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Monday, April 7, 2008

Greenspan's Broken Record

On more than one occasion Bill O'Reilly has recounted a story of being at a party and being cornered by Bill Clinton himself at which point Clinton insisted to O'Reilly that he had done everything he could to catch UBL. The encounter as well as the statement were both offered unilaterally and without O'Reilly asking for them. Clearly, Clinton was concerned that his lack of aggressive action against UBL would weigh heavily on his legacy. I believe that Greenspan is now feeling the same way about the housing market. I have already made my feelings clear that his actions in setting off the mortgage crisis will weigh heavily upon a very mixed legacy. A few months ago Greenspan wrote an oped that tried to explain the roots of the mortgage crisis and he threw everything in there including the kitchen sink and the only thing missing was his setting the fed funds rate to an obscenely low .75%. Today, Greenspan is at it again and again he is desperately trying to blame anything but his own actions. Now, this reminds me of that great Shakespeare line...

thou dost protest a bit too much

I firmly believe that Greenspan sees this as coloring his legacy and is hoping to formulate a narrative that will spare him of the blame that I believe he rightly deserves at least a part of. I don't believe that Greenspan is solely responsible however he must take his part of the blame along with the industry at large. Here is how Greenspan starts...

I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long-term interest rates statistically explains, and is the most likely major cause of, real estate capitalisation rates (rent as a percentage of a property’s value) that declined and converged across the globe. By 2006, long-term interest rates for all developed and main developing economies declined to single digits, I believe for the first time ever.

Doubtless each individual housing bubble has its own idiosyncratic characteristics and some point to Federal Reserve monetary policy complicity in the US bubble. But the US bubble was close to median world experience and the evidence that monetary policy added to the bubble is statistically very fragile. Paul De Grauwe, writing in the Financial Times’ Economists’ Forum, depends on John Taylor’s counterfactual model simulations to conclude that the low funds rate was the source of the US housing bubble. Mr Taylor (with whom I rarely disagree) and others derive their simulations from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the basis for policy.

Greenspan is doing a sophisticated financial slight of hand. There is no doubt that most that read this will simply take his word for it, however this statement leaves out a lot of things that happened. Obscenely low interest rates certainly contributed to the real estate boon however trying to blame low interest rates for the bubble is just plain wrong. That's because the nexus of the mortgage crisis happened in sub prime which weren't governed by the low interest rates of prime loans.

The nexus of the sub prime crisis was the obscenely low .75% federal funds rate. By lowering rates as much as Greenspan did, he gave too much incentive for banks to borrow. The problem was that at the time real estate was one of the few performing sectors. Because borrowing was so easy, banks had more money than loans. As such, they created more loans, and eventually it lead to the sub prime crisis.

Greenspan spends much of the article trying to explain why he kept rates low as long as he did, and some of the factors that played into it at the time. That, frankly, wasn't the real problem. When Greenspan lowered the fed funds rate to .75%, he lowered it to an irresponsible level. The problem wasn't merely that he kept the rate there too long but that he lowered to that level in the first place.

Now, Greenspan will try and try and try to make a complicated explanation for the housing crisis and everytime he will conspicuously remove his own role in it. Unfortunately, the facts are a tricky thing. Greenspan dropped the fed funds rate to an irresponsible level. That lead banks to borrow irresponsibly, and that irresponsibility eventually lead to the mortgage crisis.

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