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Monetary Accelerator

Helping cash pour into the financial system were global central bankers, who were pressing hard on the monetary accelerator. None pressed harder than Alan Greenspan, Chairman of the U.S. Federal Reserve. The Fed had grown nervous about the U.S. economy’s prospects after the 9/11 terrorist attacks and the tech bust. The central bank’s concerns grew as the economy flirted with deflation after the 2001 recession. The Fed knew how to fight off excessive inflation, but it had fewer options and little experience handling the economic dislocations that occur when prices fall too much. The central bank began by sharply cutting its key interest rate from above 6% to 1%, a level not seen since the late 1950s (see Figure 1.2).

Figure 1.2

Figure 1.2. Federal funds rate, %.

Source: Federal Reserve Board

Lower interest rates were like a shot of adrenalin for the housing market; as mortgages became cheaper, buyers could afford more and larger homes. This was by design; Greenspan hoped housing would drive the economy out of its funk and diffuse the deflation threat. He publicly urged homeowners to take out adjustable-rate mortgages, suggesting they would be cheaper in the long run than more popular fixed-rate loans. 1 Many took his advice, and the use of ARMs took off, even among borrowers with checkered credit histories and limited means—the soon-to-be-infamous subprime market.

Greenspan accomplished his goal; home sales, housing construction, and house prices all rose. In the 4 years following 9/11, national house prices surged nearly 50%. The effect was profound; homeowners felt much wealthier and acted like it, borrowing aggressively against their homes and spending the proceeds. Homeowners extracted a stunning $3.1 trillion through home equity loans and cash-out refinancings between 2002 and 2006. 2 The economy’s growth accelerated and the deflation threat faded away.

But the boom became a bubble. Years of strong price gains attracted speculators looking to flip homes for quick profits. As long as prices were rising, the house flippers could make big bucks using borrowed money, and their activities helped drive prices even higher, particularly in Arizona, California, Florida, and Nevada. Builders responded to what looked like booming demand by putting up more new homes. By 2006, both housing construction and house prices were exceeding all records (see Figure 1.3).

Figure 1.3

Figure 1.3. Case Shiller repeat-sales house price index: 2000Q4=100.

Source: Fiserv Case Shiller

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