The Prospector spoke to Douglas Duncan, the senior vice president and chief economist at the US Federal National Mortgage Association, which is commonly known as Fannie Mae. It is an organisation founded in the 1930s in response to the Great Depression, but is now a private company which acts in the mortgage market to help lenders maximise their borrowing capacity by securitising mortgage debt and issuing residential mortgage-backed securities.
Duncan is responsible for managing Fannie Mae’s Economics & Strategic Research Group and the conversation covered a broad spread of subjects, the results of which will be published here in the coming days.
Jay Elwes: How do you characterise US growth at the moment? Do you think it is substantial?
Doug Duncan: I think it’s sustainable, but we’ve never fully gotten the growth burst that has been typical of post-World War II expansions. Normally in the first two or three years we would have seen a pretty large rebound to recapture most of what was lost during the recessionary period, but we never really got that. We’ve had very slow growth by historical standards–of the nature of one and a half to two per cent or thereabouts. Consequently this recovery’s level of employment growth has lagged every recovery post-WWII.
JE: Why is that?
DD: Part of the cause is the breadth of credit damage and wealth destruction that was done through the housing sector. Wealth in the housing sector is distributed broadly—the home ownership rate in the United States is about 65 per cent. So something that impacts housing values broadly is likely to impact consumption. This was the first time since WWII that there was a national decline in nominal house prices. That was a significant hit to consumption. A lot of folks also got into difficulty with their mortgages and that led to credit constraints. So certainly that was a piece of it.
Another way to think about it is that when house prices started to accelerate, people after a time perceived that the gains in their home’s value were real, and that they were sustainable, so they started to increase their propensity to tap that equity for consumption. US tax laws related to housing appreciation are supportive of that consumption. For example, a household with two parties in it can deduct up to $500,000 in capital gains, tax free, with the sale of their home, or $250,000 per individual. So there is a propensity to tap that equity and consume.
So, on the way up, with house prices rising, that phenomenon increased. More people extracted equity. That, of course, went into business sales. When the tax law was revised in 1997, the hope was that the extracted equity would go into investment, based on the view that capital tied up in housing was less efficient than if it was extracted and invested to increase production. But of course it could also be used for consumption, and at the household level a lot of it was. That became sales for businesses. They saw sales rise and profits increase, so they expanded and they raised the wages of their workforce in response to seeing greater sales and profits. And that process continued until it became obvious that house prices were unsustainably high and the process reversed itself.
Then you observed the reverse of that whole mechanism: house prices fell, so wealth became constrained, so consumption fell, and with consumption falling, sales of businesses fell along with profits, so businesses had to either lay people off or reduce wages and investment simultaneously. That reversed the cycle. And that was the story of the crisis.
JE: That analysis is very subversive to the “Great Moderation” idea—it suggests that the last interest rate cycle, and the clement economic conditions of that cycle of decent growth of interest rates and so forth, was predicated on the long inflation of a housing bubble. Do you think that the period—maybe to coincide with the tenure of Greenspan at the Fed—do you think the growth experienced in that period was essentially a mirage?
DD: I don’t think we’ve repealed the business cycle—that would be one answer to that. Certainly the monetary policy had an impact on extending that expansion longer than the business cycle normally would have done. And it supported the run up in house prices by maintaining easier credit conditions. I think that’s certainly plausible and verifiable empirically. I think that the view is growing that monetary ease was a contributing factor.
The other thing I would say, that has not really been discussed a lot, is that there is a growing ageing population across significant portions of the globe. Particularly in China, the fact that they have a rapidly ageing population is under appreciated. Their one child policy has lead to very high savings rates since there is almost no social safety net, or a minimal one. And that savings rate, partnered with their rapid economic growth, led to an appetite for fixed-income kinds of securities, which is a normal move for ageing households. All of that interacted in the US with the advent of electronic loan underwriting and an efficient securitisation mechanism that suggested that if people were willing to—or investors were willing to—purchase fixed-income securities rated AAA, then the market would continue to produce them.
Then that interacted with the rising house price story to generate demand for securities that were, in fact, less well underwritten and were certainly overrated from a securities ratings perspective. And all that worked together to support the expansion until it finally collapsed in on itself.
