Did Greenspan Cause The Housing Bubble?

Jeffrey Rogers Hummel and David R. Henderson

His role is exaggerated.

Critics across the political spectrum are having a field day blaming the current economic crisis on former Federal Reserve Chairman Alan Greenspan, who they allege carried out an excessively expansionary monetary policy following the recession of 2001. But a careful examination of his record shows little support for this view.

Greenspan, however unintentionally, came close to freezing the domestic monetary base. He therefore still stands out as the only truly successful chairman of the Fed, which, by the way, is one good reason among many for abolishing it. We simply can't depend on his like coming to the fore again, as Ben Bernanke's disastrous tenure is making clear.

Why do people now believe Greenspan was an "inflationist?" Mainly for one reason: they note the low interest rates from 2002 to 2004. But this ignores the simple fact that interest rates can change as a result of real factors involving supply and demand. As Greenspan, among others, has repeatedly (and again recently) demonstrated, these unusually low interest rates were due primarily to a massive flow of savings from emerging economies in Asia and elsewhere.

Although the broader measures of money have become an unfashionable way to gauge monetary policy, their behavior during the period of low interest rates should still make us skeptical of the idea that Greenspan had opened the floodgates. The annual year-to-year growth rate of money with zero maturity (MZM) actually fell from over 20% in 2001 to nearly 0% by 2006.

During that same time, growth of the M2 money supply (includes currency, checking accounts, time-related deposits, savings deposits and non-institutional money-market funds) fell from over 10% to around 2%, and M1 (currency plus checking accounts) growth fell from over 10% to negative rates. Admittedly, the Fed's control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base, which the Federal Reserve directly controls, fell from 10% to below 5% between 2001 and 2006.

The real key to what was going on is revealed by the components of the monetary base. It consists of reserves held by the banks and other depositories, either in their accounts at the Fed or as vault cash, plus currency in circulation among the general public. Between December 1986, eight months before Greenspan became Fed chairman, and December 2005, nineteen years later, the monetary base rose from $248 billion to $802 billion (figures are not seasonally adjusted). True, that doesn't sound like a freeze, but virtually the whole increase was in circulating currency.

During those same 19 years, total bank reserves (including all vault cash) grew from $65 billion to $73 billion, for an average annual growth rate of a mere 0.65%. In some years, aggregate reserves rose, in others they fell, with the major bump surrounding the year 2000. Total reserves are also the one monetary measure with growth showing a temporary uptick into 2003, when interest rates were down.

Currency in circulation exploded even faster than the base, at an annual rate of 7.54%. But most of this new cash went abroad, as a stable dollar became an international currency. These growing foreign holdings of Federal Reserve notes became an additional factor increasing money demand and keeping U.S. inflation in check during the 1990s. On the other hand, Greenspan's virtual freezing of reserves is the most salient yet ignored feature of his tenure. After adjusting for currency going abroad, it means he approximated a de facto freezing of the domestic base.

Greenspan also helped deregulate the broader monetary aggregates: M2, MZM, and M3 (the broadest measure of money). The Depository Institutions Deregulation and Monetary Control Act of 1980 had begun phasing out interest-rate ceilings on deposits and modified reserve requirements in complex ways.

Combined with subsequent administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1--savings deposits, small time deposits, money market deposit accounts, and retail money market mutual fund shares--utterly free of reserve requirements and allowed banks to sweep a large portion of M1 checking accounts into M2 money market deposit accounts. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.

One result, which the late Milton Friedman noted in 2003, is that fluctuations in the velocity of M2 were automatically offset by fluctuations in the amount of M2. Interestingly, this is exactly what monetary economists George A. Selgin and Lawrence H. White predict would happen under free banking, that is, a market-determined monetary system without any government involvement.

They argue that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rises, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity falls, signaling a rise in money demand, banks would enlarge the quantity of money.

Thus, during the dot-com boom of the '90s, M2 velocity rose as people shifted into stocks. But this was perfectly offset by the declining growth rate of M2, which fell to near zero between 1994 and 1996. Assorted Fed-watchers reached opposite conclusions, depending on which variable they focused on.

Those who looked at M2 warned that Greenspan's policies were deflationary, while those who looked at the higher growth rates of the base and M1 predicted higher inflation. Both were wide of the mark, but not because of Greenspan's miraculous central-bank discretion; the result was a product of market process, and when the collapse of the dot-com boom burst the M2 velocity bubble, it induced a new spike in M2 growth.

If Greenspan almost froze total reserves, why, in a growing economy, wasn't there deflation? The reason is the free market's enormous capacity for innovation. Because bank reserves in the U.S. paid no interest until October of last year, banks had a strong incentive to economize on their use. Each dollar of reserves was standing behind more and more dollars of M2.

So what caused the current financial crisis? Economists will probably not know the full answer until many years from now. Minor blips in total reserves under Greenspan may have played some role. Because Greenspan only imperfectly implemented Milton Friedman's proposal of freezing the monetary base, without intending to do so, his policy may have ended up slightly too discretionary. But that possibility hardly justifies the widespread claim that the Fed could have pricked or prevented the housing bubble.

