housing bubble: The Case Against the Fed

Former Fed official, Citibank vice president and Hayekian macroeconomics Gerald O’Driscoll, Jr.:

Alan Greenspan responded to his critics on these pages on March 11. He singled out an op-ed by John Taylor a month earlier, “How Government Created the Financial Crisis” (Feb. 9), for special criticism. Mr. Greenspan’s argument defending his policy is two-fold: (1) the Fed controls overnight interest rates, but not “long-term interest rates and the home-mortgage rates driven by them”; and (2) a global excess of savings was “the presumptive cause of the world-wide decline in long-term rates.”

Neither argument stands up to scrutiny. First, Mr. Greenspan writes as if mortgages were of the 30-year variety, financed by 30-year money. Would that it were so! We would not be in the present mess. But the post-2002 period was characterized by one-year adjustable-rate mortgages (ARMs), teaser rates that reset in two or three years, etc. Five-year ARMs became “long-term” money.

The Fed only determines the overnight, federal-funds rate, but movements in that rate substantially influence the rates on such mortgages. Additionally, maturity-mismatches abounded and were the source of much of the current financial stress. Short-dated commercial paper funded investment banks and other entities dealing in mortgage-backed securities.

Second, Mr. Greenspan offers conjecture, not evidence, for his claim of a global savings excess. Mr. Taylor has cited evidence from the IMF to the contrary, however. Global savings and investment as a share of world GDP have been declining since the 1970s. The data is in Mr. Taylor’s new book, “Getting Off Track.”

The former Fed chairman also cautions against excessive regulation as a policy response to the crisis. On this point I concur. He does not directly address, however, the Fed’s policy response. From the beginning, the Fed diagnosed the problem as lack of liquidity and employed every means at its disposal to supply liquidity to credit markets. It has been to little avail and, in the process, the Fed has loaded up its balance sheet with dubious assets.

The credit crunch continues because many banks are capital-impaired, not illiquid. Treasury’s policy shifts and inconsistencies under both administrations have sidelined potential private capital. Treasury became the capital provider of last resort. It was late to recognize the hole in banks’ balance sheets and consistently underestimated its size. The need to provide second- and even third-round capital injections proves that.

In summary, Fed policy did help cause the bubble. Subsequent policy responses by that institution have suffered from sins of commission and omission. As Mr. Taylor argued, the government (including the Fed) caused, prolonged, and worsened the crisis. It continues doing so.

UPDATE:  Hayekian macroeconomics Larry White and his colleague David Rose have also answered Alan Greenspan and his excuse making:

Alan Greenspan’s non mea culpa (“The Fed Didn’t Cause the Housing Bubble, March 11) is unpersuasive. Greenspan tries to blame the housing bubble entirely on a global savings glut causing a decline in long-term interest rates. He deems irrelevant his pushing down and holding short-term rates to historic lows during 2001-2006, on the grounds that a house’s price should be based on discounting its future housing services at 30-year rates only. Not so. House buyers can borrow at one-year rates through an Adjustable Rate Mortgage. Greenspan himself has elsewhere acknowledged that because he pushed one-year rates farther below 30-year rates, the share of adjustable-rate mortgages rose (indeed it doubled from one-fifth to two-fifths of new mortgages). The demand from new ARM borrowers was critical to fueling the housing boom.

The demand for housing was also augmented by monetary policy through an important second channel that Greenspan neglects to mention: the wealth effect of the economic boom set off by cheap money.

Greenspan’s global-savings-glut theory of the housing boom leaves unexplained why the boom ended when the Fed finally restored short-term rates to sanity. China and other savings suppliers to the US did not, after all, repatriate their savings.

John Taylor’s critique of Fed policy is basically right and Greenspan is basically wrong.

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