Resident Fellow  Desmond Lachman

On attempting to assess the extent of the economic damage wrought by the ongoing U.S. housing market bust, one has to be reminded of the story about Chou En-Lai, the former Chinese premier. When asked for his assessment of the French Revolution, he replied that, two hundred years on, it was still too early to draw definitive conclusions. So too appears to be the case with the current unraveling of the U.S. housing market. We are simply too close to the event to draw definitive conclusions.

It is not too early, however, for us to know that the present U.S. housing bust has no precedent in U.S. economic history over the past seventy years. For U.S. home prices at the national level are now already declining at an annual rate of more than 5 percent. And, with massive unsold housing inventories and with the scheduled resetting of Adjustable Rate Mortgages, there is every indication that home prices will continue to decline by between 5 and 10 percent a year over the next two years. Not since the Great Depression will we have seen as large and as sustained an erosion of the primary source of U.S. household wealth, which almost certainly will damage the global financial system and will have a negative bearing on consumption behavior.

It is also not too early to apportion major part of the blame for the current housing bust to Alan Greenspan's Federal Reserve. For it was his Federal Reserve that allowed home prices to run up by an extraordinary 80 percent between 2000 and 2006, thereby setting the stage for today's housing market bust. While all of this was happening, Mr. Greenspan kept insisting that it was very difficult for the Federal Reserve to identify asset price bubbles and that in any event, it was not the appropriate role of the Federal Reserve to target asset prices even were it to determine that there was a bubble.

Worse still, despite Mr. Greenspan's increasingly vociferous protests to the contrary, the Federal Reserve must take responsibility for having initiated the housing price bubble. It did so by cutting interest rates aggressively in the wake of the bursting of the NASDAQ bubble in 2001 by a full 550 basis points to as low as 1 percent. It subsequently went on to take its sweet time to normalize those interest rates as the economic recovery got underway and as the housing market bubble barreled on.

Seriously compounding the ill-effects of extraordinarily low interest rates, the Federal Reserve irresponsibly allowed an unprecedented relaxation in mortgage lending standards. It did so by turning a blind eye to the freewheeling originate-to distribute practices of the increasingly important non-bank mortgage originators. Those entities came to account for almost half of all mortgages originated in 2006 and, not holding those mortgages for very long, they had little incentive to ensure that those mortgages performed well till maturity.

It is very difficult to understand why the Federal Reserve did not exercise its authority under the Home Ownership Protection Act to reign in those non-bank originators, which were patently making loans with very high loan-to value ratios to un-creditworthy borrowers that had little chance of being repaid. The Federal Reserve's inaction is all the more inexplicable given the very magnitude of those egregiously sub-standard loans. Between 2004 and 2006, a total of U.S.$1.2 trillion in sub-prime loans were extended, which we now know all too well pose a real threat to the stability of the global banking system.

Far from reigning in irresponsible mortgage lending, Mr. Greenspan championed the financial innovations that facilitated such lending on so large a scale. Rather than seeing sub-prime lending and Adjustable Rate Mortgages as a danger, Mr. Greenspan enthusiastically embraced them as a means to promote an “ownership society”, in which households formerly deemed to lack creditworthiness could now buy homes. He also championed the associated securitization of mortgages as an efficient means to spread risk despite the blatant lack of transparency of the securitized loans.

As estimates of the probable sub-prime lending losses to the financial system steadily rise to the U.S.$250 billion range, Mr. Greenspan's reputation as a maestro central banker has begun to get tarnished. How much harsher will history's judgment of Mr. Greenspan's tenure as Fed Chairman be should the current severe housing downturn lead to a nasty recession, as it has done in as many as eight of the ten post-war recessions.

Hopefully, history will cast doubt on a number of the misguided tenets that Mr. Greenspan held so dear to his heart. Gone will be the days when central bankers cavalierly ignore major asset price developments. And gone will be the days when they shirk from their responsibility to ensure that there is the minimum of regulatory frameworks that might ensure the proper functioning of the mortgage market.

Desmond Lachman is a resident fellow at AEI.