Greenspan Should Have Warned Against Mortgages

Brad DeLong can't decide whether or not Greenspan made a mistake when he kept interest rates low after the collapse of the dot.com bubble:

Sympathy for Greenspan, by J. Bradford DeLong, Commentary, Project Syndicate: In the circles in which I travel, there is near-universal consensus that America’s monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis. ... US policymakers erred when:

-the decision was made to eschew principles-based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government’s guarantee of the commercial banking system was enough to keep us out of trouble;

-the Fed and the Treasury decided, once we were in trouble, to nationalize AIG and pay its bills rather than to support its counterparties, which allowed financiers to pretend that their strategies were fundamentally sound;

-the Fed and the Treasury decided to let Lehman Brothers go into uncontrolled bankruptcy in order to try to teach financiers that having an ill-capitalized counterparty was not without risk, and that people should not expect the government to come to their rescue automatically.

There is, however, a lively debate about whether there was a fourth big mistake: Alan Greenspan’s decision in 2001-2004 to push and keep nominal interest rates on US Treasury securities very low in order to try to keep the economy near full employment. In other words, should Greenspan have kept interest rates higher and triggered a recession in order to avert the growth of a housing bubble?...

I have argued the Fed's decision to keep interest rates low contributed to the bubble, but was not itself the sole cause of it. As to whether the Fed made a mistake, I'll just note that the tradeoff wasn't quite as stark as Brad implies, i.e. there were other policy instruments that the Fed could have used to limit the housing bubble. Regulation is certainly one means the Fed had to that end, but Fed communication could have helped too. If Greenspan had, for example, told people to stay away from mortgages because they were toxic rather than implicitly encouraging them to invest in housing, things might have been different.

Would limiting the bubble through regulation, communication, or other means have limited the employment response, the primary worry? I don't think so, at least not enough to matter. The money would have been invested somewhere, housing had an opportunity cost after all, so the next best alternatives would have been pursued to the extent that they were profitable (and many would have been, just not as profitable - apparently anyway - as investing in housing and mortgages). So people still would have been employed somewhere as the money was invested, just not in housing, and that would have helped to insulate us from the housing crash. (And a lot of them might still have those jobs, unlike the people who depended upon the housing markets for employment.)

So narrowly, keeping interest rates low and employment high was the right thing to do. The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing market in pursuit of profits based upon the misperception of risk. Those resources could have been redirected into other sectors and put to productive use rather than wasted on building houses nobody wants, and achieving this result did not require the Fed to aggressively raise the target rate, it only needed to use the other tools it already had available.

Unfortunately, however, those tools were not used, and the ideology Greenspan brought to the Fed played a large role in this outcome.

Comments

[prairiedog555:]

The major blame goes to the watchdogs of the financial industry, Barney Frank and Chris Dodd. These guys took money from the companies they were supposed to regulate. Sure, Countrywide ect. sold bad loans, the Brokers packaged them, and AIG insured them, but it could have stopped with Frank and Dodd.
So, they are either criminals or incompetents. Whichever, if you live in Mass or Conn and reelect them your are equally to blame.

Jun 30 07:59 AM

[Moto:]

While watching Greenspan on CSPAN speaking to some Congressional committee, he said that there was no way possible for them to foresee all the mortgage defaults on subprime loans. As aforementioned, either criminal or incompetent.

Jun 30 08:21 AM

[gu econ:]

Mark, you state, "The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing". Three questions: 1) Does the Fed really have the tools to restrict the flow of credit into a given sector of the economy? 2) If it does, would the politicians, and even the public, have allowed the Fed to put the clamps on the housing boom? 3) Finally, do we even want the Fed to have so much control over individual sectors of the economy that it can decide how much credit is allocated to each, which ones are potential bubbles, etc.?

Jun 30 11:23 AM

[notsosmart:]

he was blind or a coward.but he could not have parted the ocean as the tide lifted all boats.these bubbles cant be stopped going back to tulips. if you are not too greedy & get in & out @ the right time you will be ok.the up-down momentum will always be there & the dumb-dumbs(many more now with 201k's)will get caught.

Jun 30 12:33 PM

[LaVern Isely:]

I agree with the article. Greenspan was the problem but you can't blame the Obama Democrats because Greenspan was in under President Clinton and George W. Bush. He talked President Clinton into getting rid of the GLASS-STEAGALL ACT, which he did and President GW Bush took full advantage of it and deregulated just about everything in the banking industry, particularly the HEDGE FUNDS selling those TOXIC DERIVATIVES which they call REAL MONEY. The GLASS-STEAGALL ACT SHOULD BE REINSTATED. My question is--why isn't someone in the Obama Administration going after this problem as fast as possible? They seem to be dragging it out, I suspose, because of Fed Chm Ben Bernanke, who isn't any better than the former Fed Chm, Alan Greenspan in doing what's right.
Yours truly, Disgusted Middleclass Taxpayer, Public Citizen and AARP Member, LaVern Isely

Jun 30 02:44 PM

[snagglesnarf:]

Greenspan did not force anyone to lie on their mortgage applications or buy much more house than they could afford or take out some whackadoo pick-a-payment loan. He may have partly allowed this crisis to happen but the American people caused it.

Jun 30 07:04 PM

[CLH:]

Only idiots expect the govt. to care for them. Who is to blame --look in the mirror. Everyone who spent more money then they made is to blame.

Jul 01 07:46 AM

[for parity:]

Here's how it started - speaking of govenment stimulus!! Yea, Greenspan should have warned.. but the public simply is not aware of the several large actions which led to a very dangerous housing bubble being born right smack in the middle of the aftermath of the dot.com crash and recession. How'd they do that? here's how:

Oct., 31, 2000 - HUD ANNOUNCES NEW REGULATIONS TO PROVIDE $2.4 TRILLION IN MORTGAGES FOR AFFORDABLE HOUSING FOR 28.1 MILLION FAMILIES

www.hud.gov/library/bo...

And the housing bubble was born.

Jul 02 04:12 PM