The Atlantic gets results! I hope you've been following Richard Posner's writing for us as an Atlantic Correspondent. Now he's received a response to his criticisms from Alan Greenspan, who defends the "Global Savings Glut" hypothesis.
Posner finds this defense unconvincing:
The federal funds rate, being the rate at which banks borrow reserves (cash) from each other, has a strong influence on long-term interest rates. The lower the cost at which a bank acquires capital to lend, the lower will be the rates at which it lends, whether long term or short term, because competition will compress the spread between the bank's cost (its interest expense) and its revenue (such as interest on the loans it makes). At the beginning of 2000, when the federal funds rate was 5.45 percent, the interest rate for the standard 30-year fixed-monthly-payment mortgage rate was 8.21 percent. By the end of 2003, the federal funds rate was below 1 percent (and was negative in real terms, because there was inflation), and the mortgage interest rate had fallen to 5.88 percent. The Fed then gradually raised the federal funds rate, to 5.26 percent in July 2007, and the mortgage interest rate rose also, to 6.7 percent, a smaller but still significant increase; and the bubble burst. Furthermore, given the popularity of adjustable-rate mortgages--which Greenspan encouraged--short-term interest rates had a direct effect on the cost of mortgages during this period.
Greenspan's analysis implies that the Federal Reserve lost control of long-term interest rates because of foreign capital and therefore could not have lanced the housing bubble even if it had wanted to, which is hard to square with the fact that the bubble did burst when the mortgage interest rate rose. (Though there was a lag, as I explained in a blog entry of May 19, because of the self-sustaining tendency of a bubble.) And it is plain from the earlier statements to which Greenspan has directed us that he neither was aware that there was a housing bubble nor would have lanced it had he realized it, since it was and appears to still be his position that bubbles should be allowed to expand and burst, and then the Federal Reserve will wake up, step in, and clean up the debris ("mitigate the fallout when it occurs")--which we have discovered it cannot do.
One wades into a debate between Richard Posner and Alan Greenspan with more than a little trepidation. Still, I have to disagree with Judge Posner on a substantive point: the power of short term interest rates is not nearly as powerful as he implies.
I say this for two reasons. First, we observe (and observed, during the bubble) marked disconnects between short-term and long term rates. It is true that they usually vary roughly in tandem, but there is a confounding factor: the Fed's expectations are tied to the market's expectations. So if everyone thinks there will be inflation, both short term and long-term interest rates rise; if everyone things there will be a recession, they both fall. But this does not mean that the fed's action mechanistically determines the direction of long-term rates--if it did, we would not now be witnessing Treasury yields rising as the Fed holds interest rates to nothing. It is true that many adjustable rate mortgages (ARMs) are pegged to the Fed funds rate, but many others are not. And at any rate, the problem ARMs had teaser rates or odd structures (negative amortization rates) that further broke the relationship between the Fed and the sticker price of peoples' mortgages.
Indeed, there's some possibility that the decision to raise interest rates by the time a bubble is firmly established may be counterproductive--John Kenneth Galbraith chronicles how the attempt to raise the price of margin loans in the late 1920s simply attracted more European money into the trade. If the price of stocks or houses is rising by double digits every year, raising the interest rate from 6 to 8 percent doesn't much dim the mania, but it does make lending into it more lucrative.
But also, the price of credit is not merely the interest rate--it's also the availability. Mortgage interest rates are low right now, but the credit score required to get one of these low priced loans is much higher than it used to be. That means that the price of loans has increased for alll but the most creditworthy. For those with the lowest credit scores, it approaches infinity.
We know for a fact that American markets were flooded with foreign loans in the early part of the decade--the current account deficit marched upwards when rates were low, and when they were high. The price of loans fell in both interest rate and availability terms. By that time, the house price increases that were already well established--the Case-Shiller 10 city index shows home appreciation reaching 10% a year in the late 1990s, with only a mild dip after 9/11. In those circumstances, it's hard to see how he could have stopped this by fiddling with interest rates. Perhaps he might have managed it had he jammed interest rates up to somewhere between 8-10%. But the result would have been a recession like the early 1980s--the one with the double-digit unemployment levels that we now fear we may repeat. Assuming that he had succeeded in averting the worst of the runup, most of us would now remember Alan Greenspan as the lunatic who threw millions out of work in order to pop an imaginary housing bubble.
Greenspan might have had more success with changes in the mortgage origination rules. But his power in this area was much more limited--America's fractured system of bank regulation, which desperately needs reform, has six different agencies that oversee banks. This patchwork affords quite a few opportunities for regulatory arbitrage (remember the Savings and Loan crisis?), which leave it an open question whether Greenspan could have succeeded in cracking down on loose lending standards.
A few weeks ago, I was talking to a well-respected journalist who doesn't cover financial matters. She was pushing me for the culprit behind this mess, and was unsatisfied when I pointed out that there were a lot of good reasons to make most of these bad decisions. Ultimately she cried in frustration, "but somebody must have done it!" This is how we approach the problem: we want villains, guilt, punishment. But when systems fail, they usually fail systemically. If one person, even Alan Greenspan, could bring down the entire edifice, then we'd be in massive trouble, so we should be grateful that it isn't the case.