Greenspan Is to Blame for Today's Problems

Last night Mrs. Businomics and I were doing things we hardly ever do. I was admitting that I had been wrong. She was agreeing with me.

Then I went to read some blogs and I found Brad DeLong saying exactly what I had been thinking, which is also fairly unusual. The subject: we economists have been wrong about monetary policy and asset bubbles.

Back in the old, old days, like the 1980s, we had all become monetarists.  Professor Friedman taught that money supply growth rates should be stable and low. Then financial deregulation, sweep accounts, and other innovations made the money supply numbers hard to interpret. So we economists looked at inflation, and the gap between actual output and potential output, to assess whether the Fed was being loose or tight with monetary policy.

Chairman Greenspan kept interest rates extremely low from 2002 through 2004, and very low in 2005. We weren’t seeing inflation, and output didn’t seem to be surging excessively, so it seemed that the Fed was not too loose with money.

A few folks worried about asset bubbles being nurtured by easy money. DeLong cites Michael Mussa, former research director at the International Monetary Fund, and calls this view “Mussaism.” The view actually goes back to much older theories (Don Patinkin for you economists) that can be thought of this way: folks have three types of assets: money, investment assets, and consumption assets.  If you increase the money supply through easy monetary policy, then people try to get into asset allocation balance again, by selling money (also called “spending”) and buying the other assets. When they are buying consumption goods, we worry about inflation. 

Well, the easy money of the early 2000s did not lead to above-trend consumer spending; it led to above-trend buying of houses. Some of that buying led to construction of new houses, but a great portion of the effect was to induce a run-up of home prices. Easy money WAS leading to inflation, just not inflation of consumer goods, but rather housing inflation.  Thus the housing boom, which resulted in the oversupply of housing, the over-optimism about sub-prime home loans, and the subsequent financial crisis. Man, I loved Alan Greenspan, but it turns out that he is to blame for today’s problems.

With this view, we have a better understanding of what happened during the easy money period of the late 1990s, with the high-tech stock price boom.

We don’t yet have a consensus among economists on this. The theoretical guys will write equations, then the empirical guys will test them with data. But this feels right in MY gut.

OK, we economists have learned our lesson. Monetary policy must be conducted with an eye to both consumer price inflation and asset inflation. This lesson does not mean that we economists are stupid, just that we still have some stuff to learn. Now, lesson learned.

Going forward, once we can get past the current recession, look for monetary policy to be more cautious. Look for a greater willingness to tolerate small recessions. Look for an avoidance of easy money, and thus an avoidance of this mistake. 

I hate to sound like we’re just making this up as we go along, but that’s what I see. We in the economics profession learned a lot from the Great Depression.  Even in the current crisis, we’re avoiding the dreadful mistakes of the 1930s.

We learned a lot from the inflation of the 1960s and 1970s. We’ve avoided that mistake ever since.

Now we have a new lesson, and we’ve learned it.  Monetary policy won’t be error free in the future, but I’m highly confident that we economists … will learn from our future mistakes.

Comments

[fireball:]

bill
about a month back i read the hearings betwee n ron paul and greenspan. what i gathered from the reading was that greenspan agreed with dr. paul about a sound monetary system. it appeared to me that greenspan was trying to do the best he could with a fiat system that he knew could not work. i had much disdain for greenspan until i read his answers to dr. paul. my new perspective is that he did all he could to keep a foolish system going. greenspan as a young man was a rand fan and an advocate for a backed currency. it was evident that his beliefs had not changed but he was stuck with reality. i would go further back and spread the blame from wilson to bush at least. i would also blame the many congresses over the same period.
i continue to hear from the media that it is the fault of the free market advocates, yet we have not had a free market. i would give much blame to lbj for stupid financial policies. i would give clinton his fair share for making bad policies worse. then i would blame the other presidents for not trying to fix stupid policies. give mccain his share for his earlier invlvement but do not leave obama out as the young lawyer that helped force fannie and freddie to make even worse loans.
most of the blame goes to the federal reserve which is one of the biggest scams in history.
just my humble opinion. got gold? got silver?

2008 Oct 12 09:18 AM

[john s. gordon:]

don't blame alan for what the predatory lenders did. they were after the big fat fees & then skipped town with their loot.
> jack

2008 Oct 12 12:01 PM

[flow5:]

Greenspan wasn't soley responsible. It was the FEDs technical staff & their Keynesian training that said the money supply could be regulated using interest rates. That is a fallacy.

Milton Friedman lacks a great deal of knowledge about money & central banking. I don't consider him a monetarist.

Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.

Bubbles are impossible to miss as is any signifant change in GDP.

2008 Oct 12 04:16 PM

[Moon Kil Woong:]

I agree Greenspan was a contributor but not just because of asset bubbles. 1) Clinton approved the fed to mess around with substitution and other ways to falsify inflation 2)Others allowed falsification of real unemployment. This made them lagging or just incorrect measures making it harder to see real trends.

Although the fed should have seen the mass inflation of assets during the last bubble, the SEC is mainly to blame for not regulationg a $41 trillion dollar CDS monster. In fact Cox seemed not even to be aware of it even though it was the main driver of asset inflation for the last 6 years.

And Paulson, being complicit in shorting the housing market while under Goldman is also to blame for lack of impartial oversight.

Bad show for everyone all around. But Greenspan get's the cake for inspiring giant spreads in mortgage bonds by allowing 1% fed funds while they wrote flexible ARM mortgages that everyone knew would go to 6-8% for people who couldn't even pay rent.

2008 Oct 13 12:55 AM