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How the Bubble Started

By Joseph Stiglitz

The pessimists who have long forecasted that America's economy was in for trouble are 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 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 didn't 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 understand what they were getting into.

And Greenspan egged on 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.''

The housing price bubble eventually broke, and, with prices declining, some have found that their mortgages are larger than the value of their houses. As interest rates rose, others found they 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.

Joseph Stiglitz is a Nobel laureate in economics. His latest book is Making Globalization Work.

©2007 Project Syndicate


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