security program was prepared to significantly curtail individual freedoms
by such measures as tightening identification requirements, stepping
up identity checks, restricting travel, and limiting privacy.* The leaders of
both parties were on board. But when no further attacks came, the politicians
gradually reverted to their pre-9/11 positions on civil liberties, some
more quickly than others. It is interesting to hypothesize how the United
States would look today if there had been a second, third, and fourth attack.
Could our culture stand it? Would we be able to maintain a viable
economy as the Israelis have, and as Londoners did during the decades of
bombings by the Irish Republican Army? I had great confidence that we
could ... but there is always that doubt.
*The Homeland Security Act itself was less draconian, but did curtail civil liberties by making
it easier for the government to deny Freedom of Information Act requests, by imposing criminal
penalties on officials who disclosed "critical infrastructure information" obtained from private
companies, and by developing a program that would monitor citizens' everyday lives.
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The Fed's response to all this uncertainty was to maintain our program
of aggressively lowering short-term interest rates. This extended a series of
seven cuts we'd already made in early 2001 to mitigate the impact of the
dot-com bust and the general stock-market decline. After the September 11
attacks, we cut the fed funds rate four times more, and then once again at
the height of the corporate scandals in 2002. By October of that year, the
fed funds rate stood at 1.25 percent, a figure most of us would have considered
unfathomably low a decade before. (Indeed, rates had not been so low
since the days of Dwight Eisenhower.) As officials whose entire careers had
been devoted to fighting inflation, we found the experience of making such
cuts decidedly strange. Yet, the economy was clearly in the grip of disinflation,
in which market forces combine to hold down wages and prices and
cause inflation expectations, and hence long-term interest rates, to recede.
So inflation, for the moment at least, was not a problem. Between
2000 and 2003, long-term interest rates continued to decline—the rate on
ten-year treasuries dropped from nearly 7 percent to less than 3.5 percent.
It was clear that the ultimate explanation extended far beyond American
shores, because long-term interest rates around the world also were trending
down. Globalization was exerting a disinflationary impact.
We put that broader issue aside to wrestle with the immediate challenge
facing the Fed, a weakened economy. The FOMC's working assumption
was that rising prices did not pose an imminent threat and that gave us
the flexibility to lower short-term rates.
By 2003, however, the economic funk and disinflation had gone on so
long that the Fed had to consider a more exotic peril: a declining price
level, deflation. This was the possibility that the U.S. economy might be
entering a crippling spiral like the one we'd seen paralyze Japan for thirteen
years. I found it to be a very unsettling issue. In modern economies, whose
chronic headache is inflation, deflation is a rare disease. After all, the United
States was no longer on a gold standard. I couldn't conceive of deflation occurring
under a fiat money standard. I'd always assumed that if deflation
seemed imminent, we could start up the printing presses and create as
many dollars as would be necessary to stop a deflationary spiral. Now I was
not so sure. Japan had figuratively opened its money taps, driven interest
rates to zero, and run a large budget deficit, yet its price level had continued
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to fall. The Japanese seemed unable to break the grip of deflation and must
have been quite fearful that they were in the type of downward spiral that
nobody had witnessed since the 1930s.
Deflation became the focus of increasing concern within the Fed.
While the economy eked out 1.6 percent real GDP growth during 2002; it
clearly was being constrained. Even powerful companies like Aetna and
SBC Communications were showing weak profits, laying people off, and
reporting difficulty making price increases stick. Unemployment had risen
from 4 percent at the end of 2000 to 6 percent.
At the FOMC meeting in late June, where we voted to reduce interest
rates still further, to 1 percent, deflation was Topic A. We agreed on the reduction
despite our consensus that the economy probably did not need yet
another rate cut. The stock market had finally begun to revive, and our
forecasts called for much stronger GDP growth in the year's second half.
Yet we went ahead on the basis of a balancing of risk. We wanted to shut
down the possibility of corrosive deflation; we were willing to chance that
by cutting rates we might foster a bubble, an inflationary boom of some
sort, which we would subsequently have to address. I was pleased at the
way we'd weighed the contending factors. Time would tell if it was the
right decision, but it was a decision done right.
Consumer spending carried the economy through the post-9/11 malaise,
and what carried consumer spending was housing. In many parts of
the United States, residential real estate, energized by the fall in mortgage
interest rates, began to see values surge. The market prices of existing homes
rose 7.5 percent a year in 2000, 2001, and 2002, more than double the rate
of just a few years before. Not only did construction of new houses rise to
record levels, but also historic numbers of existing houses changed hands.
This boom provided a big lift in morale—even if your house was not for
sale, you could look down the block and see other people's homes going for
what seemed like astonishing prices, which meant your house was worth
more too.
By early 2003, thirty-year mortgages were below 6 percent, the lowest
they'd been since the sixties. Adjustable-rate mortgages cost even less. This
spurred the turnover of houses that drove prices higher. Since 1994, the
proportion of American householders who became homeowners had ac
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THE AGE OF TURBULENCE
celerated. By 2006, nearly 69 percent of households owned their own
home, up from 64 percent in 1994 and 44 percent in 1940. The gains were
especially dramatic among Hispanics and blacks, as increasing affluence as
well as government encouragement of subprime mortgage programs enabled
many members of minority groups to become first-time home buyers.
This expansion of ownership gave more people a stake in the future of
our country and boded well for the cohesion of the nation, I thought. Home
ownership resonates as deeply today as it did a century ago. Even in a digital
age, brick and mortar (or plywood and Sheetrock) are what stabilize us
and make us feel at home.
