Wednesday, April 9, 2008

A Misguided Greenspan Defender

Alan Greenspan has been busy lately defending his legacy. He is responding to the ground swell of opinion that views him as a key contributor to the U.S. housing boom-bust cycle. Fortunately for him, he has one prominent observer coming to his defense: Martin Wolf of the Financial Times. Here is what Martin has to say:
When a wave of destruction hits, everybody looks for somebody to blame. Alan Greenspan, former chairman of the US Federal Reserve, once lauded as the “maestro”, has, to his discomfort, become the scapegoat... much of the criticism is highly unfair.


US monetary policy cannot be responsible for all these bubbles. This might not be the case if these other countries had followed US policy slavishly...
Really? What do we know about the ECB? Did it follow the Fed's lead in cutting rates? Here is a graph from the IMF's latest WEO report that sheds some light on this question:

It sure looks to me like the ECB followed the Fed's lead in cutting short-term interest rates. If we look at real short-term interest rates the picture is even more stark:

Both the Fed and the ECB pushed short-term real interest rates into negative territory for a sustained period. Negative real interest rates in a growing economy are a sure way to light an asset bubble fire. Now take a look at the following graph. It indicates these downward interest rate moves were policy-driven:
This figure shows a large spike in the policy-determined monetary base relative to the G3's GDP. In sum, these figures indicate loose monetary policy in the U.S. and the ECB coincided with the global housing bubble.

An important question these figures do not answer is why would the ECB (and other monetary authorities) follow the Fed's lead in loosening monetary policy? The answer is that the Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage for the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom.

William Buiter writing at Financial Times does a nice view articulating this view in his article titled "The Greenspan Fed: A Tragedy of Errors":
Mr Greenspan is correct that a major global decline in risk-free real interest rates was an important factor in the housing booms that occurred in a couple of dozen countries between, say, 2002 and the end of 2006[.]

But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system.
Well said Dr. Buiter.


  1. 1. Wonkish note: how did you compute real interest rates (in other words, how commensurable are price indexes in US and Euroland?)
    2. Yes I agree up to a point but....we did not see house bubbles across Euroland..Ireland and Spain yes, but Germany, France...I dont think so.
    So monetary policy cannot be everything.

  2. Anonymous:

    All the charts, including the real interest rate one, come from the WEO report. (links in posting should be working now)

    Monetary Policy is not everything as I alluded to in my posting--I acknowledged the saving glut and financial innovation. However, many of the financial innovations found their footing in the low interest rate environment. This indirect effect as well as the traditional transmission channels of monetary policy meant it had an inordinate bearing on the housing boom.