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Yes, Greenspan Did It

December 31, 2008

Tags Booms and BustsThe FedInterventionismMonetary Theory

With no one denying anymore the obvious fact that America is in a deep slump, the discussion has instead shifted to why it happened. The Austrians (including me) who predicted these problems based on Greenspan's low-interest-rate policy know of course that the main cause was that low-interest-rate policy, with his numerous bailouts of failed financial institutions also creating a moral hazard that encouraged risky behavior.

But non-Austrians who for various reasons seem determined to exonerate the central bank have instead offered various other explanations. I will not here answer them all here. Instead, I will simply comment on the most common alternative explanations and the various arguments used for the explicit purpose of exonerating Greenspan.

Fannie, Freddie, and the CRA

From the supply-side Republican establishment who until 2007 and in some cases well into 2008 denied the existence of any serious problems the blame is cast on Fannie Mae and Freddie Mac and the Community Reinvestment Act (CRA). Despite having been so wrong, they are closer to the truth than other deniers. Surely the fear of being accused of violating the CRA made some lenders more willing to lend to some low-income and minority households that really weren't credit worthy. And surely, the role of Fannie and Freddie in buying up many of the mortgage-backed securities and then passing them on with their guarantees helped increase such lending.

But there is little reason to believe that either of those factors contributed significantly to the crisis. After all, both Fannie and Freddie and the CRA have existed for decades without causing anything similar. And most subprime loans were issued by institutions not covered by the CRA, and the act itself isn't really that draconian since it says that lenders aren't compelled to make loans that are likely to be unprofitable. Similarly, lending not covered by Fannie or Freddie also expanded rapidly during the bubble.

Insufficient Regulation

One argument left-wingers in particular have advanced is that "deregulation" or "lack of regulation" is the cause of the crisis. Rarely do they specify exactly which regulations were lacking. (I suspect that many simply have such great faith in government that there must be some lack of regulation at the heart of any big problem.) But often said the claim is that securitization—and its lack of regulation after the repeal of the Glass-Steagall Act—is the problem. As the argument goes, by being able to sell the mortgages, which are then transformed into mortgage-backed securities, mortgage lenders do not need to worry about the money ever getting paid back, so they loosen their lending standards and make loans that wouldn't be profitable if they were forced to keep them. But this raises the question of why investors would want to buy such dodgy debt. Or to put it another way, how could mortgage lenders fool investors into not demanding high-risk premiums to cover the likely loan losses? If investors had demanded sufficiently high risk premiums, then the initial loans wouldn't have been profitable.

There are two possible explanations for this: either (1) they rationally assume that they will be able to let others take losses, or (2) these investors are incompetent and didn't understand the nature of these securities—didn't realize, that is, that once interest rates rose again, the subprime borrowers wouldn't be able to make their payments. Explanation number one takes us back to the moral hazard created by Greenspan's previous bailouts, as well as the guarantees that Fannie Mae and Freddie Mac created for the various mortgages they bought and either kept or sold to others with that guarantee. Explanation number two also takes us back to Greenspan's bailouts, and the fact that incompetent financial firms weren't weeded out like incompetent companies are in other sectors. Either way, previous bailouts are the root cause of this problem.

The Global Savings Glut

One common argument from all deniers of Greenspan's guilt is that a "global savings glut" was to blame. One of the arguments for that explanation is the alleged inability of the Fed to influence long-term yields. I analyze this claim below.

The other argument for this explanation is that the United States wasn't the only country experiencing a housing bubble. Yet not all countries experienced a bubble and the fact that some other countries also experienced bubbles that only shows that other countries pursued policies similar to those of the United States.

And this explanation really doesn't explain why the bubble started to inflate in 2001 and ended in 2006-07. Did the savings glut start in 2001 and then end in 2006? To the contrary, the external surplus of both China and oil-exporting nations fell in 2001, while they rose quickly in 2006-07. And, as explained below, given how the central bank sets interest rates, those flows will mainly affect money supply instead of interest rates.

Greenspan himself makes this argument by pointing to how long-term interest rates did not rise after the rate increases in 2004-2005. This is dishonest for more than one reason. First of all, the housing bubble started already in 2001, when he pushed through rate cuts of an unprecedented magnitude, from 6.5% to 1.75% in a mere year. Secondly, because of the increased popularity of adjustable-rate mortgages, short-term interest rates were just as important as long-term interest rates. Thirdly, movements in market interest rates always tend to precede movements in the federal-funds rate as market interest rates are really the future average federal-funds rate during the duration of the bond.

If really long-term interest rates were determined only by global liquidity, then were long-term interest rates about 1.5% in Japan and 6.5% in Australia until only recently? This is all the more telling given the fact that Japan has a very high budget deficit and a huge public debt, while Australia had a budget surplus and a very small public debt. And to further illustrate the point, after the Reserve Bank of Australia unexpectedly reversed its previous rate-hike policy and started to aggressively lower short-term interest rates, the 10-year yield has fallen some two percentage points, while the Japanese yield has stayed unchanged.

