Alan Greenspan Says — Not My Fault

Alan Greenspan is one of the most highly respected financial minds in the world. He was Chairman of the Federal Reserve under four consecutive Presidents, and was laughed at when he uttered the words “irrational exuberance” foretelling the eventual collapse of the dot-com bubble.

But even if he was expected to be so by the Presidents he served, he’s not superman. He missed a call, and explained to Congress in Oct 2008 “that we’re not smart enough as people. We just cannot see events that far in advance.”

He’s right, and while I would have suggested some humility about his power while he was in office, I respect that he realized that he doesn’t know everything.

So I was a bit surprised to find out today that he’s got an op-ed in the Wall Street Journal about something he seems very sure of: it wasn’t his fault.

The Mises Guys Don't Believe You

The Mises Guys Don't Believe You

There are at least two broad and competing explanations of the origins of this crisis. The first is that the “easy money” policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier — in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

To some extent, I think what he is saying is correct. There were factors in the economy holding interest rates down and leading to the liquidity glut that we experienced — and some of those factors were outside of the control of the Federal Reserve. But if there were worries about what was going on as early as the middle of 2004, why wasn’t Greenspan on television talking about “irrational exuberance” again?

There were a lot of factors leading up to this. Easy money policies by the fed were one of them. Fannie and Freddie were another. Government endorsement of corrupt ratings agencies that turned crap into AAA bonds played a big part. And the natural belief of the market to believe that the bottom will never fall and keep levering up was a big part of it. Most of those issues were either direct government intervention into the market or an enabling government factor that gave investors and lenders the confidence to overreach.

The structure of our economy incentivized leverage, and I explained a while ago how dangerous excessive leverage can be. At the scale we’ve reached globally, trying to unwind it will be very, very painful. And if anything, you would be expecting the Fed to be standing athwart the trend yelling “STOP”. It’s not like there weren’t warning signs (and doomsayers predicting this eventual end), but the Fed wasn’t paying attention. The guys responsible for it didn’t see it, and if they can’t see it, you wonder what the purpose of having them is at all. For that, I place the blame at the top, on Greenspan.

The problem, as I see it, is that we expect these supposed supermen to be perfect regulators and perfect forecasters of our economy. It’s just not possible. Hayek said it best:

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

The problem isn’t that they don’t know. The problem is that we entrust them with power as if we expect them to know.

  • tfr

    So if exuberance was so irrational, why didn’t he bump up interest rates and keep them there?

  • Merf

    TFR, by 2003, interest rates were low and that contributed a lot to the problem, but the major part was that if you had a pulse, you could get a mortgage. Whatever lending standards might have existed before and exist again now simply weren’t applied, mostly because lawmakers wanted everyone to have their own home — regardless of weather they had the right mentality to take care of that home, or even weather they were able to pay for it.

    The bubble grew to epic proportions from 2002 to 2004, and into 2005. We are now seeing the foreclosures that are the result of ARMs adjusting and balloon payments coming due.

    The rate dropped at the end of 2110 and beginning of 2002 in an effort to jump-start the economy. If he had pulled back on the reigns in say, 2003, he would have stalled the economy or, if he had raised the rates in 2004, it would not have done much good, because by then, the property values had inflated enough that there still would have been a crash.

    Maybe the fall would have arrived earlier, because the illusion that was the housing bubble would have become obvious and thus popped sooner, but maybe not — it is the ARMs that are causing problems now, as well as the job market.

    As it stood, though, Fannie and Freddie had to back many, many, many mortgages that they should not have touched, simply because Congress said so. Because F&F were willing to back the loans, banks made more of them . . . . but we all know the spiral.

  • Akston

    Some people have the power to dramatically and disproportionately affect the economy. These people are no less prone to irrational exuberance, short term greed, power lust, and denial than anyone else. Government employment, or government sanctioned monopoly doesn’t change this.

  • Merf

    Actually, Akston, it was the gov’t itself that had the power to dramatically and disproportionately affect the economy. They were the ones who acted with irrational exuberance, short term greed, power lust, and denial in their very short-sighted aim to get more votes. The mortgage brokers are but pale imitators of political robber-barons.

