I'd rather he be speaking about what is really important, which is what he told a housing conference yesterday sponsored by the Federal Reserve Bank of Atlanta: At the end of 1990, Fannie's and Freddie's combined portfolios amounted to $132 billion, Greenspan said. By 2003, their combined holdings came to $1.5 trillion.

Two days ago, a reader to this blog (John from CO) pointed out:

---

"The bond market appears to be focused on the longer term here (12 months?). What happens after the two collateral assets are deflated? Best template... Japan. If the fed is concerned about risks rising in the banking system due to aggressive real estate lending http://www.federalreserve.gov/boarddocs/press/bcreg/2005/20050516/ and they have observed that the 'savings crisis' is linked to irrational expectations of real estate appreciation http://www.federalreserve.gov/boarddocs/speeches/2005/20050422/default.htm ... they're likely to continue on their path until the risk of aggressive lending is recognized and the irrational expectations are corrected- regardless of inflation numbers."

---

When the capital market system breaks down, as John pointed out, as it did in Japan for the same reason, the result is typically deflation.

Of course, there is a possibility that it could be inflation if the U.S. were to depreciate the USD, but that is highly unlikely. In this case, the Japanese model (deflation) appears to be the one the U.S. is tracking.

I think at the peak of the Japanese cycle, real estate prices in Tokyo were so extreme that the land underneath the Canadian Embassy there exceeded that of the Parliament Buildings in Ottawa " I'd have to check that, but you get my point.

More even to the point is that the Fed Chairman is fighting an important campaign this year, his final one at the helm, which is to get Congress to restructure Fannie and Freddie. We need that done in order to put the financing of U.S. real estate back into the commercial system " out of the hands of Government Sponsored Agencies " before there is a systemic failure throughout the financial system as interest rates rise, and then spike upward as one financial institution after another fails.

This problem, as I see it, is a bigger one for America than the twin deficits.

The availability of low cost mortgage money is driving real estate prices higher. The simultaneous Fed tightening is squeezing the economy. Let's look at what happened in Japan as posted in an interesting paper by Benjamin Powell (November 2002), von Mises Institute:

---

"After the September 1985 Plaza Accord, the yen's appreciation hit the export sector hard, reducing economic growth from 4.4 percent in 1985 to 2.9 percent in 1986 (EIU 2001).1 The government attempted to offset the stronger yen by drastically easing monetary policy between January 1986 and February 1987. During this period, the Bank of Japan (BOJ) cut the discount rate in half from 5 percent to 2.5 percent. Following the economic stimulus, asset prices in the real estate and stock markets inflated, creating one of the biggest financial bubbles in history. The government responded by tightening monetary policy, raising rates five times, to 6 percent in 1989 and 1990. After these increases, the market collapsed.

The Nikkei stock market index fell more than 60 percent—from a high of 40,000 at the end of 1989 to under 15,000 by 1992. It rose somewhat during the mid-1990s on hopes that the economy would soon recover, but as the economic outlook continued to worsen, share prices again fell. The Nikkei fell below 12,000 by March 2001. Real estate prices also plummeted during the recession—by 80 percent from 1991 to 1998 (Herbener 1999).

Real GDP during the 1990s stagnated, rising only from 428,826 billion yen in 1990 to 469,480 billion yen by the end of 2000.2 Growth has been negative since 1998. The unemployment rate rose from 2.1 percent in 1991 to 4.7 percent at the end of 2000. Although the unemployment rate may seem low by international standards, the rise to 4.7 percent is significant in Japan, given the cultural and historical precedent of lifetime employment and given that it was never above 2.8 percent in the 1980s. The official unemployment rate is also biased downward because the Japanese government offers "employment adjustment subsidies" to companies that maintain employees as "window sitters" (Herbener 1999)."

---

That succinct overview of Japan's economy and capital market from 1985 through 2000 could offer a picture of what lies ahead for America.

Readers wonder why I remain overall bearish (with occasional periods of short time-horizon buying in corrective cycles), and therein lies the answer. The Fed Chairman is concerned that Congress is missing the point: Fannie and Freddie are boogeymen, and Government ought not to be sponsoring them.

The answer, of course, in the long-run is to let the free market manage itself. In other words, why not clip the Fed's wings at the same time. But that too seems to be impossible for politicians to understand and deal with.

But if no action is taken with respect to Fannie and Freddie, within a year or so, today's events in the bond market (with yields far below where they ought to be), at the same time the Fed is tightening to fight an inflation battle (one that is real), there is going to be a situation evolve like Japan.

It could be too late in fact to do much about it. As you know, hot money today ignores jurisdiction. Capital owners and fund managers have no allegiance to jurisdiction. They go where the opportunities lie. If the American financial system collapses, I can hear them now saying to themselves, "So be it."

As much as it pains me to say it, Alan Greenspan should not retire until he's able to convince Congress to harness the power and influence of Fannie and Freddie, if not dismantle these agencies and put mortgage lending entirely back to the private sector.