Wednesday, March 11, 2009

The Fed wasn't to blame?

Alan Greenspan today writes in the WSJ that "The Fed Didn't Cause the Housing Bubble." He asserts that "it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages." He blames the bond market for setting long-term interest rates too low.

Well, as George Will would say. We are thus left to conclude that the Fed can set the funds rate wherever it pleases, and things will only go awry if the bond market misjudges where long-term rates should be. Greenspan further defends his now-tarnished legacy by attacking John Taylor for promoting the mistaken notion that the Fed kept short-term interest rates too low.

I have my own explanation for what happened. I think the Fed was at least partially responsible for the housing boom, and government subsidization of borrowing costs (e.g., via Freddie and Fannie, the home mortgage deduction, the Community Reinvestment Act, and favorable capital gains tax treatment) did the rest. Monetary policy was generally inflationary following the 2001 recession, as evidenced by rising prices of almost all tangible goods: gold, energy, commodities, and real estate. Interest rates were in general not high enough to offer a compelling alternative to borrowing money and buying hard assets. The housing boom was copied in the commodity and energy markets. That is how monetary inflation works.

The Fed only sets the overnight interest rate, but the Fed can and does influence interest rates along the rest of the yield curve through its actions and its statements. When the Fed tells the world that it will keep interest rates extremely low for a long period, as it did in 2003, the bond market assumes that inflation is not a problem and sets long-term interest rates at levels that it believes are consistent with a reasonable expectation of where the funds rate is likely to be in a noninflationary future.

The corollary to this view of how Fed policy works is that the bond market is not always a good predictor of inflation, and it can and does make mistakes. But that doesn't absolve the Fed of blame. If the Fed had paid more attention to commodity prices, and in particular gold, it would have realized by late 2003 that policy was too easy, and it would have moved sooner to tighten. That might well have mitigated the subsequent housing boom, as well as the commodity and energy price roller coaster that has rocked the global economy.

UPDATE: A new book by John Taylor, "Getting Off Track" appears to do a good job of describing how this whole crisis evolved.


prophets said...

the real question is whether or not they should have done something about it.

should the fed target asset bubbles?

that's the question that matters.

Don Harrison said...

Methinks The Maestro doth protest too much.
In his assertion that there is little link between short rates and long mortgage rates, he misses a major factor in the mortgage meltdown. A great deal of the damage was done by upfront teaser rates on adjustable mortgages, which of course take their cue from the Fed Funds rate. My guess would be that the bulk of the defaults have not come from conventional, fixed rate mortgages.

Scott Grannis said...

Don: excellent point about the adjustable rate mortgages.

dave said...

Alan Greenspan should stop writing Op Ed's to defend his monetary policy, each time he does he exposes just how bad the second half of his tenure was.

After a miserable start in 1987 , he did a very reasonable job until he deflated the economy in the in the late 90's only to reflate the economy and then go too far pushing up commodity prices (including housing prices).

Continuing to justify his policy blunders doesn't really fool anyone! Does it?

Mark A. Sadowski said...

I refuse to exonerate Greenspan for many reasons. But his editorial in the WSJ today was largely in response to John Taylor’s explanation of the origins of the crisis, that placed most of the blame on a too low fed funds target rate in 2002-2005. I was following the fed funds rate closely during that time and thought that according to a foreward looking Taylor Rule (I understand the irony) that Greenspan was dead on in his practice of monetary policy (there was a lot of slack in the labor market during the "job loss recovery").

In the final analysis the biggest problem with John Taylor’s assertion is that the original cause of the financial crisis, the housing bubble, was already well inflated by the middle of 2001 before the fed funds target rate fell below 4%. Between mid-1997 and mid-2001 the US national Shiller index had risen 18% in real terms and 36% in nominal terms. This was unusual since real housing prices had stayed in a narrow band throughout the postwar period prior to that. Thus a low fed funds rate could not have been the primal cause.

If I had to pick a primal cause (I know that many factors contributed, and I agree with Menzie Chinn’s assertion that it was a toxic mix of policy failure) I would pick the Taxpayer Relief Act of 1997. That was the very year that the housing bubble started to inflate. The Taxpayer Relief Act lowered capital gains tax rates and dramatically increased the amount of excludable real estate capital gains. More importantly it extended most of the tax deductions and credits that had previously only been given to primary residences to second homes. It fits the timing better than any other single policy change made.

I suspect that it has been ignored mostly for ideological/partisan reasons (this applies to most economists as well). The right is too busy trying to pin the blame on policies designed to make homeownership more affordable. The left is too busy trying to pin the blame on deregulation. I have come to the conclusion that the original cause was a bipartisan tax act that provided huge tax incentives for the upper middle class to engage in speculative real estate investments.

Scott Grannis said...

Mark: we agree that the reduction in the capgains tax on real estate was a factor in the housing bubble. I think it fits neatly in the category of "government subsidies" to housing. The deductibility of mortgage interest, Freddie and Fannie, the CRA, and the favorable tax treatment of gains, all contributed to the housing bubble, and they were all government interventions. The lesson: government should not play favorites; the tax code should be neutral (no deductions) and flat for all. When government intervenes in the free market, the free market fails.

Scott Grannis said...

prophets: I don't think the Fed should do something about asset bubbles. For one, they are very difficult to identify. Two, if the Fed stuck to its knitting (i.e., delivering a stable value of the dollar relative to other assets), asset bubbles would not become major problems. When all tangible asset prices increase year after year that is a sign that monetary policy is too easy. That's what the Fed should do something about. If they had been on a gold standard, gold would have told them in 2003 that a tightening was required.