Spread Between Fed Funds Rate and Mortgages: History Doesn't Support Greenspan

Courtesy of Lugwig von Mises Institute

There are two interesting charts shown above produced by the Mises Institute. They were produced to respond to the bogus defense of Alan Greenspan, who has been trying very hard to exonerate himself from the housing boom and bust.

Specifically, Greenspan said, “U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.”

Any statisticians would argue this statement is very misleading. First of all, when you use a long period of data, in this case 30 years, to compare with a 3 year self-selected period of data, you are really comparing apples to oranges. Statistically they are not at all comparable and have no meaning and significance. It is more his excuse than anything else.

Secondly, the behavior between mortgage and fed fund rates during period of 2002-2005 is hardly anything abnormal. If you look at the spread between them at the 2nd chart above, it had happened many times in recent history, twice under Greenspan’s early era as a Fed chairman, both in late 1980s and early 1990s. What happened in 2002-2005 is not the first time for Greenspan. Why would he suddenly forget about them? Maybe he has a selective memory lapse?

The truth about influencing long term rate by manipulating short term rate is always that they only make recessions much worse and longer in the future. Sometimes it is better just to leave things alone and let them run naturally. If Greenspan didn’t drop the interest rate to 1% in 2004 to “rescue” us, we wouldn’t have been in such a bad depression now.

Mr. Mayo is right that this is much worse than the great depression, as also voiced by former Goldman chairman John Whitehead last November. The total bad loans could be at the range of $7 - $11 trillion, or 3.5 - 5.5% of all loans, as estimated by Mr. Mayo, worse than the 3.4% ratio during the great depression. We have written off only about 2% so far, about 3rd or 4th inning of a 9 inning game. There is still a very long and dark night to go.

A lesson from the past rate manipulation for today is that we should just let banks fail, including several big ones, like WaMu, the largest bank in the US that failed last year. Let subordinate bondholders get wiped out and let a few senior bondholders get some residual money back through a “pre-package” bankruptcy process. Similar to shareholders, if bondholders make bad decisions by investing in toxic banks, why doesn’t the government allow them to share some of the losses? Why should shareholders be totally wiped out but not bondholders? Why should the taxpayer's money be placed at risk before the bondholders?

Comments

[Dirk McCoy:]

Thomas,

Your first graph certainly supports the idea that there is correlation between short term rates and mortgage rates. And the correlation is much better for short term rates, increasingly used to fund mortgages back in 2005-2007. So on one level I totally agree with you that Fed rate manipulations can be damaging.

But on the other hand, I disagree with your characterization of the interest rate decreases at the beginning of the decade. The Fed undertook significant rate decreases in 2001, not 2004, because the economy was in danger of the same kind of downward spiral we're seeing now- remember, this was just at the beginning of the retail boom, and housing was one of the few growing games in town as tech and manufacturing were crashing. Using the Taylor rule would have indicated starting rate hikes a quarter or two earlier, but rate hikes started in 2004. The problem was not the hikes, but that they went too far.

I think Mr. Greenspan is trying to say that they raised rates as high as they did because they didn't get the long term rate response they were looking for to cool the housing boom. It's clear now that perhaps the Fed should have used more energy detecting fraud and rating agency ignorance.

In fact, your excellent graph above points out one other point I'd like to make- interest rates have been trending down for nearly 30 years, and Fed manipulations seem to do a better job of raising rates than lowering them- notice the quick upward adjustments of longer term rates and slower moderation. Perhaps this is because Fed manipulations remind creditors to price in risk created by Fed manipulations.

The Fed is kind of like a monetary doctor. When sickness strikes the economy, they can provide stimulus via rate cuts and quantitative easing to help it recover. And they can provide advice to a healthy economy in the way of regulation and moderation to keep it healthy. But someone needs to tell the Fed that doctors aren't supposed to create sickness in healthy patients to slow them down- there are plenty of other risks and challenges that will take care of that.

Apr 07 02:21 PM

[Diegojames:]

Mr Greenspan was and is displaying cognitive impairment. If Congress had a business background instead of "social spendings gone wild",appropriations for "my state" and "look I am saving the environment", he would have been discovered before he destroyed us.

And ,yes, he played to his Investment bank friends on Wall Street and fooled many in Washington and mega media. Come out to California for 2 weeks and your point of view will change from "East Coast-Washington DC-New York TV Media" mentality.

Apr 09 02:21 PM