Did Greenspan Cause the Crisis?

Jeff Sachs says Greenspan and the Fed are to blame for our current troubles. Greenspan disagrees:

The roots of crisis, by Jeffrey Sachs, Project Syndicate: The US federal reserve's desperate attempts to keep America's economy from sinking ... do not seem to be effective. Although interest rates have been slashed and the Fed has lavished liquidity on cash-strapped banks, the crisis is deepening.

To a large extent, the US crisis was actually made by the Fed... One main culprit was none other than Alan Greenspan, who left the current Fed chairman, Ben Bernanke, with a terrible situation. But Bernanke was a Fed governor in the Greenspan years, and he, too, failed to diagnose correctly the growing problems with its policies.

Today's financial crisis has its immediate roots in 2001, amid the end of the Internet boom and the shock of the September 11 terrorist attacks. It was at that point that the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate - the Federal Funds rate - from 3.5% in August 2001 to a mere 1% by mid-2003. The Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers the costs of doing so, throughout the economy. It also tends to weaken the currency and increase inflation. All of this began to happen in the US.

What was distinctive this time was that the new borrowing was concentrated in housing. It is generally true that lower interest rates spur home buying, but this time, as is now well known, commercial and investment banks created new financial mechanisms to expand housing credit to borrowers with little creditworthiness. The Fed declined to regulate these dubious practices. Virtually anyone could borrow to buy a house, with little or even no down payment, and with interest charges pushed years into the future. ...

What was stunning was how the Fed, under Greenspan's leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash. There were a few naysayers, but not many in the financial sector itself. ...

With the housing collapse lowering spending, the Fed, in an effort to ward off recession and help banks with fragile balance sheets, has been cutting interest rates since the fall of 2007. But this time, credit expansion is not flowing into housing construction, but rather into commodity speculation and foreign currency.

The Fed's easy money policy is now stoking US inflation rather than a recovery. ... Yet the Fed, in its desperation to avoid a US recession, keeps pouring more money into the system, intensifying the inflationary pressures.

Having stoked a boom, now the Fed can't prevent at least a short-term decline in the US economy, and maybe worse. If it pushes too hard on continued monetary expansion, it won't prevent a bust but instead could create stagflation... The Fed should take care to prevent any breakdown of liquidity while keeping inflation under control and avoiding an unjustified taxpayer-financed bailout of risky bank loans. ...

Recent data make inflation less of a worry, though not completely absent, and I am not as sure as Sachs is that the Fed's unconventional policies steps, e.g. adjusting balance sheets, expanding lending facilities, etc., have not had any effect. We can't know for sure without rerunning the last several months absent the policy steps that have been taken to see how things would have been different, something we'd need a time machine to do, but I think it's safe to say that the Fed's actions have helped some financial firms avoid experiencing more severe problems, and the psychological effect - the perception that the Fed stands ready take action - is also important but hard to measure.

Going back to the question of who caused the crisis, Greenspan says, as usual, get off of it - it wasn't my, or the Fed's, fault:

Greenspan Stands His Ground, by Steven Mufson, Washington Post: ...The record of longtime Federal Reserve chairman Alan Greenspan -- worshipped by business leaders and dubbed "Maestro" in a 2000 biography by The Post's Bob Woodward -- is getting a critical look as his successor Ben S. Bernanke wrestles with problems that began on the Maestro's watch.

Many economists blame Greenspan for lax bank supervision and for keeping interest rates too low, too long from mid-2003 to mid-2004. ...

In an interview yesterday, Greenspan said the Fed wasn't to blame. He said that global forces beyond the control of the Federal Reserve had kept long-term interest rates low, fueling the housing bubble earlier this decade. "Those who argue that you can incrementally increase interest rates to defuse bubbles ought to try it some time," he said. "I don't know of a single example of when interest rate policy has been successful in suppressing gains in asset prices."

Regarding the current turmoil, Greenspan said that a market crisis was inevitable. "If it weren't the subprime crisis it would have been something else," he said. That is because an era was ending that had seen "disinflationary forces" from developing countries such as China and a "protracted period" in which there was an "underpricing of risk."

Not all economists are ready to let the former Fed chairman off so easily.

Lee Hoskins, former president of the Cleveland Fed and Fed chairman from 1987 to 1991, says that to find "partial causes" of the credit turmoil, "you have to go back to the Fed's decision to push the federal funds rate down to 1 percent and leave it there for over a year." ...

Greenspan says that the Fed was worried about "corrosive deflation" at the time and that he saw that as a greater threat to the U.S. economy than a housing bubble. "There was a real serious concern about deflation," he said yesterday. "If you look at the notes of the Open Market Committee, the pressures were to go lower than 1 percent. There were no dissents." Bernanke, a member of the Fed board at the time, was also concerned about deflation.

Greenspan also argues that while the Fed has a lot of power over short-term rates, it has less influence over long-term rates, which he asserted were more important to housing prices. ... He said that at the time "it became apparent that we lost control" of long-term interest rates "as did the Bank of England and all the central banks. As a consequence, we had very little ability to put a brake on the rise in home prices." ...

Others reviewing the Greenspan era at the Fed say there is a difference between the way Greenspan reacted during sharp sell-offs of stocks and the way he reacted to the technology and housing bubbles.

Kenneth Rogoff, a Harvard economics professor and former chief economist at the International Monetary Fund, says that "the important point . . . is the philosophy of monetary policy that says 'you don't pay attention to asset prices when they are rising, only when they are falling.' " In reality, Rogoff adds, "if you cut interest rates when asset prices are in free fall, then when asset prices are rising while indebtedness is rising all over country, you need to raise rates. He actively chose not to do that."

Other economists fault Greenspan for his failure to closely regulate big banks. Alan Blinder ... says that the delay in raising rates in 2003-04 was a "minor blemish" on Greenspan's "stellar" record managing monetary policy. But Blinder says that he would give the former chairman "poor marks" for bank supervision, another key role of the Fed. ...

"Lending standards were being horribly relaxed, and the Fed should have done something about that, not to mention about deceptive and in some cases fraudulent practices," Blinder said. ...

Greenspan said that most of the subprime mortgages were originated by firms regulated by other agencies, but he adds, "In retrospect it was clearly a mistake" not to examine bank lending more closely. ...

I'm with Blinder. It wasn't the low interest rates, those were needed at the time, the lack of regulatory oversight was the much bigger problem.