Former Fed chairman Alan Greenspan suggests to Paul Tansey, Economics Editor, that the subprime credit crisis may lead to a recession in the US
Famed for the creative ambiguity of his statements on monetary policy as chairman of the Fed, Alan Greenspan has become more outspoken since he cast off the chains of office. Equipped with an extraordinary command of data, economics is his natural territory.
He is less sure-footed when venturing on to political ground, particularly when that ground is the Middle East. We met in London last Tuesday, the day after the Dow Jones Index has hit an all-time high.
Tansey: The recent performance of US stock markets appears to indicate that they are drawing a line under the subprime crisis: what's your own view? Have we seen the worst of it, or will it have a long tail?
Dr Greenspan: It's likely that we have seen the worst of it, but there will be an Act II. The probable outcome of the existing crisis is more than likely to be a gradual easing of the pressures, What we are observing is that risk-taking is spreading modestly and, most importantly, is reaching beyond overnight credits where it has been concentrated. While volumes of activity are still quite sub-normal, they are gradually picking up.
Tansey: So trust is returning to financial markets?
Dr Greenspan: Trust is returning very gradually. It's gradual and could be unsettled by unexpected events. Clearly, however, trends are developing in the right direction. It's clearly the case in the United States and the UK, less so in other countries.
Tansey: How do you see the US economy evolving over the next 12 to 18 months?
Dr Greenspan: That is Act II. That Act II may turn a different phase of the subprime crisis. The crucial issue is American home prices. In the United States, there is a very large segment of single-family home construction that is for speculative sale, roughly 75-80 per cent of private housing starts. When the subprime problem hit, home sales fell very significantly, with a very large part of the decline being subprime adjustable rate-financed homes. The market fell very dramatically.
The consequence is that home builders were caught with very large, under construction inventory which is coming out now as new homes going for sale, vacant, seeking a buyer and deteriorating. This inventory is costly to maintain and is pressing home builders to initiate fire sales, which is having a very clear effect on price.
Tansey: How steep has been the decline in the US housing market to date?
Dr Greenspan: In the second quarter, it subtracted a full percentage point from the annual rate of US growth. The issue here is that the level of inventories is about eight months' [ housing] supply, about twice the level that is normal. Prices are falling fairly rapidly. Latest data we have for existing home sales, between March and July, show that prices fell at a 6.6 per cent seasonally-adjusted annual rate.
This is fairly unprecedented in recent American economic history. My strong suspicion is that August was down, as was September, but we don't know that yet. But while the impact on housing construction is important, it is far less important than the potential impact of declining prices for existing homes on the net worth of households.
That is driven by three forces: the market value of stocks and the market value of homes minus outstanding mortgage debt. What we are seeing now is equity in homes, the market value minus the debt, beginning to slide.
Unless the stock market picks up the slack, the increase in household net worth is going to slow down quite significantly. What our history suggests is that 15 per cent of our personal consumption expenditures is not the result of the income of households but rather their capital gains, essentially financed by mortgage debt. This has been the most volatile part of consumption expenditures over the years and there is every expectation that as the equity in homes declines, it will begin to press on consumption expenditures.
Tansey: So will this Act II of the subprime crisis, the secondary effect of falling house prices depressing US consumer spending, cause a recession next year?
Dr Greenspan: There is a probability of not quite half - I guess between one-third and one-half - we will move into a recession which will likely impact on mortgage default rates. And since there are $900 billion (€637 billion) in asset-backed subprime mortgages, there's a distinct possibility that the market value of that $900 billion, which already adjusts for some foreclosures in the actual structure of the mortgages, may find that the foreclosure rate is a lot higher.
That could be a problem because the overall current situation is fragile. What's of concern here is that we could have a second episode, caused by the fact that unanticipated defaults are pressing down on the market value of assets which have to be marked down. Because existing conditions are fragile, it doesn't have to be a very large problem to create difficulties.
The fact that we're going to get lower house prices is close to certain. The fact that we are going to get some diminishment in equity in homes is reasonably certain. What is unclear is the order of magnitude of that force as it impacts on American consumption expenditures and, therefore, potentially, on the financial markets and, with weakening consumption expenditure in the United States, spillover effects on our trading partners whose US markets will have shrunk.
Tansey: When do you think it will be possible to make a judgment on whether the US is tipping into recession?
Dr Greenspan: I think through Christmas, in the early weeks and months of the new year. We will learn by then how severe this problem is and probably be able to judge whether it's correcting or whether it's still an open wound.
