Sun, Aug 12, 2007 - Page 9 News List

A day of reckoning for Americans who lived beyond their means

By Joseph Stiglitz

The pessimists who have long forecast that the US economy was in for trouble finally seem to be coming into their own. Of course, there is no glee in seeing stock prices tumble as a result of soaring mortgage defaults. But it was largely predictable, as are the likely consequences for both the millions of Americans who will be facing financial distress and the global economy.

The story goes back to the recession of 2001. With the support of former Federal Reserve chairman Alan Greenspan, US President George W. Bush pushed through a tax cut designed to benefit the richest Americans but not to lift the economy out of the recession that followed the collapse of the Internet bubble.

Given that mistake, the Fed had little choice if it was to fulfill its mandate to maintain growth and employment. It had to lower interest rates, which it did in an unprecedented way -- all the way down to 1 percent.

It worked, but in a way fundamentally different from how monetary policy normally works. Usually, low interest rates lead firms to borrow more to invest more, and greater indebtedness is matched by more productive assets.

But given that overinvestment in the 1990s was part of the problem underpinning the recession, lower interest rates did not stimulate much investment. The economy grew, but mainly because American families were persuaded to take on more debt, refinancing their mortgages and spending some of the proceeds. And, as long as housing prices rose as a result of lower interest rates, Americans could ignore their growing indebtedness.

Even this did not stimulate the economy enough. To get more people to borrow more money, credit standards were lowered, fueling growth in so-called "sub?prime" mortgages. Moreover, new products were invented, which lowered upfront payments, making it easier for individuals to take bigger mortgages.

Some mortgages even had negative amortization: payments did not cover the interest due, so every month the debt grew more. Fixed mortgages, with interest rates at 6 percent, were replaced with variable-rate mortgages, whose interest payments were tied to the lower short-term T-bill rates.

What were called "teaser rates" allowed even lower payments for the first few years. They were teasers because they played off the fact that many borrowers were not financially sophisticated and didn't really understand what they were getting into.

And Greenspan egged them to pile on the risk by encouraging these variable-rate mortgages. On Feb. 23, 2004, he pointed out that "many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade."

But did Greenspan really expect interest rates to remain permanently at 1 percent -- a negative real interest rate? Did he not think about what would happen to poor Americans with variable-rate mortgages if interest rates rose, as they almost surely would?

Of course, Greenspan's behavior meant that, under his watch, the economy performed better than it otherwise would have done. But it was only a matter of time before that performance became unsustainable.

Fortunately, most Americans did not follow Greenspan's advice to switch to variable-rate mortgages. But even as short-term interest rates began to rise, the day of reckoning was postponed, as new borrowers could obtain fixed-rate mortgages at interest rates that were not increasing.

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