  • Akston

    Absolutely. We’re in agreement Merf.

    The most salient difference between the people who dramatically affected the economy from private enterprises and those who affected it from government positions is that government participants employ a monopoly on initiated force.

    People affecting the market from government positions use funds that originate from taxes, printing presses, or borrowing against the productive capacity of the people working in private enterprises.

    If you’re in private enterprise, try jailing people who choose not to buy your products or services; try printing your own currency when you run out; try borrowing on your claim to your neighbor’s coerced future capacity to produce.

    Greedy CEO’s didn’t cause the bulk of this downturn. There have always been those. Speculators who took unwarranted risks didn’t cause this downturn. In the past, over-risky speculation triggered bankruptcy, not bailed outs. People with limited means who bought too much house didn’t cause this downturn. In the past, they just lost the house to foreclosure and bought more wisely the next time around.

    The downturn came from corrections to over-leveraging and mal-investment. The extent of the over-leveraging was exacerbated by government policies intended to fix prices, and the moral hazard created by pretending to be able to guarantee all the risky investments.

    Generally it was caused – and is being made worse – by people in government positions inappropriately using the ham-fist of government to forcefully try to “adjust” a market with billions of participants. No one is that smart. Not Alan Greenspan, not Paul Krugman, not anyone.

  • Eric

    Brad, I think that you have it wrong. I tend to think that Greenspan was well aware of the issue. The reason he wasn’t yelling about irrational exuberance is that he was worried that his voice saying that would start the pop of the bubble.

    His point about how clear it was that the mortgage market was decoupled from all other financial markets is fairly good. In 2004, when the Fed tightened up on money, we all expected the mortgage market to tighten up. But it didn’t. In fact, it got even more loose and heated. That’s when the problem became really obvious. Unfortunately, all Alan Greenspan and the Fed could really do was try to ameliorate the crash. Speaking out about the size, scope and magnitude of the bubble (is a bubble that destroys half the value of the Dow Jones 30 really a bubble?) in the way he would have to do to have any effect would probably have made things worse. Witness the dramatic effect that doomsaying has been having for the last 6 months when Congress Critters, Presidents, etc open their mouths.

    Greenspan wasn’t at fault, in the sense that he caused the problem. Nor in the sense that he could have softened the problem. However, the system that believes that a few smart people centrally managing things is better than a market full of people is very clearly and obviously at fault. Greenspan, as one of those “few smart people” simply cannot say what needs to be said. The government caused the problem and doesn’t know how to fix it.

    That said, how bad is the problem in the US? Well, we’ve essentially lost a dozen years of wealth production. But 1997 was a pretty good year, the first year I earned over $50K, if I recall correctly. We’ve lost (or are about to lose) 10 years of increase in home ownership, with a return to more traditional levels of home ownership. Oil and gas prices are once again below their 1983 benchmark highs. This year will be likely to have inflation that is nearly flat, or perhaps a very slight deflation. I don’t think it’s as disastrous as the 1930’s, although it feels a lot like the 82-83 recession.

    Plenty of signs, in fact, exist to indicate that we are at the bottom of the hole and able to begin a recovery. Only one problem, the Federal government generally, and Obama specifically, can’t keep their damn mouths shut. If they would shut up, step back from the controls for a few months, and let things happen, the recovery from this recession would start and kick into high gear, quite likely.

    Of course, if Obama keeps going and can’t keep his mouth shut, we have the potential to spiral right into a depression. All the signs are there for that to happen, too. Obama is much more likely to be the Hoover of that possible depression than the FDR. People never remember that Hoover was an interventionist at least as bad as FDR and that he had established 75% of what FDR eventually did. Obama will be the guy that makes it worse than it had to be. Then, if we are lucky, we will elect another interventionist Republican who will make sure it lasts 8 years too long.

    Or ….. Obama will get lucky, keep his mouth shut and have his healthcare plan get stalled and we will recover from the recession.