So it’s not all an Alan Greenspan story. There is a much wider label here because the Federal Reserve Board all voted for those policies. But the Federal Reserve policies were enacted in a larger environment where global as well as technical factors were under appreciated.
Duncan is responsible for managing Fannie Mae’s Economics & Strategic Research Group and the conversation covered a broad spread of subjects, the results of which will be published here in the coming days.
Jay Elwes: How do you characterise US growth at the moment? Do you think it is substantial?
Doug Duncan: I think it’s sustainable, but we’ve never fully gotten the growth burst that has been typical of post-World War II expansions. Normally in the first two or three years we would have seen a pretty large rebound to recapture most of what was lost during the recessionary period, but we never really got that. We’ve had very slow growth by historical standards–of the nature of one and a half to two per cent or thereabouts. Consequently this recovery’s level of employment growth has lagged every recovery post-WWII.
JE: Why is that?
DD: Part of the cause is the breadth of credit damage and wealth destruction that was done through the housing sector. Wealth in the housing sector is distributed broadly—the home ownership rate in the United States is about 65 per cent. So something that impacts housing values broadly is likely to impact consumption. This was the first time since WWII that there was a national decline in nominal house prices. That was a significant hit to consumption. A lot of folks also got into difficulty with their mortgages and that led to credit constraints. So certainly that was a piece of it.
Another way to think about it is that when house prices started to accelerate, people after a time perceived that the gains in their home’s value were real, and that they were sustainable, so they started to increase their propensity to tap that equity for consumption. US tax laws related to housing appreciation are supportive of that consumption. For example, a household with two parties in it can deduct up to $500,000 in capital gains, tax free, with the sale of their home, or $250,000 per individual. So there is a propensity to tap that equity and consume.
So, on the way up, with house prices rising, that phenomenon increased. More people extracted equity. That, of course, went into business sales. When the tax law was revised in 1997, the hope was that the extracted equity would go into investment, based on the view that capital tied up in housing was less efficient than if it was extracted and invested to increase production. But of course it could also be used for consumption, and at the household level a lot of it was. That became sales for businesses. They saw sales rise and profits increase, so they expanded and they raised the wages of their workforce in response to seeing greater sales and profits. And that process continued until it became obvious that house prices were unsustainably high and the process reversed itself.
Then you observed the reverse of that whole mechanism: house prices fell, so wealth became constrained, so consumption fell, and with consumption falling, sales of businesses fell along with profits, so businesses had to either lay people off or reduce wages and investment simultaneously. That reversed the cycle. And that was the story of the crisis.
JE: That analysis is very subversive to the “Great Moderation” idea—it suggests that the last interest rate cycle, and the clement economic conditions of that cycle of decent growth of interest rates and so forth, was predicated on the long inflation of a housing bubble. Do you think that the period—maybe to coincide with the tenure of Greenspan at the Fed—do you think the growth experienced in that period was essentially a mirage?
DD: I don’t think we’ve repealed the business cycle—that would be one answer to that. Certainly the monetary policy had an impact on extending that expansion longer than the business cycle normally would have done. And it supported the run up in house prices by maintaining easier credit conditions. I think that’s certainly plausible and verifiable empirically. I think that the view is growing that monetary ease was a contributing factor.
The other thing I would say, that has not really been discussed a lot, is that there is a growing ageing population across significant portions of the globe. Particularly in China, the fact that they have a rapidly ageing population is under appreciated. Their one child policy has lead to very high savings rates since there is almost no social safety net, or a minimal one. And that savings rate, partnered with their rapid economic growth, led to an appetite for fixed-income kinds of securities, which is a normal move for ageing households. All of that interacted in the US with the advent of electronic loan underwriting and an efficient securitisation mechanism that suggested that if people were willing to—or investors were willing to—purchase fixed-income securities rated AAA, then the market would continue to produce them.
Then that interacted with the rising house price story to generate demand for securities that were, in fact, less well underwritten and were certainly overrated from a securities ratings perspective. And all that worked together to support the expansion until it finally collapsed in on itself.
So it’s not all an Alan Greenspan story. There is a much wider label here because the Federal Reserve Board all voted for those policies. But the Federal Reserve policies were enacted in a larger environment where global as well as technical factors were under appreciated.