Jeffrey Rogers Hummel is an associate professor of economics at San José State University and the author of Emancipating Slaves, Enslaving Free Men: A History of the American Civil War. David R. Henderson, a research fellow with the Hoover Institution and an associate professor of economics at the Naval Postgraduate School, is the editor of The Concise Encyclopedia of Economics (Liberty Fund, 2008).

Immigrants Can Help Fix the Housing Bubble

RICHARD S. LEFRAK A. GARY SHILLING

The Obama administration should seriously consider granting resident status to foreigners who buy surplus houses in this country. This makes more sense than the president's $275 billion housing bailout plan, which Americans greeted with a Bronx cheer.

The federal bailout forces taxpayers to subsidize overextended homeowners who bet on ever-rising house prices and used their abodes as ATMs, and it doesn't get to the basic problem -- the huge inventory of excess houses. We estimate that 2.4 million houses over and above normal working inventories are left over from the 1996-2005 housing bubble. That's a lot, considering the long-term average annual construction of 1.5 million single- and multi-family units.

Excess inventory is the mortal enemy of house prices, which have already fallen 27% since the peak in early 2006. We predict another 14% drop through the end of 2010 if nothing is done to eliminate the surplus.

Chad Crowe

Doing nothing to eliminate the excess inventory might well push the recession through 2010 and into a depression. Declining home values, for example, are eliminating the home equity that has funded oversized consumer spending for years.

As consumers retrench, production is cut, payrolls are slashed, and consumer confidence, incomes and spending are savaged in a self-feeding downward economic spiral. But if the government buys surplus houses and sells them at low market-clearing prices, other house prices will drop, destroying more home equity and driving many more mortgages under water. Bulldozing excess houses would be an inefficient end for perfectly habitable structures.

A better idea is to offer permanent residence status to the many foreigners who are clamoring to get into the U.S. -- if they buy houses of minimal values (not shacks). They wouldn't need to live in those houses, but in order to remove the unit from the total housing market, they couldn't rent them. Their temporary resident status granted upon purchase would become permanent after, perhaps, five years, if they still owned the houses and maintained clean records. The mere announcement of this program might well stop the ongoing collapse in house prices, especially in cities such as Las Vegas, Miami, Phoenix and San Francisco, where prices are down 40% -- but where many foreigners like to live.

Each year, 85,000 H-1B visas are granted for foreigners with advanced skills and education, and last year, 163,000 petitions were filed in the first five days after applications were accepted. The Ewing Marion Kauffman Foundation estimates that as of Sept. 30, 2006, 500,040 residents of the U.S. and 59,915 individuals living abroad were waiting for employment-based visas. Many would buy homes if their immigration conditions were settled.

These people tend to be highly productive. In 2006, foreign nationals residing in the U.S. were listed as inventors on 25.6% of the patent applications filed in the U.S., up from 7.6% in 1998. A Council of Graduate Schools survey found that in the fall of 2007, 241,095 non-U.S. citizens were enrolled in graduate programs. Some 55% were in engineering and the biological and physical sciences, compared with only 16% of U.S. citizens. In 2007, more people on temporary visas received doctorates in physical sciences and engineering than U.S. citizens.

There is a high correlation between education and incomes, and in today's uncertain economic climate, many wealthy foreigners desire U.S. resident status just as a number in Hong Kong secured residences in Singapore and Canada before the British handover to China in 1997. They rapidly became over a quarter of Vancouver's population, and brought in billions of dollars to buy houses and make other investments.

We could benefit from such an influx. Merrill Lynch estimates that in 2007 there were 10.1 million individuals in the world, 7.1 million outside the U.S., with at least $1 million in financial assets that totaled $29 trillion. If new immigrants bought the 2.4 million excess houses at today's $184,000 median price with funds from abroad, they would bring untold billions. The immigrants would also buy consumer goods, pay taxes, and start many new businesses.

The blueprint for a program to sell surplus housing to immigrants is already in place with the EB-5 visa program. Each year, 10,000 EB-5 visas for this country are available for foreigners who each invest $1 million in a new enterprise ($500,000 in economically depressed areas) that creates at least 10 full-time jobs. After two years, the entrepreneur and his family can become permanent residents.

America's relatively open immigration policy makes this country better off than many other developed lands whose governments also must fund the pensions and health care for growing numbers of retirees. Yet there's still a huge need for more productive and skilled people, both current residents and immigrants, who will produce enough goods and services to provide for their own needs and for those in retirement. Otherwise, entitlement spending eventually will touch off intergenerational warfare.

Granting permanent resident status to foreigners who buy houses in this country will curtail a primary driver of the deepening recession and financial crises -- excess house inventories and the resulting collapse of prices. Since the people who will buy these houses will tend to have money, education, skills and entrepreneurial talents, they will be substantial assets to America in both the short and long runs.

Mr. LeFrak is chairman and CEO of LeFrak Organization, a real estate builder and developer. Mr. Shilling, an economic consultant and investment adviser, is president of A. Gary Shilling & Co.