Capital gains, especially gains realized in cash, began burning holes in
people's pockets. Soon statisticians could see a bulge in consumer spending
that matched the surge in capital gains. Some analysts estimated that
3 percent to 5 percent of the increase in housing wealth showed up annually
in the demand for all manner of goods and services, from cars and refrigerators
to vacations and entertainment. And, of course, people poured
money into home modernization and expansion, further fueling the boom.
This pickup in outlays was virtually all funded through increases in home
mortgage debt, which financial institutions made particularly easy to tap.*
The net effect was characterized neatly by economics columnist Robert
Samuelson, who wrote in Newsweek on December 30, 2002: "The housing
boom saved the economy.... Fed up with the stock market, Americans
went on a real-estate orgy. We traded up, tore down and added on."
Booms, of course, beget bubbles, as the owners of dot-com stocks had
painfully learned. Were we setting ourselves up for a harrowing real estate
crash? That concern started to surface in hot markets like San Diego and
New York, where prices in 2002 jumped by 22 percent and 19 percent, respectively,
and where some investors now began viewing houses and condos
as the latest way to get rich quick. The Fed tracked such developments closely.
As the boom rolled on, the evidence of speculation became hard to miss.
The market for single-family homes in the United States had always been
*When a home changed hands, the buyer almost invariably took out a mortgage that exceeded
the unpaid balance on the seller's outstanding mortgage. The net increase of debt on the house
went as cash to the seller. Such home equity extraction tends to track, but is not exactly equal
to, the realized capital gain on the sale.
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predominately for home ownership, with the proportion of purchases for
investment or speculation rarely more than 10 percent.* But by 2005, investors
accounted for 28 percent of homes bought, according to the National
Association of Realtors. They became a force in the market, driving
up turnover of existing homes by almost one-third. By then, the TV news
was carrying reports of "flippers"—speculators in places like Las Vegas and
Miami. They would use easy credit to load up on five or six new condos,
aiming to sell them at a large profit even before the apartments were built.
Such dramas remained strictly regional, however. I would tell audiences
that we were facing not a bubble but a froth—lots of small, local bubbles
that never grew to a scale that could threaten the health of the overall
economy.
Whether a bubble or a froth, the party was winding down by late 2005,
when first-time buyers began to find prices increasingly out of reach. Higher
prices required larger mortgages, which began to claim a burdensome share
of monthly income. The heady days when buyers paid above offering prices
to bid away a house were over. Sellers' offering prices held up, but buyers
pulled their bids. Sales volumes accordingly fell sharply for both new and
existing homes. The boom was over.
It had been part of a historic international trend. Mortgage interest
rates had fallen not just in the United States but also in Great Britain, Australia,
and many other countries that have viable mortgage markets. In response,
home prices worldwide had soared. The Economist, which tracks
home prices in twenty countries, has estimated that between 2000 and
2005 the market value of residential property in developed nations rose
from $40 trillion to more than $70 trillion. The largest share of that
increase—$8 trillion—occurred in U.S. single-family homes. But the experience
of other economies was suggestive because their booms began—and
ended—a year or two ahead of ours. In Australia and Britain, demand began
to cool in 2004 for the same reasons it later cooled in the United States:
first-time buyers got priced out of the market, and speculative investors
*Such purchases are largely made by people who purchase and rent out dwellings. Often, such
an individual is the owner of a condominium or of a two-family attached house, one unit of
which is rented out.
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drew back. Importantly, as the boom ended in those countries, prices leveled
out or declined slightly but at this writing have not crashed.
Because of the housing boom and the accompanying explosion in new
mortgage products, the typical American household ended up with a more
valuable home and better access to the wealth it represented. Its mortgage
is bigger too, of course, but since the debt carries a lower interest rate, the
drain on income from debt service as a share of homeowner income did not
change much between 2000 and 2005.
The post-9/11 recovery had a dark side, however. It was marred by a
disturbing shift in the concentration of income. For the past four years,
gains in the average hourly salaries of supervisory workers have significantly
outstripped gains in the average hourly earnings of production and non-
supervisory workers. (For many households, the lag in real incomes was
offset by capital gains on their homes, even though the bulk of the capital
gains went to households in the upper-middle and upper income groups.)
You could see the income divergence reflected in the polls even as
economic growth returned. By 2004, real GDP was expanding at a healthy
3.9 percent a year, unemployment declined, and aggregate wages and
salaries weren't doing all that badly either. Yet most of the rise in average
incomes was owing to disproportionate gains among the highly skilled.
There are a lot more workers who earn at the median income, and they
have not been doing all that well. Thus, it is no surprise that researchers
who telephoned a thousand households found that 60 percent thought
the economy was awful, while only 40 percent thought it was just fine.
Two-tier economies are common in developing countries, but not since
the 1920s have Americans experienced such inequality of income. It used
to be that when the aggregate numbers were good, the polls would be positive
as well.
More recently, the unwinding of the housing boom has hurt some
groups. It did not create great difficulties for the great mass of homeowners
who had built up substantial equity in their houses as prices rose. But many
low-income families who took advantage of subprime mortgage offerings
to become first-time homeowners joined the boom too late to enjoy its
benefits. Without an equity buffer to fall back on, they are having difficulty
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making their monthly payments, and increasing numbers are facing foreclosure.
Of the nearly $3 trillion of home mortgage originations in 2006, a
fifth were subprime and another fifth were so-called Alt-A mortgages. The
latter are mortgages taken out by people with good credit histories, but
whose monthly payments are often interest-only, and whose documentation
