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Greenspan Absolves Himself

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Tags The FedFinancial MarketsMonetary Theory

11/06/2007Frank Shostak

Now that Alan Greenspan is no longer the Fed chairman, some financial commentators are daring to suggest that perhaps the present financial crisis is the result of the extremely low interest rate policy of Greenspan's Fed between December 2000 to June 2004 that fueled the housing bubble.

Is there are basis for believing this? Well, the federal funds rate was lowered from 6.5% in December 2000 to 1% by June 2003. It was kept at 1% until June 2004 when the rate was raised by 0.25%. The yearly rate of growth of the S&P-Case-Shiller house price index jumped to 20.5% by July 2004 while the average growth of this house price index during 2005 stood at 17%.

So, there we have the data but what about the cause and effect? In an interview on October 21, 2007 the former Fed chairman rejected the view that his loose monetary policies might have been the source of the current financial markets' instability. Greenspan argued that it is extremely low long-term interest rates, which depressed mortgage rates, that were the major cause of the housing bubble.

According to Greenspan, the Fed doesn't have much control over long-term interest rates.

For instance, according to Greenspan, between June 2004 and June 2005 the Fed had embarked on a tighter interest-rate stance. The federal funds rate target was lifted from 1% in June 2004 to 3.25% by June 2005. Yet despite this tighter stance the yield on the 10-year T-Note fell from 4.58% in June 2004 to 3.92% by June 2005. As a result of this, the 30-year fixed-mortgage rate fell from 5.75% in June 2004 to 5.58% in June 2005.

As one can see, long-term interest rates and mortgage interest rates fell while the Fed was tightening its stance. So, asks Greenspan, how in the world can the Fed be blamed for the housing bubble and the current financial crisis?

According to Greenspan, since the Fed doesn't control long-term interest rates it therefore cannot be seen as the cause behind the present financial-market turmoil. The market, not the Fed, is to be blamed for the current crisis.

We suggest that, contrary to Greenspan, it is not long-term rates as such that fueled the bubble but the monetary pumping by the Fed. It is the monetary pumping that depressed the long-term rates and triggered the housing bubble.

We suspect that, because of the aggressive lowering of interest rates between December 2000 and June 2003, the Fed had pushed the federal funds rate target below where market conditions would have dictated. This means that to prevent the federal funds rate from overshooting the target, the US central bank had to aggressively push money into the economy.

The yearly rate of growth of monetary pumping, as depicted by the Fed's balance sheet (also known as Fed Credit) jumped from negative 2.7% in December 2000 to 9.8% as of June 2003. At one stage in September 2001, the yearly rate of growth climbed to 12.2%.

The possibility that the federal funds rate target was far too low is also "supported" by the Taylor Rule. According to the Taylor Rule, in May 2004, the target was below the so-called "correct" rate by 2.3%.

In response to this pumping, we suggest that the yield on the 10-year treasury note fell from 5.11% in December 2000 to 3.5% by June 2003. During that period the 30-year fixed-mortgage interest rate fell from 7.38% to 5.23%.

What about the discrepancy between short-term and long-term interest rates during June 2004 and June 2005, which Greenspan presents as the case to absolve himself from current financial instability?

Historically, the 30-year fixed-mortgage rate and the federal funds rate have had a tendency to display a very good visual correlation. This doesn't mean that the correlation is perfect; a discrepancy in the movements between the federal funds rate and long-term rates can occur. The emergence of a discrepancy doesn't imply however that, all of a sudden, the Fed's policies have nothing to do with the housing bubble and boom-bust cycles.

Various discrepancies between the movement in the federal funds rate and the mortgage rate are due to a time-lag effect from changes in monetary policy and economic activity.

Because of the time lag, a situation could emerge that long-term rates could ease, notwithstanding the central bank's tighter interest-rate stance. Despite a tighter interest-rate stance, the past loose interest-rate stance may still dominate economic activity.

Hence, despite a tighter interest-rate stance, the federal funds rate target could still be too low. In order, then, to prevent the federal funds rate from overshooting the target, the Fed may be forced to push more money into the economy. As a result, more money becomes available for financial and bond markets, which puts downward pressure on long-term rates.

So while Greenspan is correct that the Fed does not directly manage long-term rates, it remains true that a main influence on  long-term rates is that quantity of money and credit in the economy, a variable that the Fed can directly control through its management of short-term rates. To say otherwise is like claiming that bathroom flood isn't your fault, since you only control the faucet, not the height of the water in the tub.  

In November 2004, the yearly rate of growth of Fed's credit (Fed's balance sheet) jumped to 7.2% from 4.5% in June 2004. Note that this increase in the pace of monetary pumping took place while the federal funds rate target was lifted from 1% in June to 2% in November. Also note that between December 2004 and June 2005, the average yearly rate of growth of Fed Credit stood at a still elevated 6.2%. (The economic activity was gaining strength from June 2004 to June 2005 — the yearly rate of growth of industrial production climbed from 2.5% in June 2004 to 4.2% by June 2005.)

We can thus conclude that the current financial-market instability is more than likely to be the product of the policies of Greenspan's Fed. We also suggest that, contrary to Greenspan, a bubble cannot emerge without a preceding increase in monetary pumping by the central bank.


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