American families were persuaded to take on more debt, refinancing their mortgages and spending some of the proceeds

A day of reckoning for Americans who lived beyond their means | By Joseph Stiglitz

08/12/07 "Taipei Tomes" -- -- 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." ..
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Just as the collapse of the real estate bubble was predictable, so are its consequences: housing starts and sales of existing homes are down and housing inventories are up. By some reckonings, more than two-thirds of the increase in output and employment over the past six years has been real estate-related, reflecting both new housing and households borrowing against their homes to support a consumption binge.

The housing bubble induced Americans to live beyond their means -- net savings have been negative for the past couple of years. With this engine of growth turned off, it is hard to see how the US economy would not suffer from a slowdown. A return to fiscal sanity will be good in the long run, but it will reduce aggregate demand in the short run.

There is an old adage about how people's mistakes continue to live long after they are gone. That is certainly true of Greenspan. In Bush's case, we are beginning to bear the consequences even before he has departed. ...
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Joseph Stiglitz, a Nobel laureate in economics, is professor of economics at Columbia University and was chairman of the Council of Economic Advisers under US president Bill Clinton and a chief economist and senior vice president at the World Bank. Copyright: Project Syndicate