A Failure of Capitalism: Reply to Alan Greenspan

I have received an email from Alan Greenspan in which he expresses regret at what he describes as my "rather thin analysis of the source of the current financial crisis." He states that his "view is different," and by way of explanation prints excerpts of three pieces written by him. The first is from remarks, entitled "Risk and Uncertainty in Monetary Policy," that he made at a meeting of the American Economics Association in January of 2004, while he was still chairman of the Federal Reserve and the housing bubble was expanding. The second is from an article that he published in the Financial Times on April 6, 2008, called "A Response to My Critics." The third is from an op-ed that he published in the Wall Street Journal on March 11 of this year, entitled "The Fed Didn't Cause the Housing Bubble." Here are the links to the three pieces, and I suggest you read them before reading my reply, which follows the links.

http://www.federalreserve.gov/BoardDocs/Speeches/2004/20040103/default.htm

http://blogs.ft.com/economistsforum/2008/04/alan-greenspan-a-response-to-my-critics/

http://online.wsj.com/article/SB123672965066989281.html

The first piece is a narrative of the Federal Reserve's monetary policy between 1979 and 2004. Greenspan explains that the Fed during this period, under Paul Volcker's chairmanship and then Greenspan's, raised and lowered the federal funds rate (the rate at which banks borrow from each other overnight) in order to achieve so far as possible full employment with minimal inflation. He notes the dot-com stock market bubble of the late 1990s and explains that the Fed did not try to puncture it by raising interest rates, fearing that to do so would cause "a substantial economic contraction and possible financial destabilization." But the article does not explain why he thought those consequences would have ensued. He notes that after the bubble burst and a recession ensued in 2001, the Fed reduced the federal funds rate; by June 2003 it was at 1 percent, "the lowest level in 45 years."

He thought this could be done without risk of inflation (the usual consequence of extremely low interest rates) because "both inflation and inflation expectations were low and stable." In fact, as I have explained in my book and in previous blog entries, the low interest rates had caused asset-price inflation--the housing and stock market bubbles, both well under way when Greenspan wrote the article in 2004.The rest of the article is devoted to generalities about monetary policy. There is no mention of a housing bubble. And rather than "trying to contain a putative bubble by drastic actions with largely unpredictable consequences," he contended that the Fed should "focus on policies 'to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.'" The quotation appears to be from earlier testimony by him before Congress.

Greenspan's second article, published in April of last year, remarks that similar housing bubbles emerged in more than two dozen countries, including the United States, between 2001 and 2006. He attributes these housing bubbles not to monetary policy (namely the low federal funds rate) but a "dramatic fall in real long term interest rates." He therefore refused to acknowledge that the Fed should have started pushing up interest rates before 2004, adding that "regulators confronting real time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act preemptively." He said that tighter regulation would have made no difference. He attributed the entire subprime debacle to "misjudgments of the investment community," thought the situation was stabilizing, and repeated the view expressed in his 2004 article that the Federal Reserve should not try to prick bubbles.

Presented by

Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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