Thursday, January 7, 2010

John Cassidy on the Greenspan Put

John Cassidy shows no mercy in critiquing Bernanke's defense of the Fed's low-interest rate policies in the early-to-mid 2000s and more generally the Fed's asymmetric response to swings in asset prices:
Behind his white beard, Federal Reserve chairman Ben Bernanke has a wry sense of humour. On reading his recent speech to the American Economic Association, in which he defended the Fed’s actions during the housing bubble, I initially suspected it was a practical joke. Rather than conceding that he and his predecessor, Alan Greenspan, made a hash of things between 2002 and 2006, keeping interest rates too low for too long, he said the Fed’s policies were reasonable and the main cause of the rise in house prices was not cheap money but lax supervision.

Searching in vain for a punch line, I was reminded of Talleyrand’s quip about the restored Bourbon monarchs: “They have learned nothing and forgotten nothing.” Mr Bernanke is far smarter than Louis XVIII and Charles X, two notorious boneheads, and has done a good job of firefighting. But his unwillingness to admit the Fed’s role in inflating the housing and broader credit bubble raises serious questions about his judgment.

The individual elements of his presentation were questionable enough... but most disturbing was its failure to address the larger picture: from the mid-1990s, the Fed adopted a stance that encouraged irresponsible risk-taking. In periods of growth, it raised interest rates slowly, if at all, stubbornly refusing to acknowledge the course of asset prices. But when a recession or financial blow-up beckoned, it slashed rates and acted as a lender of last resort.

On Wall Street, this asymmetric approach came to be known as “the Greenspan put”. It gave financial institutions the confidence to raise their speculative bets, using borrowed cash to do it. None of the Fed’s actions since then have addressed this central issue of moral hazard. Indeed, the problem may have become worse. For all the damage that the financial industry has inflicted on itself, when disaster arrived the Greenspan/Bernanke put did pay off. By slashing the funds rate and providing emergency credit facilities to stricken financial firms, the Fed further entrenched the perception that its ultimate role is to provide a safety net for Wall Street.

Unlike his predecessor, Mr Bernanke recognises the problem of excessive speculation and the massive externalities its sudden reversal can impose. In that sense, intellectual progress has been made. But he and his deputy, Donald Kohn, still refuse to acknowledge the Fed’s role in motivating reckless behaviour...

This is not entirely true, at least for Donald Kohn. In a November 2007 speech Kohn hints at this possibility via a comment on the Fed's role in creating the Great Moderation:

In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.
The victim of my own success tone is slightly annoying here, but at least Kohn alludes to some of the concerns associated with the Greenspan put. Still, Cassidy's bigger point holds: the Fed has yet to fully account for its role in causing investors to underestimate aggregate risk and, as a result, make decisions that contributed to the financial crisis on 2008-2009.


  1. One thing that seemed lacking in this whole debate about the causes of the housing boom is an explicit quantitative model that could allow us to explore various factors . One such model is that of
    Iacoviello (
    His conclusion is that monetary policy only accounts for at most 20% of the housing boom!
    A criticism of his model however, like those of most DSGE models, is that it does not really do a good job of modeling the financial sector. Relatedly, it doesn't have any channel for these risk factors that you have been talking about. But it is a good point of departure for discussion and it is surely the way the literature will have to evolve. When DSGE models can handle Minsky themes, we will have a powerful model.

  2. Thanks ECB for the tip on this Cassidy piece. Given your large teaching load you seem to stay exceptionally engaged with the latest research developments, articles, and OpEd pieces in macroeconomics. I am impressed.

  3. Well, thanks. Alas, these days mostly a consumer rather than a producer, although I guess that integrating breaking research into your teaching is also a product.
    Anyway, your blog, along with Mark Thoma's and the Aussie Bill Mitchell's blog are some of my "must reads" everyday.