Greenspan Forgets Where He Put His Asset Bubble: Caroline Baum

Commentary by Caroline Baum

March 12 (Bloomberg) -- “Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.”

Even if one missed the headline (“The Fed Didn’t Cause the Housing Bubble”) and the byline (Alan Greenspan) on the op-ed in yesterday’s Wall Street Journal, there could be no confusion over authorship: That “Master of Garblements” and former Federal Reserve chairman was back to defend his legacy.

Greenspan lays out his case that the Fed’s easy money policies can’t possibly be to blame for “the U.S. housing bubble that is at the core of today’s financial mess.” It is long-term interest rates that determine “the prices of long-lived assets,” such as housing, he writes. And those rates, which stayed low as a result of a “global savings glut,” are out of the Fed’s control.

Control, yes. Influence, no.

“Why not try raising short rates if long rates are too low?” asks Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. “The recession was over in 2001. Why did he take so long to start to raise the funds rate?”

Greenspan is selective in arguing his case. By any measure, the overnight fed funds rate was too low earlier in the decade. The real funds rate, which is the nominal rate adjusted for inflation, was negative for three years, from October 2002 to October 2005, a longer stretch than in the mid-1970s. And we know how well that turned out.

Now we have additional evidence of the effect of negative real rates. When financial institutions are being paid to borrow, borrow they will.

Free-Money Policy

Banks and other mortgage lenders were happy to arbitrage the spread between the free money provided by the Fed and the rate they charged for an adjustable-rate mortgage. The share of ARMs as a percentage of total mortgage loans averaged 10 percent in 2001; by 2004, it was 32 percent, according to the Mortgage Bankers Association. The dollar volume swelled to more than 50 percent that year.

It was Greenspan who sang the praises of ARMs from his Fed pulpit in a Feb. 23, 2004, speech. American consumers “might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” which may be “an expensive method of financing a home,” he said.

Greenspan’s op-ed avoids any incriminating evidence of his role in what he calls “the most virulent (crisis) since the 1930s.” (No 100-year flood this!) Instead, he focuses exclusively on what he, as Fed chief, called the “conundrum:” that long-term interest rates barely budged in the face of gradual increases in the funds rate.

Bubble Asymmetry

“If only the Chinese hadn’t been saving so much in the U.S., there would have been no problem,” says Bill Fleckenstein, president of Fleckenstein Capital in Seattle and author of “Greenspan’s Bubbles.” That analysis “flies in the face of all the evidence” that Greenspan took interest rates too low and held them there for too long; that he “cheerled all the securitization products and ARMs; that he told us not to worry about a real estate bubble.”

Even worse, Fleckenstein says, Greenspan “doesn’t discuss the fact that it was Fed’s stated policy to act asymmetrically in regard to asset bubbles,” allowing, or encouraging, them to inflate and cleaning up afterwards.

The clean-up is proving harder than Greenspan imagined.

There were other measures that shouted -- yes, shouted -- “monetary policy is too easy” in 2003 and 2004. Apparently Greenspan wasn’t listening.

Spreading Evidence

The spread between the overnight rate and the 10-year Treasury note ballooned to an historically wide 365 basis points by the middle of 2004, when the Fed started to raise the funds rate in baby steps. A steep yield curve is a sign of an expansionary monetary policy.

Rising long-term rates reflect an increased demand for credit. That same increased demand would push up the overnight rate, too, except when the Fed intervenes, creating as much credit as the banking system demands to keep the rate at the designated target.

The spread between the funds rate and nominal gross domestic product -- a proxy for the difference between the cost of borrowing and the return on investment for the overall economy -- was also emitting a warning sign that policy was too easy. The gap reached a three-decade high of 6 percentage points in 2004, creating an incentive to borrow and lend.

Greenspan’s op-ed is full of explanations, correlations and obfuscations. He defends himself against accusations by “my good friend,” Stanford economist John Taylor, who has argued that “monetary excesses” were the main cause of the boom and resulting bust.

No Mea Culpa

He also ignores the literature on asset bubbles.

“Greenspan is a student of history,” Kasriel says. “Surely he’s read (Charles) Kindleberger’s book on asset price bubbles.”

One element common to all bubbles, according to “Manias, Panics and Crashes,” is cheap credit. With so much cheap credit coming from abroad, Greenspan didn’t need to add to it.

And that’s the point. If he’s satisfied with his explanation of a savings glut -- the idea that there was too much credit being supplied from the rest of the world -- why not reduce the supply of Fed credit? That raises the price and reduces the quantity demanded.

Victim isn’t a role Greenspan plays particularly well, especially when it’s an attempt to exonerate himself from responsibility.

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the columnist on this story: Caroline Baum in New York at cabaum@bloomberg.net.