The possibility that the housing boom could one day turn to bust, leaving many homeowners penniless, seemed not to have caused any sleepless nights at the Fed. On the contrary, recently released Fed transcripts show how future Treasury Secretary Timothy Geithner scrambled in 2006 at a Fed meeting to come up with a superlative for "terrific" to describe Greenspan's tenure.
But it was China, not the U.S. economy, that prospered on Americans' spending binge. The world's most populous country grew at double-digit rates for much of the 2000s. And while the U.S. savings rate hovered around 15 percent of GDP, China's savings rate increased from 38 percent in 2000 to 54 percent in 2006. China's savings are heavily skewed toward risk-free assets, perhaps because the Chinese are culturally more risk-averse, but also because the country's financial markets are still underdeveloped and not fully liberalized.
The large buildup of savings in China and other emerging economies (mostly oil exporters) depressed interest rates worldwide from 2004 on, as too much money was chasing U.S. Treasury bonds and other supposedly risk-free securities, driving up the price of bonds and driving down interest rates. Thus, by the time the Fed started to worry about rising inflation by mid-2004, leading the Fed to try to put the brakes on the economy, it was already too late. Although the Fed started to raise the policy rate in July 2004, long-term interest rates in the United States remained stubbornly low. While the subprime mortgages with exotic features did not help, it was these low long-term interest rates that were the most important factor in enlarging the housing bubble.
Europe's story is slightly different, but the messy conclusion is broadly similar. The establishment of a common currency in the eurozone caused interest rates on Greek, Irish, Italian, Portuguese, and Spanish government bonds to converge to the much lower rate on German government bonds. While opinions differ on what caused this convergence, the fact that exchange-rate risk disappeared significantly contributed to Northern European banks' willingness to buy Greek, Irish, Italian, Portuguese, and Spanish bonds. It was, after all, only prudent for banks to invest in assets that were denominated in the same currency as their future financial liabilities.
As a result, Greece, Ireland, Italy, Portugal, and Spain saw interest rates fall from a level of about 13 percent in the late 1990s to only 3 percent in 2005. The same excess of savings in China and other emerging economies that depressed long-term interest rates in the United States played a role here, too.
The sharp fall in interest rates had a significant impact on the housing market in the eurozone's periphery. Year after year, housing prices in Ireland and Spain rose by 10 to 20 percent. That in turn resulted in exuberant consumer spending and borrowing, driving up wages as well. While labor costs in Germany rose a modest 18 percent from 2000 to 2008, labor costs in Spain and Ireland increased by 41 and 45 percent, respectively, and by 78 percent in Greece.