A Failure of Capitalism: Reply to Alan Greenspan

by Richard A. Posner

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." Above are the links to the three pieces, and I suggest you read them before reading my reply, which follows.

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.

Greenspan's third article, published just this last March, is, as one would expect, more defensive in tone; for by then, as he acknowledges, disaster had struck. He argues in the article that the cause of the housing bubble and the ensuing near collapse of the international banking system was in no measure due to the Federal Reserve's having under his chairmanship pushed the federal funds rate way down and kept it there for years, but instead was the result of the adoption by developing countries such as China of an export-oriented trade policy, as a result of which these countries accumulated huge dollar surpluses which they then lent in the United States, driving down interest rates.

This must be so, he argues, because the housing bubble was caused by long-term interest rates--mortgage interest rates are long term--and the federal funds rate is a short-term rate; and while short-term rates and long-term rates used to move in tandem, this relation was, he argues, shattered, beginning in 2002, by the flood of foreign capital into the United States.

I do not find this analysis persuasive. 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.