- The Washington Times - Friday, August 26, 2005

Federal Reserve Chairman Alan Greenspan said yesterday the housing boom is causing major distortions in the economy and suggested it must be reined in with higher interest rates.

But he warned in a speech at a gathering of economists in Jackson Hole, Wyo., that Congress’ failure to curb budget deficits and its protectionist war with China could cause a sharp jump in long-term interest rates and prevent a smooth and damage-free resolution of the problem.

“The developing protectionism regarding trade and our reluctance to place fiscal policy on a more sustainable path are threatening what may well be our most valued policy asset: the increased flexibility of our economy, which has fostered our extraordinary resilience to shocks,” he said.

“If we can maintain an adequate degree of flexibility, some of America’s economic imbalances — most notably the large current account deficit and the housing boom — can be rectified by adjustments in prices, interest rates and exchange rates rather than through more-wrenching changes” brought on by financial crisis and recession, he said.

Mr. Greenspan’s comments helped trigger declines in stocks, bonds and the dollar yesterday.

Also weighing on the markets was a report showing that the sharp jump in oil and gasoline prices in the last month is hurting consumer confidence.

Mr. Greenspan’s speech was the first to clearly indicate he views the rapid run-up in housing prices — which have doubled or tripled since 2000 in Washington and other boom areas on the East and West coasts — as posing a danger that requires corrective action by the Fed.

A growing number of prominent economists already had reached that conclusion, and have criticized the Fed’s weak response.

John Makin, a scholar at the American Enterprise Institute, calls the housing boom “Greenspan’s bubble” because it developed while the Fed was slashing interest rates between 2000 and 2004 to the lowest levels in a generation.

Mr. Greenspan said the central bank now is having to keep an eye on housing as well as stocks and bond assets as it determines at what level to set interest rates, because the fast accumulation of home equity wealth is powerfully stimulating consumer spending and the economy.

American’s burgeoning trade deficits with China and oil-producing countries, which have fed the record $668 billion current account deficit, have indirectly enabled the housing bubble, because foreigners have re-invested large portions of their trade earnings in U.S. Treasury bonds.

That has driven bond yields and interest rates — which determine the rates on mortgages — to their lowest levels in decades.

The ready availability of low-cost credit and financing options has enabled consumers and investors to turn their housing wealth into cash like never before, leading to an unprecedented build-up of mortgage debt as well as wealth, according to Fed surveys.

The way consumers and investors have so blithely gone deeply into debt to buy houses and bonds, which also are richly priced currently, raises questions about whether they correctly perceive the risks of such investments, Mr. Greenspan said.

“What they perceive as newly abundant liquidity can readily disappear,” he said. “Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen.”

The rapid increases in the value of homes in some areas “is too often viewed by market participants as structural and permanent,” he said, in part because of the U.S. economy’s extraordinary resilience and stability in recent years despite record-high oil prices and other shocks.

But a sudden change in favorable conditions, particularly low interest rates, that have fostered the housing boom could cause prices to drop, forcing investors and homeowners to try to unload their properties. A wave of panic selling would drive prices down further, in the classic boom-to-bust scenario, Mr. Greenspan said.

“History has not dealt kindly with the aftermath” of bubbles caused by investors who ignored or underestimated risks, he said.

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