Monday, March 16, 2009

Greenspan's Failed Attempt to Exonerate the Fed

Alan Greenspan is again defending U.S. monetary policy under his watch. Writing in the Wall Street Journal last week he acknowledges interest rates were too low in the past decade, but not the short-term interest rate targeted by the Federal Reserve (Fed). Rather, it was those stubborn long-term mortgage rates that failed to go up when the Fed started its tightening cycle in 2004. So do not blame the Fed, blame those folks overseas whose excess savings were funneled into the United States and, in turn, pushed down long-term interest rates. These are the real culprits according to Greenspan.

Greenspan's defense is wrong on several counts.

First, as noted by observers such as Barry Ritholtz and Larry White much of the problematic mortgage lending took place under adjustable rate mortgages, interest-only mortgages, and other non-traditional mortgages whose interest rates were tied to short-term interest rates. Thus, the Fed's super low interest rate policy in the early-to-mid-2000s was highly consequential to these types of loans.

Second, Greenspan's invoking of the interest rate "conundrum"--the Fed pushing up short term rates in the mid-2000s but long-term rates not following--and explaining it away by the foreign saving glut makes it appear that the Fed was helpless at that time. As Greg Ip shows this was not the case. The Fed could have tightened monetary policy or tightened the lending standards in the mortgage industry. While Greg is technically correct, I will go one further and say the saving glut story is at best a partial explanation for the conundrum. Another more compelling story is that there was no conundrum, but rather the bond market was expecting a recession in the near future and pricing it into long-term interest rates. In short, the conundrum was simply the case of a yield curve inverting and pointing to a recession. Moreover, this explanation makes sense in light of the fact that yield curves across the globe were flattening or inverting and thus indicating a global recession was in store. (See here and here for more).

Third, Greenspan overlooks the fact that Fed is a monetary superpower whose loose monetary policy got exported to the rest of the world in the early-to-mid 2000s. As I wrote earlier:
One important factor was the emergence of an unexpected global liquidity glut created by the Federal Reserve (Fed) in the early-to-mid 2000s. The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.
This global liquidity glut served to facilitate a global credit expansion and as a result, a global housing boom. Yes, there was also a saving glut coming out of Asia and oil-exporting countries but it was more important to the story beginning about 2005 after the Fed's tightening cycle had begun to be take hold.

Finally, the original motivation for Greenspan's easing in the early-to-mid 2000s was a case of misreading the deflationary pressures. As documented in this post, nominal spending was not collapsing at the time. Also, the lack of robust employment gains coming out of the 2001 recession were not alarming given the robust productivity growth and the (policy-induced) low interest rates that encourage inordinate substitution of capital for labor.

To be clear, there were other developments such as the the securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agency failures, etc. that contributed to the current economic crisis. The Fed's role in this crisis, though, is unmistakable and clear. Consequently, no matter how many editorials Greenspan writes he will never be able to exonerate the Fed from the responsibility it bears for this crisis.

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