- The Washington Times - Monday, June 13, 2005

In testimony before the Joint Economic Committee last week, Federal Reserve Chairman Alan Greenspan delivered some upbeat data about the U.S. economy. He also repeated his now-standard warnings about “the same imbalances and uncertainties” that have confronted policy-makers in the past.

On the upbeat side, the Fed chairman noted that “the soft readings on the economy observed in the early spring were not presaging a more serious downturn.” During the 12-month period ending in March, the economy expanded by 3.7 percent, while the latest unemployment rate (May) fell to 5.1 percent. As the nation’s — and, arguably, the world’s — foremost inflation-fighter, Mr. Greenspan reported that core personal-consumption-expenditures (PCE) prices increased “a historically modest 1.6 percent” over the 12-month period ending in April. Since the core PCE price index, which excludes the volatile energy and food sectors, has long been Mr. Greenspan’s favorite inflation gauge, he clearly wasn’t cherry-picking his data to support his view that “underlying inflation remains contained.”

Even the roaring housing market did not seem worrisome to Mr. Greenspan. While rejecting the idea that a nationwide “bubble” in home prices had developed, Mr. Greenspan once again acknowledged “signs of froth” in some local markets, where home prices seem to have risen to “unsustainable” levels. He warned, however, that the “apparent froth,” which he believes has been confined to some local housing markets, “may have spilled over into the mortgage markets,” which essentially operate nationally. As evidence of a frothy mortgage situation, Mr. Greenspan cited the “dramatic increase in the prevalence of interest-only loans” and other “relatively exotic” forms of adjusted-rate mortgages (ARMs), whose developments merited “particular concern.” Indeed, despite the prevalence in recent years of historically low fixed-rate mortgages, Mark Zandi of Economy.com recently told economics commentator Robert Samuelson that ARMs comprised nearly half of new mortgages during the past year. Initially reflecting even lower interest rates than fixed-rate mortgages, ARMs carry greater risk because they are subject to potentially large market-based rate increases in the future. Riskier still are the relatively new interest-only ARMs, which require no principal payments. Today, Mr. Zandi estimated, these especially risky instruments represent 20 percent of new mortgages. Even under these rather unique financing circumstances, however, Mr. Greenspan envisioned no “substantial macroeconomic implications” in the event that housing prices fell in frothy markets or nationwide. He explained his optimistic view by referring to the rise in nationwide banking and the widespread securitization of mortgages, both of which would mitigate the impairment of financial intermediation that afflicted the economy during previous housing corrections.

Despite the economy’s “reasonably firm footing,” Mr. Greenspan highlighted several risks. He repeatedly warned of long-term fiscal imbalances. Expounding upon one horrific, self-reinforcing scenario, he explained: “[A]s you move into the next decade and beyond, you begin to create potentially unstable [budget] deficit situations in which deficits increase, the [federal] debt increases, the interest on that debt increases, both because interest rates go up and because the debt itself goes up, which increases the deficits still more.” He matter-of-factly reported that the “econometric scenarios that we have run in that context [do] not reach equilibrium very easily.”

Other major imbalances include the nation’s ongoing “negligible” household savings rate. He also said there will have to be “a significant pickup” in productivity. As history teaches, that will have to be “associated with increased capital investment, which in turn requires mainly domestic savings to finance it since we cannot count indefinitely on foreign savings doing that.” Acknowledging the leapfrogging record levels of the nation’s annual current-account deficits, Mr. Greenspan explained: “[T]o the extent that we borrow or even get equity capital from abroad, you’ve got to pay the servicing costs of that” in the form of interest payments on debt or dividend payments on equity. As a result, “a significant amount of domestic production is essentially owned by foreigners. Indeed, the income from production goes abroad and is not available to domestic residents of the United States.” So, Mr. Greenspan did not appear optimistic when he observed that “we are, at best, in only the earliest stages of a stabilization of our current-account deficit — a deficit that now exceeds 6 percent” of gross domestic product.

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