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.

6 comments

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Greenspan is a batty old man

Posted by Story_Burn | Report as abusive

Giving the Fed frictionless control is like giving a horde of junkies frictionless keys to Kabul. The taxpayer not only pay for their rehab, but gets hooked on their Methadone into the bargain.

Posted by HBC | Report as abusive

It’s funny – all the Libertarians who hate the Fed should have loved that Greenspan stood by and did nothing to stop the bubble.

The blame game on our financial crisis is incoherent. The Fed controls too much or not enough? We need derivatives to help spread risk and add liquidity but they didn’t seem to help because no one understood what they were buying or they rigged. The expansion of credit for uwworthy individuals allowed us all to exploit the bubble, but we all could have (and should have) said “no thanks”.

Mr. Salmon can explain and justify the arcane details of swaps and derivatives all he wants, but can he refute the assertion that none of it worked to efficiently allocate capital and risk? Isn’t it all just a tool to gamble and distort true financial performance beyond recognition? Why is that so important to us?

Posted by silliness | Report as abusive

Greenspan was good atleast in one thing, picking up difficult words from dictionary and using them in front of Senate Banking Committe. ^ irrational exuberance^.

One thing baffles me even after eight years ^ why on earth did Fed, Greenspan and other central banks panicked after Sept 11.
Though it was a very tragic day lots of life were lost, but it was not the end of US economy. The Us economy was not dependent on two high rise towers, the destruction of the two towers panicked the old man, and he started cutting interest rates to zero. All the central bankers were very happy that they saved the Stock Markets.
How long and how much you could help inflate the assets?
From World war 1 to Kuwait war in 1991 the highest S&P 500 has gone was 330. It took 73 years for S&P 500 to reach 330 points. Then after 1991 to March 2000 S&P moved to 1574 ie it took 9 years to add another 1250 points.
On one side you have 73 years and 330 points and on another side you have 9 years and 1250 points, What was fed doing when assets were inflating at such a tremendous pace, just watching and saying irrational exubereance. That was not enough.

Again after sep 11 when the stock mkt S&P 500 dropped from 1574 to 860, the zero interest rates again helped the assets to inflate , and the S&P went up from 860 to 1586 in october 2007.

In my view the Greenspan Fed did more damage to US economy in particular and the world economy in general than the 9/11.

Then came George Bush, who was made a president and given an agenda by hook or crook take the oil prices up, the Texas oil companies advantage.
He complied with the agenda given to him. He went to proxy war killed millions of innocent people in Iraq then went to Afghanistan to hunt one person and in that process also killed 100s of thousands innocent people.
The crude prices were going up and up.
Not only war was used for taking the crude up, but the Bush administration did their best and succeeded in killing the US $. What benifit was there to kill the US $, the answer is it will ignite inflation, and when inflation is going up crude prices will go up and up as per the agenda.
THe white house spokesman used to make a comment every week, whenever the US $ was about to move up, the comment was ^ We want strong $, Strong $ is in our interest but let the Market decide. But let the Market decide phrase was used as a signal to sell Us $. The moment this comment was made the US $ was hammered down.
In my 30 years of financial mkts experience I have never seen White house spokesman giving comments on US $ every week, every now and then, with a hidden message.

So george Bush was successful in taking the oil prices higher by 1) making an illegal war,2) by killing the Us $
3) By smartly selecting Bernanke as White House adviser, then making him the Fed Chairman. Ben bernanke has the reputation of a person who is paranoid of deflation, unfortunately Bernanke has researched about japanese deflation spiral. Soon after Bernankes confirmation by Senate in late 2005, Gold, crude and other commodities skyrocketed, taking the CRB to super high values, which in turn created an unnatural phenomenon of price spiral,
real estate prices, land prices,rents of apartments, school fees, college and university fees, rice, crude, sugar, edible oils shot up. from early 2006 when Bernanke took over as Fed chairman till Aug 2008( LEHMAN BROTHErS) it was a choaos of unprecedented historical proportion, it was a limitless moves higher and higher.
We should be happy that Lehman brothers demise brought to an end that maniac price rises temporarily. But with the Feds 0 interest rate stance for extended period, things are again moving into chaotic direction.

A combination of Greenspan(doveish), who did not believe in proAction, George Bush the president with a hidden agenda, Ben bernanke a person studied japenese deflation and became a paranoid man, did not bode well for world economy and for humanity.

Posted by badsha | Report as abusive

That’s very funny H(S)BC.

silliness, don’t confuse hedging with gambling.

badsha, are you sure that the ‘proxy war killed millions of innocent people in Iraq’ ? It sounds a bit high, maybe it unleas(h)ed millions of barrels of crude oil per day. Your article is good, it just requires a spell check and counter arguments, remember, a debate has 2 sides to it. Remember the first law of physics ? Every reaction must have an equal and opposite reaction. It applies to economics too, that’s what the traders thrive on, its all about information and timing and staying awake a bit longer.

Greenspan’s gravest error is that he looks like Woody Allen.

Posted by Ghandiolfini | Report as abusive

The Fed did indeed realize the impending doom facing the economy, as did the American Congress.

That is precisely why after decades of no significant changes in bankruptcy law at the federal level, Congress enacted sweeping changes that benefitted the lender a couple years before the economy collapsed.

Posted by breezinthru | Report as abusive