Locality is the common sense understanding that every effect is ultimately caused by something coming in contact with something else. The “something” may be as obvious as a little boy knocking a lamp off a table or as subtle as a caller on a satellite phone in Rio bouncing a signal to a colleague in Helsinki. The basic idea is that some force must be transmitted in some way from point A in order for something to happen at Point B. As it happens, our common sense, indeed all of our actual real life experience, is wrong. At the most fundamental, quantum level, the universe is non-local. Things can and do happen without causes. Numerous experiments have confirmed that the spin of one of a pair of entangled electrons can instantaneously affect the spin of the other even if they are on opposite sides of the universe.
We rarely—about once in every 15 billion years or so—come across spinning electrons, entangled or not, in our daily activities, which may be why we find it hard to abandon our notions of cause and effect. And this brings us to the topic of March’s commentary, a recent op-ed piece in the Wall Street Journal by former Federal Reserve Chairman Alan Greenspan called, “The Fed Didn’t Cause the Housing Bubble.” Our argument will be that Mr Greenspan is correct; the Fed did not cause the housing bubble, but not for the reason Mr Greenspan propounds. The Fed did not cause the housing bubble for the simple yet fundamental reason that the Fed was incapable of doing so. The many, various, and entangled influences that created the bubble have much more in common with the behavior of spinning electrons than with naughty little boys.
A bubble in a class of financial assets develops when a great amount of them trade for a brief period at prices well above both earlier and later prices. This is not quite the textbook definition, which holds that prices of bubble assets do not merely rise spectacularly, but that the rise is at variance with those assets’ intrinsic value. Acceptance of this definition requires subscription to the highly dubious concept that assets can actually possess intrinsic value. My conviction is that assets can only have relative value, which changes for any number of complicated and often incomprehensible reasons—and sometimes for no rational reason at all. It follows, then, that a bubble is a phenomenon of time more than value. The difference in value between diamonds and tulip bulbs, for example, is that people have been willing to pay dearly for diamonds for a long time, while only a few Dutchmen in the 1630s were willing to pay up for tulip bulbs.
Similarly, there is no such thing as an intrinsic or appropriate value for an average home in an average community in the United States. All we can really be certain of is that housing was a bubble during this decade because home prices rose sharply above previous levels and then quickly fell, as the following graph makes obvious.
Mr Greenspan makes the argument that home prices rose to unsustainable levels because long-term interest rates generally and 30-year mortgage rates specifically “had gradually decoupled from monetary policy.” While the Fed could affect short-term interest, factors beyond its control vitiated its ability to affect long-term rates. The Fed lost its power because growing global trade created an excess of global savings, which sought safe and profitable investments. These savings found a home in “a well-arbitraged global market for long-term debt instruments,” including trillions of dollars of pooled mortgage securities.
Let’s tease Mr Greenspan’s chain of logic apart. To understand it, we have to believe that low borrowing costs led to rising home prices. Yet, US interest rates had been low for 15 years before home prices broke sharply to the upside. Inflation in general was well under control. Low interest rates did not contribute to home price inflation until powerful technologies made the entire mortgage process from application, to closing, to sale, fast, cheap, and easy. But these technologies would not have been applied to mortgages had not even powerful societal forces made homeownership a realizable dream for nearly all households. These forces included but were no means limited to the large scale entrance of women into the workforce, the explosion in higher education, and the lessening of racial barriers to opportunity. The rise in global savings ran on a parallel track. It was driven in large measure by the purchases of American consumers, which in term were fueled by debt often collateralized by equity in homes. The equity was easily extracted by stream-lined mortgage lending, which was, in turn, fueled by global investors’ appetite for pools of securitized American mortgages and home equity loans. The growing demand for securitized mortgages led originators to seek more supply, which meant making mortgages to less qualified borrowers and to mortgage terms that were unsustainable. In the end, it was all one vast self-reinforcing feedback loop.
My description of this process uses a broad brush. It oversimplifies and leaves out innumerable subtleties and details. But, the point, I think, is clear. Any identifiable “cause” is so interwoven with every other “cause” that beginning and end—that is, cause and effect—quickly become indistinguishable.
