Robert Shiller had warned about irrational exuberance in stocks in the run up to the technology bubble bursting. He also cautioned about the rapidly rising home prices and how they were primed to fall. Shiller had forecast the tech bubble and the housing crisis. He won the Riksbank prize in Economic Sciences in Memory of Alfred Nobel this year. Alan Greenspan says many, including himself, had not forecast the housing crisis.
The Federal Reserve is an acolyte of Eugene Fama – another of this year’s Nobel economics laureates for postulating random walk in stock prices – a man in whose vocabulary bubbles don’t exist. Never mind Tulipomania. The institution has always expressed skepticism about bubbles. ‘If we do not know there is a bubble, how can we respond in real time with appropriate policy’ has always been the Fed’s refrain. Therefore, the best policy, says Alan Greenspan, is to support the financial markets and the economy after inflated asset prices fall or after a bubble bursts as he had done in 1987 and in 2000.
Markets take risks not when long periods of economic stability breed complacency but when risk taking is incentivized by the central bank – when market participants know that the central bank is standing by in case they falter.
I argue here that technology asset price inflation was a bubble and housing was not. Bubbles occur when asset prices are out of line on the upside relative to earnings as was the case with technology stocks. Stock prices were deliberately driven up to profit even when the fundamentals were not commensurate. Market behavior was premeditated and not irrational. Housing crisis, on the other hand, occurred because of financial innovation and lax lending standards which had spurred real housing demand raising home prices. Federal Reserve contributed by introducing moral hazard into monetary policy: promising to bail out failure in housing if interest rates went up.
Financial innovation in housing and poor lending standards were intentionally encouraged by the Fed and the government at large to raise homeownership in the United States. The consequence is the housing crisis, of the establishment’s own making and not because of market irrationality.
Greenspan says he would have cut interest rates and engaged in quantitative easing after any sharp downward adjustment in the market but would not have bailed out Wall Street firms. A lesson, however, which he does not learn is that ex ante assurances that the Fed will provide liquidity to support the financial markets in the event of market failure only promote unethical cycles of highs and lows in asset values for markets have little to lose.
Market participants are rational but not all wise.