History according to Greenspan
Alan Greenspan, the former Chair of the U.S. Federal Reserve, has been vilified as the architect of the real estate bubble. Critics of Greenspan and the Fed have claimed that his low interest policies, following the bursting of the dot com bubble in 2000 and the events of 9/11, created the foundation for the real estate bubble.
Alan Greenspan has argued that the Fed’s policies did not create the problem. In a paper prepared for and presented at the Brookings Institution, he reiterated this argument, claiming that the Fed’s policy of low interest rates was not to blame. He lay part of the blame on “geo-political events” which “ultimately led to a fall in long-term mortgage interest rates that in turn led, with a lag, to the unsustainable boom in house prices globally.” The geo-political events cited were primarily the large trade surpluses generated by China and the investment of these surpluses by the Government of China in long-term U.S. Government bonds.
He added, as he has done in the past, that little could be done to identify a bubble before it burst, much less to pop it.
There are several problems with Greenspan’s view of history. Alan Greenspan always voraciously studied data, looking for the earliest hints of trouble. It should have become obvious to him by the first half of 2007, if not earlier, that the sharply rising house prices were not sustainable, even with record low mortgage rates. The indicator, the proportion of average family income spent on housing, should have been flashing red. There is strong empirical evidence that when this ratio exceeds a certain threshold demand for housing will collapse and so too will prices.
There also were a number of investors who recognized this in the first half of 2007, and placed big bets against housing and mortgage-backed securities. If these investors saw the bubble and ensuing problems, then the Fed, with its army of researchers, wealth of data, and enormous number-crunching capabilities, should have spotted the problem as well. Greenspan could simply have picked up his phone and called some of these investors to ask them for their views.
Next, if geo-political events and declining long-term interest rates and mortgage rates were the cause of the problems, Greenspan and the Fed must have been aware of the declining long-term rates and their potential to create a housing bubble. The Fed could have intervened to prop up long-term rates. But it chose not to do so.
The Fed understands cause and effect very well. Regardless of the cause, the Fed knew the possible effects, and had the ability to change rates and neutralize the impacts of geo-political events.
Greenspan was reluctant to intervene and exercise the regulatory powers of the Fed because he strongly believed that the market (whatever this might be) was a more effective regulator than government. He continued to stick to this position even after he lived through at least four financial market “near misses”: the stock market meltdown in October 1987; the Southeast Asian crisis in 1997; the implosion of Long-Term Capital Management; and the tech bubble in the latter half of the 1990s. Each of these should have made it quite clear that markets are unstable. And in each case, the Fed, under Greenspan leadership, intervened to save the financial system.
While Greenspan now acknowledges that there might be a need for some additional rules to govern the financial markets, his recommendations fall far short of what are needed. His predecessor, Paul Volcker, is much more realistic about the shortcomings of the financial system, and the regulatory and legislative requirements that are needed.
The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.