And long-term interest rates did in fact rise from 3.3% in June 2003, when the deflation scare made everyone believe interest rates would stay low for long, to 4.7% in June 2004 when the Fed had already signaled the start of a series of rate increases. That long-term interest rates didn't rise further after that merely reflected that the series of rate increases after that was factored in by the markets.

It's Just Not His Fault

Another attempt to exonerate Greenspan was made by Cato Institute economists Jeffrey Hummel and David Henderson. Neither predicted the crisis and both by their own admission still have no idea as to why the crisis has occurred. Yet they claim to know that Greenspan did not cause the crisis.

One of their arguments is that by 2006, money-supply growth had fallen sharply compared to 2001, regardless of whether your preferred measure of money supply is M1, M2, or MZM. That is true, but it certainly does not prove that Greenspan's interest-rate cuts weren't responsible for the bubble. The housing bubble by all measures started in 2001. Before that, the level of house prices, construction activity and mortgage debt were reasonable by historical standards. But then during 2001, house prices and mortgage debt started suddenly to rise above 10%—during a recession when they usually decline. And as is typical in a recession, residential investments increased. Normally, residential investment is the most cyclical component of GDP, falling even more than business investments during slumps. But during the 2001 recession, it actually rose even as business investments slumped. This would clearly suggest that the surge in money supply helped kick start the housing boom. That money-supply growth had fallen sharply by 2006 is also consistent with the link to the housing bubble, since residential investment reached its peak during Q4 2005. Other indicators of the housing bubble, such as housing prices and mortgage debt, continued to increase a bit longer, but, given the lags in monetary policy, that is still consistent with the monetary explanation.

Hummel and Henderson then argue that the fact that many parts of broader money-supply measures M2 and MZM lack reserve requirements somehow means that the Fed can't control them. That is true in the sense that the Fed doesn't decide on the exact money-supply increases in their meetings. As I've explained before, money supply is a residual factor of the interest rate that the Fed sets and the various other factors that affect interest rates—or more precisely, the other factors that would have affected interest rates if the Fed hadn't fixed it. Now that the Fed has fixed it, these other factors instead affect money supply. But by fixing interest rates at a certain level, the Fed is ultimately responsible for the increases in the money supply. If the Fed had targeted money supply instead of interest rates, it could have limited those increases.

Furthermore, during the latter part of the housing bubble, money-supply increases arguably understated the Fed's role. The reason is that because the low interest rate set by the Fed caused a downward pressure on the US dollar, foreign central banks that wished to avoid seeing their currencies appreciate relative to the dollar started to buy US securities, thus helping to keep down US interest rates without any increase in the US money supply.

Henderson and Hummel then assert that the Fed does control the monetary base. But while it is true that the Fed could potentially control it—as it could with the overall money supply—the fact is that it doesn't do so as long as interest rates are targeted instead. The monetary base, as they note, consists of two components: currency in circulation (paper and metal cash) and bank reserves. They themselves immediately note that the quantity of currency in circulation is determined by domestic and foreign demand for it. And they further note that these days (or more correctly, until mid-September) currency in circulation constitutes more than 90% of the monetary base. But they appear to believe that bank reserves by contrast are, or were, directly determined by the Fed.

But that is simply not true, nor has it been true. And I find it astounding that they and many other professional economists don't seem to understand the dynamics of how the monetary base was determined. The dynamics of bank reserves have recently changed radically for reasons I explain here, but before this recent upheaval bank reserves were for years basically constantly. Henderson and Hummel take this as evidence that the Fed's interest-rate moves mimicked fluctuations in the natural interest rate. Just how Greenspan and his associates could have been so remarkably skillful in predicting movements in the natural interest rate is not made clear, but I guess they figure that Greenspan was the great maestro.

But as I have pointed out elsewhere, bank reserves are not determined by the Fed, and this is especially true after the 1994 reforms they themselves mention that allows banks to "sweep" money from demand deposits (with reserve requirements) to savings deposits and money-market funds (without reserve requirements).

Instead, above the necessary minimum reserves required by the amount of money that they for various reasons must continue to classify as demand deposits, banks have complete discretion to determine how much reserves they want to hold. And before the upheaval that began in September of this year, banks had every reason to minimize reserves to the legally required level. The reason was that they could always count on immediate liquidity infusions from the Fed in the case of a liquidity crisis. Meanwhile, as bank reserves yielded zero, they had strong incentives to recycle all cash infusions into the money markets or into loans. Meaning that the quantity of bank reserves was unaffected by how tight or loose monetary policy was, and so was useless as an indicator of that.

In conclusion, there can be no doubt that Greenspan, primarily through his low-interest-rate policy but also through the negative effects of his various bailouts, was responsible for the housing bubble and therefore the current slump.


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