The Dirty Toilet Principle: The Fed and the Housing Bubble

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Dean Baker
Truthout, September 4, 2007

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We all know the dirty toilet principle. If the toilet is dirty, the custodian gets fired. That's the way it works for most people. If you mess up on the job, there are consequences. And if you mess up big time, there are serious consequences. However, that's not the way it works for the people who set the country's monetary policy at the Federal Reserve Board.

The country is now seeing the beginnings of an unprecedented drop in housing prices. House prices in many formerly hot markets, like Las Vegas, San Diego and Miami, are now falling at double-digit annual rates. Prices are also falling in many other cities, although at a somewhat less rapid pace. For the first time since the depression, the country will be seeing nominal declines in house prices nationwide.

The immediate fallout from this price collapse is the subprime crisis that threatens to throw millions of people out of homes where they can no longer afford the mortgage. The credit markets have also seized up repeatedly due to the fact investors now realize they are holding hundreds of billions of dollars of bad debt, although they are not certain where.

And, of course, this is just the tip of the iceberg. With record supplies of unsold and vacant homes, and demand suddenly curtailed by an absence of credit, there is no way house prices will stop falling anytime soon. Trillions of dollars of housing equity will vanish in the next few years as the bubble deflates and house prices return to trend levels.

Given this picture, it might be expected the folks at the Federal Reserve Board would be taking some heat. After all, it is their job to make sure catastrophic events like housing crashes do not occur. But, it doesn't look like they will pay a price for their mismanagement. At the annual meeting of central bankers last weekend in Jackson Hole, the Fed crew was eagerly explaining the housing bubble was not their fault and there was nothing they could have done to prevent it.

The basic story goes like this: The economy was very weak in 2002 and 2003; it was not generating any jobs, and the only sector that showed substantial growth was housing. If the Fed had raised interest rates at that time to stem the housing bubble, it would have curtailed overall growth and left the economy stagnating. Therefore, the Fed was right to keep interest rates low and let the housing bubble boost the economy out of its slump.

There are two big problems with this story. First, raising interest rates was not the only way to try to stem the growth of the housing bubble. Fed Chairman Alan Greenspan could have used his Congressional testimonies and other public forums to warn of the housing bubble. He could have explained house prices had diverged from their long-term trend, creating trillions of dollars of housing bubble wealth. He could also have pointed out lenders were taking huge risks since the collapse of the bubble would cause much of the country's outstanding mortgage debt to go bad.

Would this have deflated the bubble? We will never know because Greenspan refused to try this route. Instead, he derided claims there was a bubble in the housing market and, at one point, even encouraged people to take out adjustable-rate mortgages.

The other reason the Fed's excuse should be given no credence is it ignores the reason the economy was weak in the first place. The economy was in serious trouble in 2002 and 2003 because of the collapse of the stock bubble. Greenspan had made a conscious decision to just let the nineties stock bubble grow, with the idea it would be easy to counteract the consequences of its collapse.

Well, it turned out not to be very easy to get the economy out of a stock-crash-induced recession. Greenspan ran around worrying about deflation for the first time since the Great Depression. The only tool he could find to lift the economy out of the stock-crash recession was the inflation of a housing bubble. Like the alcoholic who cures one hangover by starting on the next, Greenspan sought to recover from the collapse of one financial bubble by inflating another financial bubble. That is not a very clever recipe for stable growth.

Fortunately for them, central bankers are not like custodians: To a very large extent, they get to assign their own grades. As a result, the Fed folks are likely to suffer few consequences even as millions of people lose their homes, tens of millions lose most of their life's savings and the economy stumbles into a recession. Being a central banker is good work, if you can get it.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.