ONE 4 • When the Bubble Bursts • Mortgage Update — Mike Holmes

Since When Mortgages Buy the Farm was published in the second issue of ONE Magazine, the global credit crunch has begun to look more like a full-blown crash. The UK’s Northern Rock has now been nationalized to prevent it going south, and Bear Stearns has fallen victim to a bear market in the States. The Saga continues…

They say that generals always prepare to fight the last war. Ben Bernanke, Chairman of the US Federal Reserve, has admitted his organization’s culpability for the Great Depression of the 1930s: “We did it. We’re very sorry. We won’t do it again.” The Fed’s actions are now intended to prevent any repetition of that kind of deflation, which was seen as both marking and driving financial disaster.

Bernanke specialized in studying the Depression. In 2002, he outlined how he would avoid a US repeat of the Japanese deflation of 1989–2007. This notorious speech earned him the nickname “Helicopter Ben” because he suggested that a government could always prevent deflation by printing money and air-dropping the cash on voters.
What European financiers dread, of course, is the possibility of people needing wheelbarrows full of money to go shopping, as happened during Germany’s Weimar-era hyperinflation. Needless to say, they’ve been adamant about holding up interest rates, and insist that they’ll take no chances with global inflationary risks in the face of rising food and energy prices.
Britain’s Bank of England currently tries to straddle these opposing positions. Its sole remit is to hold inflation between 1.5% and 2.5%, and Governor Mervyn King must write an explanatory letter to the Chancellor of the Exchequer whenever inflation rises above 3% – something that King admitted may happen in 2008. Interest rates are currently being cut cautiously, despite the inflationary dangers, to provide relief to the banking sector and property markets.
On the other side of the pond, Alan Greenspan, Bernanke’s predecessor and former boss, is busy giving interviews and writing articles on the credit bubble. His position appears to boil down to: “It wasn’t me – a big boy did it and ran away!” Greenspan’s detractors – including financial expert Bill Fleckenstein, who has just published a critical book with Fred Sheehan called Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve – blame him for inflating the credit bubble and he’s determined to defend his reputation.
Greenspan claims that housing bubbles have appeared all over the globe because of the low long-term interest rates caused by a surplus of global saving. His opponents counter that Greenspan’s reduction of US interest rates to a mere 1% after the 2000 dot-com crash and the 9/11 attacks – not to mention keeping them too low for too long – are responsible for a reckless expansion of global credit: this is what drove the current financial bubbles. Greenspan argues that he was trying to prevent a deflation, that it’s impossible to recognize a bubble until after it bursts, and that regulators should use only a light touch since financiers will always know markets better than those trying to regulate them.
It’s hard to believe that such low rates in the dollar, the world’s reserve currency, could have had little effect on credit markets. What’s more, if Greenspan truly believes that free markets will always be so much better informed than regulators, then why didn’t he abolish the Federal Reserve on his first day as Chairman?
The job of the Chairman has been described as taking away the punchbowl just as the party’s getting started. Greenspan’s critics argue that, in cheering on global markets, he spiked the drink instead. He received an Honorary Knighthood from Britain in 2002, prompting his detractors to dub him “Sir Printsalot”.
Meanwhile, back in Blighty, Prime Minister Gordon Brown’s reputation for fiscal prudence and sound economic stewardship is being battered as the housing crisis erupts here. He’s keen to blame world financial forces in general and the US subprime mortgage disaster in particular. What’s becoming clear in the UK is that Brown’s claimed decade of prosperity was built on top of the credit bubble. In claiming authorship of the good times, he must accept responsibility for the consequences.
One change that Brown made as Chancellor was to alter the Consumer Price Index to exclude the cost of housing – because rising house prices were making inflation look too high for comfort. If he hadn’t done this, it’s likely that the Bank of England would have held interest rates higher in response to increased housing inflation, and that this would have reduced the bubble.
Brown’s 1997 campaign motto of “no return to boom and bust” is certain to haunt him at the next election. His predecessor, Norman Lamont, stated recently that
no Chancellor should imagine that the business cycle can be abolished.
There still are some important questions that have to be answered. Joseph Schumpeter wrote about cycles of “creative destruction”, times when booms replace old technologies with new ones. Credit bubbles have appeared throughout history and have often been associated with technological progress. It’s possible – if unlikely – that busts are necessary to weed out ideas that aren’t viable while liberating resources to support those that are.
Even if we could control financial bubbles by smoothing out the credit cycle in order to avoid the chaos that these cause, there still remains the question of whether we should: progress may require them.

– Mike Holmes