department.)

The connection between the Fed and asset prices is fairly straightforward. If asset prices are always and everywhere rational, as a dwindling band of academics believe, then the Fed does not need to target asset prices, because permanently rational pricing implies fair value at all times.

If efficient-market theory is wrong, however, and the markets are not always rational, then asset prices have the potential to get out of whack…sometimes dangerously so. In this case, the Fed needs to pay attention to asset prices and discern whether current valuations are rational or bubblelike in making their decisions.

Local Housing Bubbles: Walking a Fine Line

The Fed has a fine line to walk when it comes to asset bubbles, and at least one or two groups will be upset regardless of what happens. If it looks like a bubble is developing and the Fed takes steps to curb it, both the efficient-market academics and the die-hard bulls will be upset.

The academics will say, "Who are you to play god with markets that we of the ivory tower have declared perfect?" Meanwhile, the goggle-eyed bulls will say, "Who are you to ruin our party when it’s just getting good?"

On the other hand, if the Fed does nothing and takes the bubble-blind stance as asset prices go vertical, the realists and inflation hawks will start jumping up and down, shouting, "Hey, you money-pumping nimrods, it’s not your job to be popular…You’re supposed to take away the punch bowl, not spike it!"

So should the Fed target asset prices or not? In our leverage-driven, fiat-money system, is it the chairman’s job to target bubbles in their infancy (especially ones born of their own monetary policy creation)? Noted Fed watcher and financial journalist Martin Mayer, in his book The Fed, thinks they should:

"The theoreticians have been arguing for several years about the extent to which central banks should pay attention to asset prices. The discussion is being conducted on a very high level, with very tenuous links to reality. But the truth of the matter is probably that asset prices are at the heart of what a central bank does as we open the new millennium. ‘Monetary policy,’ Charles Goodhart told a Levy Institute conference in 1999, ‘has its real effects by its influence on asset prices. But the effect of interest rates on asset prices is the result of a whole chain of attitudes, and the relations of interest rates to asset prices are highly uncertain.’"

So back to the maestro’s offhand remarks: When Greenspan says, "It’s not hard to see that there are a lot of local bubbles" in the housing market, it’s the equivalent of a lesser official shouting from the rooftops.

By acknowledging the existence of asset bubbles (even if they are dismissed as local), the maestro has reversed tack from his previous bubble-blind stance and subtly acknowledged the Fed’s need to take asset prices into future account…or at least the possibility of such.

From here, it’s not a far stretch to imagine a future Fed targeting asset bubbles proactively.

Local Housing Bubbles: Bubble Awareness

The Fed may not be comfortable making this shift from bubble blindness to bubble awareness, but it really doesn’t have much choice.

Through the rampant asset appreciation of the U.S. housing market, funded by a tidal wave of high-risk mortgage loans and growing speculative abandon, it has become abundantly clear to the rational world – sans academics, perhaps – that monetary policy is deeply intertwined with real asset values at the extremes.

The good news is that when it comes to proactively nipping bubbles in the bud, the Federal Reserve has a few precise tools at its disposal in addition to the blunt hammer of interest rates.

In the late ’90s, when the dot-com frenzy was getting out of hand, Greenspan could have sent a strong signal by raising margin requirements on equities.

This would have slowed things down a bit, acting as a psychological brake, as well as a leverage reducer. The bulls would have bellowed, but the following multitrillion-dollar debacle might have been far less painful as a result of Fed foresight.

More recently, a proactive Fed could have taken early steps to reign in loony mortgage lenders.

If insanely greedy banks have so little common sense as to hand out zero-down, adjustable-rate, interest-only loans to speculative buyers already leveraged past their eyeballs, the Fed could surely provide some common sense on their behalf by adding a mandatory "sanity clause" to all lending agreements. Sadly, this is asking too much.

In acknowledging that bubbles exist (in his roundabout, ineffectual way), Greenspan has cleared a path for his replacement. That isn’t much, but at least it is something. Slowly the Fed is being brought around to the notion that markets are not perfect, or even close to perfect, except in their uncanny ability to destabilize each other and their need to be approached with common sense as well as academic theory.

This means a more proactive policy, and a chairman willing to take unpopular action much earlier in the cycle…ideally when "irrational exuberance" is first confirmed, rather than long after it has clearly run amok.

The longtime appeaser Greenspan, on his way out the door, isn’t up for the task. Hopefully, his successor will be.


Justice Litle
for The Daily Reckoning

June 09, 2005

Justice Litle is an editor of Outstanding Investments. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)

Justice is also a frequent contributor to Whiskey and Gunpowder, a free e-newsletter, from Dan Denning and Byron King (among others) that covers resources, oil, geopolitics, military history, geology and personal freedom.

A headline in the Daily Mail caught our attention this morning:

"Women who love doing housework – in the nude!"

No, not that one. The one beneath it:


Britain is ahead of the United States. Its property boom began earlier. It appears to have come to an end sooner too; prices started to flatten out last summer.

As in the other "Anglo-Saxon" economies – Canada, Australia, New Zealand and the United States – British households went on a buying spree, funded by borrowing. In America, the spree continues. In Britain, it seems to have come to an end.

