Thursday, August 23, 2007

Paying the Price of Alan's Profligacy

Tito Boeri and Luigi Guiso (hat tip Mark Thoma) do a terrific job explaining the subprime mess. They show three factors got us into this financial quagmire:

(1) The low financial literacy of US households
(2) The financial innovation that has resulted in the massive securitisation of illiquid assets
(3) The low interest rate policy followed by Alan Greenspan’s Fed from 2001 to 2004.

The authors believe, however, that one of these factors was by far the most important: the incredibly easy monetary policy of the Fed.

From their piece:

Low interest rates

The first two factors aren't new. Without the third factor – the legacy of the “central banker of the century” – the crisis probably would have never occurred. The monetary policy of low interest rates – introduced by Alan Greenspan in response to the post-9/11 recession and the collapse of the new economy “bubble” – injected an enormous amount of liquidity into the global monetary system. This reduced short-term interest rates to 1% – their lowest level in 50 years. What’s more, Greenspan spent the next two years maintaining interest rates at levels significantly below equilibrium. Interest rates were kept at low levels for a long time, and were often negative in inflation-adjusted terms. The result was no surprise. Low returns on traditional investments pushed investors and lenders to take bigger risks to get better returns. Financial intermediaries, in search of profits, extended credit to families and companies with limited financial strength. Investors with varying degrees of expertise duly reallocated their portfolios towards more lucrative but riskier assets in an attempt to increase their wealth and preserve its purchasing power. The low borrowing rates for both short and long-term maturity attracted throngs of borrowers – families above all who were seduced by the possibility of acquiring assets that for had always been beyond their means. At the same time, house prices soared, ultimately encouraging the additional extension of credit; the value of real estate seemed almost guaranteed. . .Thanks Alan! Today we’re paying the cost of your overreaction to the 2001 recession.

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