The Delusions of Greenspan's Self Defense

by: Greg Feirman

Mr. Greenspan ought to have used the pages of the Journal to apologize to the nation. Instead, his piece will stand as a testament to his hubris, or perhaps his delusions.

- Ian Shepherdson, Chief US Economist, High Frequency Economics

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier — in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

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.

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble.

- Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble” (subscription required), The Wall Street Journal, March 11

In Wednesday’s Wall Street Journal Alan Greenspan had a truly outrageous editorial: “The Fed Didn’t Cause the Housing Bubble”. I can’t even begin to tell you the level of obfuscation and disengenuity in this editorial. The guy is just unbelievable. When I was reading it last night and every time I think about it I can’t help but wonder: Is he for real? Is this some kind of practical joke? Either Greenspan is pulling some huge hoax or he is so obsessed with his reputation and legacy that honesty and truth carry no weight for him.

Greenspan’s core argument is that there are two possible explanations for the global housing bubble: low interest rates from the Federal Reserve or a global savings glut. Greenspan argues that it was entirely the latter.

The Asian countries in particular structured their economies to export goods to the US, creating current account deficits here and surpluses over there. That is, we sold less to them then they sold to us, leaving them with an excess of dollars. Those dollars got re-invested into US treasury assets, pushing down yields and mortgage rates. These low long term rates were the cause of the bubble and were in fact disconnected from the federal funds rate which the Fed was tightening from mid-2004 to mid-2006.

Now there’s something to this, but the fallacy is that the cause is entirely one of these or the other. (For those of you who are interested in logic, this fallacy is called causal oversimplification and is a specific type of the false dilemma fallacy).

Does Greenspan truly believe that there was no connection between the obscenely low federal funds rate and low mortgage rates and the creation of exotic mortgage products at the beginning of the decade? The Fed is the dominant controller of the world’s money supply and the low federal funds rate meant low rates for banks which means they could lower mortgage rates and still make a nice profit on the spread.

So here’s the basic bait and switch that Greenspan tries to pull in his editorial - with good success I might add, as I found myself momentarily discomfitted in trying to figure out where his argument failed: The global housing bubble was a function of many causes. One of those causes was indeed the export structured economies in Asia which subsidized low interest rates in the USA. But that was only one of multiple causes and not the fundamental cause!

The fundamental cause was the Fed’s low interest rate policy, which was the catalyst for the housing bubble in the wake of the tech bust. The structure of the global economy (i.e. export oriented Asian economies) added fuel to the fire as US consumers tapped home equity and wealth from the boom to buy imported goods resulting in huge current account deficits which in turn played a role in keeping interest rates low and were a cause of some sort of disconnect between short and longer term interest rates in the middle of the decade. But that was derivative and historically subsequent: the boom and all the housing related wealth that caused these huge current account deficits were fundamentally caused by the Fed’s low interest rates.

Greenspan even goes so far as to quote an editorial from Milton Friedman in early 2006 (2006!) praising his management of the Fed:

“There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.”

Of course this was before the financial crisis and before the full measure of Greenspan’s policies could be evaluated. Would Friedman say the same thing today? Highly doubtful.

Many have weighed in on Greenspan’s editorial with similar incredulity. See, for example:

“Greenspan’s Denial”, Peter Boockvar, The Big Picture, March 11

“Allan Greenspan still hasn’t got a clue”, Tim Iacono, The Mess That Greenspan Made, March 11

“Greenspan Forgets Where He Put His Asset Bubble”, Caroline Baum, Bloomberg, March 12