Mr. Greenspan Doth Protest Too Much


Alan Greenspan, former chairman of the Federal Reserve, disputes the assertion — made by many, including John Taylor of Stanford University — that

had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by [the] “Taylor Rule,” “it would have prevented this housing boom and bust. “

Mr. Greenspan continues:

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble. All things considered, I personally prefer Milton Friedman’s performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: “There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.”

It is unseemly for Mr. Greenspan to invoke Milton Friedman in this matter, given that Mr. Friedman died in 2006 and, therefore, did not live to see the debacle in the mortgage market.

More to the point, it is impossible to “decouple” financial markets from one another. Imagine trying to decouple the price of gasoline from the price of crude oil. The federal funds rate is determined by the Fed’s open market operations, that is, through the Fed’s expansion or contraction of the money supply. It is true that the only immediate effect of the federal funds rate is on the rate of interest at which banks borrow from and lend to each other. But those rate changes and the underlying changes in the money supply have ripple effects throughout financial markets.

Rates on long-term instruments, such as mortgages, “decouple” from the federal funds rate only when there is a shock to the market for those long-term instruments. The shock, in the case of the mortgage market, was a drop in the value of real-estate, followed by a squeeze on borrowers (primarily on sub-prime borrowers), followed by a jump in the incidence of defaults, followed by a sudden drop in the value of sub-prime mortgages and the derivatives created from them, etc., etc., etc.

But before that shock, the mortgage rate (like the rates of other financial instruments) had tracked the ups and downs of the federal funds rate:

Selected interest rates
Source: Federal Reserve Statistical Release H.15, Selected Interest Rates (annual data)

The recent divergence between the federal funds rate and the mortgage rate did not occur until 2008, that is, until after the collapse of the real-estate bubble — a bubble that was caused in large part by the Fed’s easing of interest rates from January 2001 to June 2004.

UPDATE: For corroboration of my analysis, see Robert Murphy’s “Greenspan’s Bogus Defense” (published April 8, 2009).

UPDATE 2: Now, Secretary of the Treasury Geithner avers that “monetary policy around the world was too loose too long.” Notice how Geithner tries to take the heat off the Fed by focusing on “the world.” But, as the WSJ piece (linked above) points out, Geithner is

still too quick to pass the buck from the Fed to other central banks. The European Central Bank was much tighter than the Fed throughout this period. The Fed was by far the major monetary player because much of the world was on a dollar standard, with its monetary policy linked to the Fed’s. That was true of China, most of Asia and the Middle East.

The Fed’s loose policy from 2003 to 2005 created the commodity and credit bubbles that made these countries flush with dollars. Given their low domestic propensity to consume, these countries then recycled those dollars back into dollar-denominated assets, such as Treasurys and real-estate-related assets such as Fannie Mae securities. The Fed itself had created the surplus dollars that kept long rates low and undermined for a substantial period its belated attempts to tighten.

Mr. Geithner’s concession is important nonetheless because before he moved to Treasury he was vice chairman of the Fed’s Open Market Committee that sets monetary policy. His comments mark a break with the steadfast refusal of Fed Chairmen Alan Greenspan and Ben Bernanke to admit any responsibility. They prefer to blame bankers and what they call the “global savings glut,” as if the Fed had nothing to do with creating that glut.

UPDATE 3: John Taylor links to more evidence for the Fed’s influence on interest rates.