"Evidence is mounting that (consumers) simply do not have the cash to meet the bills for luxury items charged to credit," explains the front-page Daily Mail article. "The increase in debt follows claims that the big banks have promoted ‘binge borrowing’ by pushing cards and loans on to customers. Staff earns bonuses based largely on the value and quantity of cards, loans and associated insurance policies they sell. A resulting ‘buy now, pay later’ approach has driven personal debt above 1 trillion pounds ($1.8 trillion)."

Britain has had one of the best performing economies in Europe. Since 1980, average household income went from 377 pounds per week (adjusted to current prices) to 570 pounds (about $1,000) last year. But even that wasn’t enough. Spending rose even faster, so that the average household spent nearly 22 pounds per week more than it earned.

"Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness," explained Mr. Micawber to David Copperfield. "Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

Misery doesn’t show up immediately. It is like an obnoxious dinner guest; you know he will show up, but you don’t know when. But until he arrives, the party is a lot of fun.

Here in London, the fun times may be over. "Bankruptcies and home repossession applications are running 25% ahead of last year," says the Daily Mail, "and appeals for help to the Consumer Credit Counselling Service are up 60%."

"When house prices fall," says a consumer credit activist, "people stop spending and unemployment goes up. Millions of people are on the edge of a precipice and many may not even realize it. In reality, a lot of people only have enough ready cash to see them through a few weeks."

More news, from our team at The Rude Awakening…


Eric Fry, reporting from Manhattan:

"Please allow us to explore the possibility that bonds might be more right than stocks about the likely course of prevailing economic trends. Stocks and bonds have been rallying together for several weeks. But we suspect that this intimate tango will end very soon. The most important question, however, is which party will end the dance."


Bill Bonner, with more opinions…

*** Oh my. A Thai court has convicted a former central banker of "gross negligence." Rerngchai Marakanond has been fined $4.6 billion after the court found him responsible for the 1997-98 currency crisis.

Advice to Alan Greenspan: Get a false mustache and an address in Switzerland.

Greenspan’s crime is a familiar one. ‘Any stimulus in excess of savings is a fraud,’ said the great economist Shumpeter. Putting interest rates below the inflation rate, and leaving them there for three-and-a-half years after the "emergency" was over, misled consumers into believing they had money to spend…and misled business (particularly Chinese business) into thinking its customers had more money than they actually had.

But everyone loves a good scam…until it comes to an end. That is when the "misery" Mr. Micawber describes shows up at the door. Until that happens, the party seems like such fun that those who weren’t invited feel left out.

That is the gist of almost all the financial press, following last week’s referenda on the European Constitution. "Why can’t they be more like us?" ask the deep thinkers in the Anglo-Saxon media.

Anatole Kaletsky, writing in the TIMES, offers the usual full-throated claptrap. Kaletsky’s argument – hardly an original one – is that the ECB’s reluctance to let the euro fall has hurt the European economies and turned voters against further political integration. If the euro did not exist, he points out, "Each country could make its decisions about the balance between social protection, wages and currency strength." What is novel, and thoroughly bonkers, in Kaletsky’s pensee is the idea that voters can set the price of their currency so as to be able to afford a "generous social safety net."

We don’t know whether the euro is too expensive. All we know is that the theory that prompts Kaletsky to think so is a swindle. Voters have no more idea what interest rates should be than we do. They have no way to know whether their currency is underpriced or overpriced. They simply want more of everything than they can actually afford. Low rates and a cheap currency give them the illusion that they are getting it – while luring them into debt, and eventual bankruptcy. That is the real lesson of the Anglo-Saxon model. And that must be why English women do their housework in the nude – they’ve lost their shirts in the housing market!

*** "I’ve been following your articles on the housing bubble in the U.S. I don’t know if there exist any serious studies on the size of this bubble, but it appears of significant dimensions, writes a Daily Reckoning reader.

"I also don’t know if anyone has considered this (yet), but if this bubble is of the dimensions you describe the impact of it bursting can have significant effects on that class of society that attempted to profit while the status quo of increasing profits remained.

"The middle class is not only the strongest class in society (in size and influence), but also the most fearful in potentially drifting into a lower stratum of society. If the bubble bursts, a lot of people who are still ranked among the middle class will find themselves unable to pay their debts. Ultimately, the poorer class will grow. However, used to a good lifestyle, giving up this lifestyle will not pass the social structure (i.e., the way affairs are handled in society) and, in the end, government
unmarked. A middle class that finds itself less well off than expected (of course, expectations are always higher than reality) has the tendency to call for leaders that take control of the present situation one way or

"The effects of the housing bubble bursting, along with today’s lack of economic growth, can be similar to those of the crash of 1929 and the Great Depression. While the tech stock disaster affected only those individuals who happened to be invested at that time, more people and entire areas that attempted to profit from the "housing boom" will be caught in this mess. The Roosevelt administration could not have grown to its size and strength without the Great Depression. It remains to be seen what effects the bursting housing bubble will have."

The Daily Reckoning