But, we aren’t going to let Mr Greenspan off the hook that easily. Undeniably, low long-term mortgage rates contributed to soaring home prices. As home values rose and then fell, mortgage delinquencies synchronously fell and then rose. From a low of 4.3% in the first quarter of 2005, the overall US mortgage delinquency rate ballooned to 7.9% by the end of last year. The total rate, however, hides more interesting details. The delinquency rate for fixed-rate mortgages—that is mortgages whose rates Mr Greenspan believes were distorted by global capital flows—made to borrowers with top-quality credit rose from 2.0% in the first quarter of 2004 to 3.9%. But the delinquency rate for adjustable rate mortgages (ARMs) made to borrowers with marginal to poor credit jumped from a low of 9.8% in the last quarter of 2004 to 24.2%. The rates on ARMs are definitely related to the fed funds target rate, which the Greenspan Fed kept below 2.00% from December 2001 until November 2004.
It is true that as the Fed gradually began increasing the fed funds target rate, long-term, fixed mortgage rates were slow to respond. Over a two-year period from June 2004 to June 2006, the Fed raised the target fed funds rate from 1.00% to 5.25%. Average thirty-year mortgage rates took the opposite direction, declining from 6.20% at the end of June 2004 to 5.53% a year later. After that, however, they turned sharply higher and reached 6.78% by June 2006. Still, in Mr Greenspan’s opinion, this is when the crucial and aberrant decoupling occurred. “US mortgage rates’ linkage to short-term US rates had been close for decades. Between 1971 and 2002, the fed funds rate and the mortgage rate moved in lockstep…Between 2002 and 2005, however, the correlation diminished to insignificance.”
“Insignificance” seems an exaggeration. Yes, there was a wrinkle in the relationship between short-term and long-term rates that made some contribution to rising home prices. But, our point, a much larger point, is the fundamental error of assigning one or even a few definitive causes to complex events. This is not just a matter of historical interest. The plethora of bail-outs, stimulus plans, and changes of direction in response to the on-going economic crisis smacks of locality. Policy makers often say there is no magic bullet, but they seem to keep looking for one. In truth, we are scrambling in the dark for solutions, and we don’t even know if the actions taken so far are producing more harm than good. Every new piecemeal program adds a strand to the tangle, to produce at least as many steps backward as forward. The original TARP legislation was designed by a Republican administration to remove poorly performing assets from bank’s balance sheets. It quickly turned into a massive capital injection for giant, favored banks. Six months later, the new Democratic administration has yet to address the now even more poorly performing assets, and, for all the government largesse it received, Citigroup’s common stock traded below $1 a share last week. The insurance holding company, AIG, has been bailed out to the tune of $170 billion and is 80% owned by the Federal government. Yet, according to The New York Times, it plans to pay $165 million in bonuses on top of the $121 million in bonuses it already paid. The 50 top executives are scheduled to receive a total of $9.6 million, an average of $192,000 each.
I am not arguing, à la Louisiana Governor Bobby Jindal, that government should do nothing. But we are past the point of when the government was forced to react to imminent crises that could bring the financial system to its knees over a weekend. Now, before action is taken, policy makers should understand that unintended consequences are more likely, more numerous, and more hazardous than intended consequences. The danger is particularly acute in the financial arena, where cause and effect are extraordinarily intertwined concepts.
And, if the rational aspects of finance are convoluted, its human aspects can be downright mysterious. Here is Nobel Peace Prize winner Elie Wiesel explaining why he invested—and lost—most of his own and his foundation’s funds with Bernard Madoff. “I remember that it was a myth that he created around him, that everything was so special, so unique, that it had to be a secret. It was like a mystical mythology that nobody could understand.”
Einstein disparagingly dismissed quantum entanglement as “spooky action at a distance.” Wasn’t Bernard Madoff’s influence over Mr Wiesel and thousands of his other dupes a kind of spooky action at a distance? And if the dynamics of Madoff’s essentially uncomplicated Ponzi scheme can hardly be comprehended in terms of rational cause and effect, how can something as convoluted as the housing bubble? No, Mr Greenspan and the Fed he oversaw did not cause the housing bubble. That he could be accused of causing it merely demonstrates how crude our understanding of causation still is.
Note: For a good discussion of locality see “A Quantum Threat to Special Relativity” by David Z Albert and Rivka Galchen in the March 2009 issue of Scientific American.
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