Alan Greenspan, Obfuscator Par Excellence

by: David Merkel, CFA

When I did my “Blame Game” series, I put Alan Greenspan near the top of the list for his mismanagement of monetary policy over his tenure, always bringing back the punch bowl too fast, and never letting enough marginal entities go into insolvency. His tenure corresponds to the fast climb in the total leverage of the US economy. When debtors realize that the Fed will not deliver any real pain, they quickly pile on the debt, leading to the overleveraged condition we are experiencing now.

In a WSJ editorial today, Greenspan has the temerity to say that his monetary policy did not cause the housing bubble:

There are at least two broad and competing explanations of the origins of this crisis. The first is that the “easy money” policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

First, small differences in correlation coefficients are not adequate to test a hypothesis. Second, the low Fed funds rate touched off a flurry of adjustable-rate home loans, which Greenspan himself inadvisably endorsed at one point. The adjustable rate loans became a much larger part of the residential mortgage space than ever before. Greenspan does not cite figures for his mortgage rate claim — I am guessing that he is comparing fixed rate mortgages to Fed funds, which is not the right metric here, given the large amount of floating rate issuance.

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.

As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

As I noted at RealMoney during 2004-2006, the yield curve flattened the hard way, with the Fed raising rates, and the long end falling. I noted that China was acting as a second central bank for the US, stimulating as the Fed withdrew stimulus. But the Fed did little to counteract China’s influence; they could have been more aggressive, and acted faster. They could have tightened margin requirements or bank capital requirements. They just plodded, and continued to let overall leverage in the economy get out of whack.

Low global interest rates were just a sign that the global marginal efficiency of capital was eroding. There was overinvestment, and not enough understanding in the neomercantilistic countries to realize that they were flooding the world with their goods, as their purchasers flooded them with credit.

Yes, the credit policies of other nations were a factor, but it does not excuse the mismanagement of monetary policy by Greenspan, where private and public debts were allowed to build up to record high ratios of GDP, threatening the health of the financial system, and the Fed did little to nothing about it.