The Oracle Reveals All

Looking back, was there anything you could have done to stop the technology bubble of the 1990s?
I concluded that we could not prevent the bubbles that emerged while I was at the Fed ... What we had happen to us in the 1990s in the stock market wasn't on purpose. We did tighten the economy quite significantly at various times during the 1990s. And what we found was that instead of defusing or incrementally declining the bubble, we enhanced it ... You can only break a bubble if you break the underlying basis of the economy. Basically, it's not possible to defuse a bubble before its time has come.

Which gets us to where we are today: the housing bubble has burst, the subprime-mortgage market has melted down and we're in a credit crunch. Critics have charged that the Fed contributed to the trouble by keeping interest rates low for so long.
This particular problem was an accident waiting to happen. The euphoria that existed in the expansion of the housing-market bubble induced investors around the world who'd had a huge buildup in liquidity—largely because of the lower real long-term interest rates that occurred as a consequence of the end of the cold war—to invest in something with a higher rate of return. And, lo and behold, the subprime-mortgage market provided it.

The mortgage brokers were just meeting demand from investors?
Precisely. And so you had Wall Street's securitizers basically then talking to the mortgage brokers saying, "We'll buy what you've got." ... The big demand was not so much on the part of the borrowers as it was on the part of the suppliers who were giving loans which really most people couldn't afford. We created something which was unsustainable. And it eventually broke. If it weren't for securitization, the subprime-loan market would have been very significantly less than it is in size.

People want the Fed to cut interest rates to alleviate tight credit conditions. Do you think the financial marketplace has come to view interest-rate cuts as a crutch? And is that an appropriate role for the central bank?
To the extent that [the Fed] interferes with the economy, we do help some of the people who are involved in rather questionable financial activities. The problem basically is that if you do effective monetary policy and stabilize the economy, you will raise all asset prices—those that are assets owned by prudent investors, but also the prices of assets of those who have taken very silly risks and should be punished as a consequence. There is no simple solution. If we do something which works for the society as a whole, we will inadvertently and undesirably bail out, if you want to put it in those terms, the people who have taken silly risks.

And how does the housing market look now?
On top of all this, we've got a housing outlook which is very unfavorable. There are estimates of about 200,000 new mainly completed units that are atrophying and have to be sold quickly. But the sales of homes are falling even though housing starts are falling sharply ... That's putting downward pressure on prices. There's an Act II to this: as prices go down, the net worth of individuals goes down. And their propensity to spend goes down.

The question everyone wants to know is, are we in a recession or headed for one by the end of the year?
Well, we're not in one now. That we're not headed for one is a forecast which has yet to unfold one way or another.