Mortgage.net - Greenspan quotes Bank of Canada

Alan Greenspan has referenced a Bank of Canada study to help explain why there has been an incredible drop in long-term interest rates since the early 1990s -- a drop which has led to surging asset bubbles that now appear to be popping. The study was referenced in a commentary the former U.S. Federal Reserve chairman wrote in the Dec. 12 edition of the Wall Street Journal, entitled, The Roots of the Mortgage Crisis. Many observers have said it is the huge build up in savings in the developing world that has helped push bond yields down as countries plough their export and foreign exchange earnings into government paper in the developed world (especially U.S. Treasuries). The study by Brigitte Desroches and Michael Francis argues, however, that it has been weak investment demand that has driven the trend.

"That weakened global investment has been the major determinant in the decline of global real long-term interest rates is also the conclusion of a recent (March 2007) Bank of Canada study," Mr. Greenspan said. He noted in particular the surge in innovation and productivity in the United States throughout the 1990s started taking a breather in 2004 after the dot.com crash.

It is this drop in borrowing rates, of course, which has helped arbritrage equity premiums and real estate and other assets prices to astronomical heights.

"The value of equities traded on the world's major stock exchanges has risen to more than US$50 trillion, double what it was in 2002," Mr. Greenspan noted.

He did offer a mea culpa, saying low U.S. federal funds rates after the tech crash, especially the drop to 1% in mid-2003, "may have contributed to the rise in U.S. home prices." But he added demand was principally driven by the expectation of higher prices what has driven all classic bubbles from the Dutch Tulip craze of the 17th century to the South Sea Bubble.

He adds, he did not think new-fangled mortgages, such as adjustable rates, had much of an impact on the U.S. house price surge.

Perhaps the most crucial point Mr. Greenspan makes is that he now believes globalization has meant that central banks have lost control over long-term interest rates.

"In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities," he said. "Simple correlations between short-and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates."

Case in point? Long-term bond rates barely moved higher as the Fed began to raise interest rates in 2004 and they have since steadily declined.
"Arbitragable assets equities, bonds and real estate, and the financial assets engendered by their intermediation now  swamp the resources of central banks," he said. "The market value of global long-term securities is approaching $100-trillion. Carry trade and foreign exchange markets have  become huge."

Central banks have all but given up intervening in foreign exchange markets, for example, he said. They do, however, still have the power to control short-term rates, giving them the ability to contain price pressures and conventional inflation.

"The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated, and home-price deflation comes to an end," he said. "That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the  world economy more generally, will be able to get back to business."

(Photo: Former Federal Reserve chairman Alan Greenspan. Nicolas Asfouri/AFP/Getty Images)
 
Jacqueline Thorpe