The optimism prop

The year was 2002. The US was on shaky economic footing, still reeling from stock market declines and the as-yet uncertain prospect of a two-pronged conflict in the Middle East. And Alan Greenspan, then Fed chairman, was worried about consumer spending.

Alan Greenspan addressed the FOMC. According to his recently-released draft paper, published by the Brookings Institution, he was aware that “almost all market participants” were aware of the growing risks in the mortgage market:

I expressed my concerns before the Federal Open Market Committee that ‘. . . our extraordinary housing boom . . . financed by very large increases in mortgage debt – cannot continue indefinitely.’ It lasted until 2006.

The transcript from the meeting shows Mr Greenspan was even more downbeat than his recent recounting.

The important issue here is that we’re seeing some erosion in the props that support demand in the consumer area, and something else has to take its place.

Mr Greenspan fretted that it was “easy to get exceptionally morose” about the economic outlook, but noted that capital spending will probably accelerate when consumer spending decelerates.

Except, it seems, no one was “exceptionally morose” or, indeed, morose at all. Even Mr Greenspan was saying publicly that a natiowide housing price downturn was “really quite unlikely.”

Mr Greenspan explains the euphoria:

The dot-com bubble that burst with very little footprint on global GDP and in the US, the mildest recession in the post-World War II period. And indeed the previous US recession (1990-1991) was the second most shallow. Coupled with the fact that the 1987 stock market crash left no visible impact on GDP, it led the Federal Reserve and many a sophisticated investor to believe that future contractions would also prove no worse than a typical recession.

So, insufficient macro-economic concern, no significant strengthening of regulations, and banks worried more about retrenching too soon and losing market share than the crash itself, created an environment where consumer spending – and housing prices – grew.

It was, in short, an optimism prop.