In a really useful article about central bankers over at The American Prospect, Brad DeLong says:
The current financial crisis has its roots in Greenspan's decision to keep interest rates very low in 2002 and 2003 to head off the danger of a deflation-induced double-dip recession, and his subsequent decision that the costs of cleaning up after a housing bubble were likely to be less than the costs of the high unemployment that would be generated by a preemptive attempt to pop a housing-speculation bubble. Two years ago, I would have said that Greenspan's judgment here was correct. Six months ago, I would have said that his judgment was probably correct. Today -- in the middle of the largest nationalizations in history -- I can no longer state that Greenspan made the right calls with respect to the level of interest rates and the housing bubble in the 2000s.
Arnold Kling replies:
My view of history is rather different from Brad's. I think that the current financial crisis was not the product of Alan Greenspan. I think it was a phenomenon that emerged from a number of subtle factors, the most important of which was the anomaly in capital requirements. See my fantasy testimony and written remarks.
The central bank does not control the risk premium, which is perhaps the most important financial variable in the economy. Had there been no housing bubble, it is possible that the general drop in the risk premium that took place from approximately 2001 through 2007 would have created a crisis elsewhere. Perhaps it indeed did create a crisis in the debts of the so-called emerging-market countries.
I, like Arnold, find it hard to credit the American central bank with this crisis. The disaster in Europe shows that lending standards fell everywhere--in the US, it was the mortgage market, in Europe, emerging market debt. Yet the Bank of England, and especially the ECB, were inflation hawks. Nor do falling interest rates explain the vast influx of foreign capital that unquestionably sustained the bubble; capital is supposed to follow rising rates. The global decline in lending standards seems to support Bernanke's "global savings glut", in which Asian savers recycled export earnings into American and European credit markets with insufficient regard to risk.
Even if we blame the post-9/11 interest rate drop, however, I think Brad's post hints at what I've been saying (I know--over and over and over): how do we separate the decision making process from the result? What looked like a sound decision in 2001 is now fairly obviously wrong. But was there some systematic rule by which Greenspan could have known that a financial collapse was more likely than a post-attack deflationary spiral? Because that's what we need in the future, if we want to prevent this from happening again. As Arnold Kling points out:
Given that Ben Bernanke was appointed in 2005, it should be noted that the worst of the housing bubble took place under Ben Bernanke'.s watch. It should also be noted that Brad DeLong hates Greenspan and adores Bernanke.
Until just a few weeks ago, all of macroeconomic theory suggested that inflation targeting was sufficient for monetary policy. In The Economics of the Great Depression, Randall E. Parker interviews the top modern macroeconomists on their view of the 1930's. Ben Bernanke, in his interview, says (p. 65)
A price target that avoided deflation would have de facto forced abandonment of the gold standard and would have eliminated a major channel of depression...So I do agree that stabilizing prices is the ultimate lesson of the Great Depression and also of the 1970s. There really is nothing more a central bank can do for domestic economic stability than make sure that inflation remains low and stable over long periods.
Re-read that last sentence. Ben Bernanke, the Depression expert, or "technocrat-prince," as DeLong hails him, says nothing about the Fed needing to pop financial bubbles or to give Treasury Secretary Mussolini power to buy hundreds of billions of dollars of mortgage assets and then use that power to partially nationalize banks, insurance companies, auto companies, or anyone else of his choosing.
Targeting asset bubbles always seems like a slam dunk--after you know there was a bubble. Prospectively, if you want to do it effectively, you probably need to intervene in the very early stages. The Fed raised interest rates in the late 1920s, to no effect--indeed, it encouraged foreign capital to flow in. Iceland's central bank, too, tried to quiet its financial bubble, but borrowers simply ignored them--borrowed at the higher rate, or stupidly took on currency risk by getting auto loans and mortgages from abroad. Meanwhile, more lenders were attracted by the higher rates. If you think house prices will go up 10% every year, a 1% increase in mortgage interest rates is not really that worrying.
So to squelch asset price bubbles you need to get in early, before the bubble takes off. But in the early stages, an asset price bubble isn't necessarily distinguishable from actual economic growth, or real changes in the relative value of assets. The various indices have fallen since the bubble peaked in 2000--but the S&P is still about twice what it was at the start of 1995, the year the bubble is generally agreed to have taken off. Stomping down on bubbles before they get going will mean accepting higher unemployment and lower economic growth any time that any asset market starts to look the least bit frothy.
At that, we don't know if it is possible to prevent bubbles (and we definitionally won't--if a central bank succeeds, all we'll see is . . . no bubbles. Which is also what we'll see in most cases if the central bank takes no action.) Speculative mania precedes fractional reserve banking, central banking, and quite possibly, the invention of currency. The central problem is that in an asset market, other people's opinions of an asset's future value are meaningful components of the asset's future value. And since guessing other peoples' future opinions about cash flows is even harder than guessing the cash flows, there is a systemic tendency to over- or under-shoot.
Almost everyone attributes the quiescent markets of the 30's, 40's and 50's to FDR's sweeping regulatory changes. But it seems to me that it's at least as plausible to think that investors simply got much more bearish on stocks, because the lesson of 1929 was fresh in their minds. As that memory faded, markets headed north.
Update: Free Exchange adds
When does a bubble become a bubble? While it's certainly sometime before your waiter begins day-trading between courses and your son refinances his treehouse, it's definitely after awareness of the sure-fire profit opportunity in the relevant sector has hit some critical mass. That's really what a bubble is all about, after all--the departure of price growth from fundamentals thanks to a rapid broadening of players in the bubbly market. Before the Ponzi scheme is a Ponzi scheme, it isn't a Ponzi scheme.
But what that means is that by the time a bubble becomes a bubble (and certainly by the time it becomes a recognisable bubble) a lot of amateur investors are involved. A healthy chunk of the body politic will have entered an inflated market believing prices will continue to increase. And Mr Roach and Mr Thoma are saying, correctly, that someone important will need to tell them that they have made a very bad decision and are about to lose their money.
Mr Thoma says that popping such a bubble will take courage. For a politician to do it would take an extraordinary amount of courage--more than we could reasonably expect a politician to display. It's important then to place the bubble popping decision in the hands of officials that are entirely--inhumanly--apolitical and independent.And frankly, I wonder if the standard of independence necessary for the job is realistic.