To Confront a Bubble
There is a way to stop the business-cycle boom bubble, but it requires radical changes in economic policy that no one seems willing to confront.
September 1, 2007
Fred Foldvary, Ph.D.

The Wall Street Journal on September 7, 2007, reported the former chairman of the Federal Reserve System as saying, "The human race has never found a way to confront bubbles." He stated this in a speech to economists in Washington, D.C. at a meeting held by the "Brookings Papers on Economic Activity." The dinner meeting was held in honor of the turnover of the editorship to the new team of editors, Greg Mankiw, Larry Summers, and Doug Elmendorf.

Greenspan said that the activity of financial markets in August 2007 was similar to that of previous times of market turmoil, such as the big stock market drop of 1987 or, going back in history, "the land-boom collapse of 1837." He also said that attempts by the Fed to decelerate booms by raising interest rates did not work.

With all due respect, Alan Greenspan is not confronting the full issue. First of all, if he believed that there was a bubble during the mid ozo years 2003-2006, he did not say so. Maybe he hesitated because his description of the stock market rise of the 1990s as "irrational exuberance" was not well timed, as it came a few years before the peak. Nevertheless, if he thought there was a bubble, he could have said so, and the world would have listened.

Secondly, Greenspan could have spoken out about the loose lending practices during the real estate boom, aided by the financial industry. For example, in 2000, the bond-rating company Standard & Poor's declared that the "piggyback" mortgages, in which borrowers get a second loan for the down payment, was no more risky than the standard mortgage that is based on a positive down payment. This lending practice contributed to the subprime mortgage problem we have today.

Greenspan was silent as these risky mortgages were sold by the originating banks to hedge funds, pension funds, insurance companies, and other financial institutions, which often borrowed to buy these mortgage packages, a practice which has increased the risks of default throughout the financial system.

"I ask you if anybody in early June could contemplate what we are now confronted with?" stated Greenspan. Evidently he did not read the works of Fred Harrison and others on the real estate cycle that has been affecting economies for 2000 years, and which in the US had already peaked out in 2006, and with recessions following these peaks. I wrote a paper on the business cycle in 1997 which predicted a recession in 2008. Evidently the gurus at the Fed did not read it, nor have they paid attention to repeated warnings of the destabilizing effects of the real estate boom, the secondary mortgage market, and role of the Fed in creating easy lending money in the first place.

The Fed chiefs should know their economic history, which tells us that lending practices have always been loose during a boom and only when defaults rise do the banks and other institutions tighten, which it is already too late.

Mr. Greenspan invoked business cycle economists who wrote that the cycle is generated by changes in "business confidence." This nonsense about "business confidence" and "consumer confidence" goes back to the British economist John Maynard Keynes, who said that investment is based on "animal spirits." Due to the deficiencies of such ideas, Greenspan thinks that economic cycle models "don't work all that well." Evidently, Greenspan never read the works of real estate economist Homer Hoyt, who wrote of the recurring real estate cycle.

Contrary to Greenspan's statement, there is indeed a way to confront bubbles: don't let them start in the first place. There may well be uncontrollable bubbles in particular stocks or commodities, but the bubble that hurts the most is the real estate bubble. The real estate bubble is caused by bad policy and can be prevented by good policy. The bad policy is the excessive expansion of money and credit by the Fed, and the subsidy of letting landowners capture the gains from economic growth. To confront the land bubble, we need two policies: 1) free-market money, and 2) a shift to efficiency taxes.

Efficiency taxes are levies on land value and pollution. Collecting most of the land rent would avoid subsidizing landowners who get a pumped up rental and land value due to public works and economic expansion. Free-market money or "free banking" would let the market set interest rates and the money supply. Loose lending would be avoided, because lenders would not be fooled into thinking that ever-increasing real estate prices will bail out their risky loans.

Greenspan and other economic heavy-weights should confront land value taxation and free banking. There is a way to stop the business-cycle boom bubble, but it requires radical changes in economic policy that neither the economic nor political chiefs are willing to confront.

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Fred Foldvary, Ph.D.

FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.

Foldvary is the author of The Soul of LibertyPublic Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.

Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.