Greenspan’s error

By Felix Salmon
March 19, 2010
Sam Jones has the clearest, shortest rebuttal of Alan Greenspan's 66-page Brookings paper that I've yet seen. And most impressively, Sam wrote it more than a year ago. While Greenspan is becoming increasingly contrite about his failures of regulatory oversight, he still continues to say that his monetary policy was blameless in the crisis, since during his tenure short-term rates, which the Fed controls, ceased to have much if any effect on mortgage rates, which were the key driver of the global housing bubble.

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Sam Jones has the clearest, shortest rebuttal of Alan Greenspan’s 66-page Brookings paper that I’ve yet seen. And most impressively, Sam wrote it more than a year ago. While Greenspan is becoming increasingly contrite about his failures of regulatory oversight, he still continues to say that his monetary policy was blameless in the crisis, since during his tenure short-term rates, which the Fed controls, ceased to have much if any effect on mortgage rates, which were the key driver of the global housing bubble.

To which Sam says:

It was, of course, (not solely, but significantly) the Fed’s low interest rates that sparked the conditions necessary for such a disconnect – an event Greenspan waves away with a vague mists of time/”turn of this century” sleight of pen. His conceit is basically that the development of a “well arbitraged global market” was a break with the past that the Fed played no part in.

Therein the problem. Precisely because the Fed should have played a part. It should have recognised the huge macroeconomic changes afoot and it should have sought to navigate them.

Instead of which, the Fed stood passively by, nay, it saw what was happening and it recused itself. Turn Greenspan’s excuse around and it becomes a damning indictment: if the Fed realised in 2004 that it could not use its monetary policy tools to control the rapidly inflating US mortgage market, then why on earth did it do nothing for the next three years?

The problem is that it would have been ideologically very difficult for Greenspan, who always wanted the absolute minimum of government interference in the markets and the world generally, to expand the role of the Fed from that of simply setting short-term interest rates. Even when the Fed’s control of short-term interest rates was clearly inadequate to achieve what it’s the job of a central bank to do.

To make matters worse, the reason that short-term interest rates were increasingly powerless was that Greenspan kept them near zero for so long: he basically created frictionless market conditions in which anything could happen — and anything did. Greenspan’s main problem was that he thought that giving up control was a good thing. And while he’s realized that he was wrong in terms of regulatory policy, he still hasn’t realized how wrong he was in terms of monetary policy as well.

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