How the US housing bubble could have been avoided

Economist Dean Baker, co-director of the Centre for Economic and Policy Research, based in Washington DC, explains what the United States could have done to rein in its housing bubble. Some lessons for Malaysia here, I think.

The main lesson here is to call a spade a spade – that is, to acknowledge there is a bubble and promote awareness of it – and then to act on it.

This excerpt is from Aljazeera.

… some quick points on what could have been done. First, the Fed has responsibility for maintaining the stability of the US economy. Alan Greenspan should have recognised the bubble and done everything in his power to burst it before it grew to such dangerous levels.

A preventable crisis

Step one in this process should have been to document its existence and show the harm that its collapse would bring. This means using the Fed’s huge staff of economists to gather the overwhelming evidence of a bubble and to shoot down anyone who tried to argue otherwise. Greenspan should have used his Congressional testimony and other public appearances to call attention to the bubble.

This would have put the bubble clearly on everyone’s radar screen. And, the reality was that there were no serious counter-arguments. It is difficult to believe that this action by itself would not have slowed the home buying frenzy and curbed the issuance of junk loans, or at least their repurchase for securitisation.

Second, the Fed has enormous regulatory power beginning with setting guidelines for issuing mortgages. They first issued draft guidelines in December of 2007. It was not hard to find abusive and outright fraudulent practices in the mortgage industry, if anyone in a position of authority was looking for it.

Finally, the Fed could have used interest rate increases as a mechanism to rein in the bubble. This should have been a last resort, since higher rates would have slowed the economy at a time when it was still recovering from the collapse of the stock market bubble.

To maximise the impact of any rate increases, Greenspan could have announced that he was targeting the housing market. He could have said that he would continue to raise rates until house prices were brought back to a more normal level.

This surely would have gotten the attention of the mortgage industry and potential homebuyers. Would it have been an extraordinary action from a Fed chair? Sure, but so what? It might have prevented the economic devastation that is now ruining tens of millions of lives. If this required Alan Greenspan to deviate from the standard script for Fed chairs, that would have been a very small price.

(Thanks to blog visitor Phua Kai Lit for the link.)