At the moment, it is an open wound. And to a large extent, it depends on how rapidly we reduce what is now an overhang of 200,000 new homes for sale.
Tansey: So, basically, any recessionary impulse in the United States is stemming, directly or indirectly, only from housing markets?
Dr Greenspan: The rest of the economy is fine. Corporations' balance sheets are in excellent shape. There's not a great deal of short-term funding requirements. Corporations took advantage of the dramatic decline in long-term interest rates and funded a lot of their short-term liabilities.
Tansey: Do you see the US interest rate cycle as having topped out following the recent cut in Fed rates?
Dr Greenspan: That's what the markets are saying. I don't want to comment directly as these are matters of policy. But clearly, short-term forward rates in the American financial system are pointing lower, though long-term rates are not.
Tansey: When you were chairman at the Fed, what was the attitude of politicians to the setting of interest rates?
Dr Greenspan: Politicians have never seen an interest rate they consider too low. Through all the years I was at the Fed, I cannot recall a single instance where a president, congressman or senator wrote me a note saying we should raise interest rates.
Tansey: I'd like to turn to what your book says regarding oil and the Iraq war. As I construed it, what you were saying was that the United States won't allow politically hostile regimes in the Middle East to disrupt the security of oil supplies to the industrial world.
(In his book, Dr Greenspan has written: "I am saddened that it is politically inconvenient to acknowledge what everyone knows: the Iraq war is largely about oil. Thus, projections of world oil supply and demand that do not note the highly precarious environment of the Middle East are avoiding the eight hundred pound gorilla that could bring world economic growth to a halt".)
Dr Greenspan: Actually, that may be true, but it's not what I had in mind. What I really had in mind was the thought that if there was no oil under the sands of Iraq, Saddam Hussein would never have been able to accumulate the resources that enabled him to attack his neighbours, first, of course, Iran, then Kuwait, clearly, and was really threatening to move into Saudi Arabia before the Gulf War.
If he had not been taken out, he probably would be still seeking an atomic device and ultimately trying to control the Straits of Hormuz, the waterway from which most of the Middle East oil comes into international trade. And, as one can judge now, if he had gained full control of that 18 million barrels of oil a day and had decided for political reasons to cut off five million to seven million barrels, the global economy would have ground to a halt.
But the fundamental issue is that if he had never gotten the real resources, we would never probably have heard of him.
Tansey: But implicit in that is still a position that this can't be allowed to happen.
Dr Greenspan: What people don't understand is how fragile our time is, how fragile global prosperity is, that rests on the security of Middle East oil.
I have no reason to question that the motives of this administration in going into Iraq were basically weapons of mass destruction. I never heard anything other than that. I just did not consider that a critical issue when I was so much involved with oil security as a major issue.
The US position has always been never to actually seek to control the oil itself. Actually, when the Saudis essentially took over the oil, we were not happy but we gladly wrote a new contract with them. Our main concern was not with who owned it but whether there was secure oil for the industrial world.
Tansey: How do you assess British economic prospects at present?
Dr Greenspan: There was a bit of weakness in housing prices in Britain in 2004, but it stabilised very quickly. As my friends in the British government continuously tell me, there's a 100,000 a year undershoot in home building and the industry needs to be much larger. There's a serious question about what's going to happen to prices, but Britain is not going to have the real price weakness that we have in the United States.
Tansey: The response of the Fed and the European Central Bank to the credit crunch appears markedly different to that of the Bank of England. Would you comment?
Dr Greenspan: The truth of the matter is that there's much less difference. It's a question of timing. And it's a very tough judgment . . . Observe that all three central banks were very reluctant to come in. They only moved when the necessity arose.
It does not follow that when necessity arises that you should have moved earlier. Holding off as long as you can has value. And the value is that you reduce the degree of moral hazard. Remember that the issue for the Bank of England is basically Northern Rock and Northern Rock is a very complex case.
Tansey: But in the end Northern Rock did manifest itself and it appears that the ball was dropped between the Bank of England, the Financial Services Authority and the Treasury.
Dr Greenspan: The tripartite problem is an exaggeration . . . There's no way to avoid a Northern Rock-type of situation. There's always some institution out there which will get into trouble. And you deal with it as best you can. The presumption that you're going to prevent things like Northern Rock happening is just utterly unrealistic - and it may even be undesirable.
Tansey: Are you now advising Gordon Brown on these issues?
Dr Greenspan: Not directly. We have a lot to talk about. I mainly discuss global issues, trends in world markets and we spend a great deal of time on the Scottish Enlightenment.
