Before I begin my analysis, I want to put the reader into the shoes of Alan Greenspan at the time in question. We have heard ad nauseum that this current economic crisis is the worst since the Great Depression. We have heard it so often that we forget just how dire things were at the beginning of the mlllenia. We entered the millenia with the bubble bursting on the internet revolution. Throughout the nineties, it looked as though our economy would be revolutionized all through the internet, and then all of that was put to an end when the bubble burst. Still, the economic downturn was predictable because it still had all the similarities to other speculative bubbles. Then, just as the economy was attempting to turn the corner and recover from this speculative bubble, an economic storm hit that had no historical context. That economic storm was 9/11. There was no playbook for the economic impact of that event. To top it off, it was only months before it was first revealed that Enron had cooked their books, and this started a domino of several large companies that also admitted to cooking their books throughout the 1990's as well.
As you can well imagine, our economic leaders, lead by Greenspan himself, faced an economic situation for which there were no easy answers, no textbook solutions, in the beginning of 2002. I have before said that Greenspan was reckless to lower the Fed Funds Rate below 1% and leave it there for so long. I think this might be a rather harsh assessment. After all, he was facing an economic downturn of a new magnitude. There were no easy answers and Greenspan must have felt that he needed to take steps of the magnitude of the crisis. That's exactly what he did when he lowered the Fed Funds Rate below 1% and kept it there for well more than a year.
It has become a fairly mainstream theory that the loose money created by Greenspan's lowering of the Fed Funds Rate below 1% was the driver that started the mortgage crisis. That's because the loose money created by these low rates were used by banks to borrow from each other and then to lend. Since real estate was one of the few industries that was booming at the time, most of this money went into real estate. Because the loose money made banks flushed with cash, they had more money than loans. This started the sub prime revolution and the rest is history.
On this point, there is little debate. After all, what is lowering rates if not loosening money? Lowering rates below one percent loosens money a lot. If Greenspan wasn't trying to create loose money, what in the world was he trying to do. It appears he saw an economic crisis in front of him and wasn't nearly as worried about the consequential future of what he was doing. Given the economic perfect storm I described, would anyone blame him.
I point all of this out to set the context of Greenspan's explanation for the drivers of the crisis.
There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.
The second, and far more credible, explanation agrees 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. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.
Greenspan continues to insist on just about any boogeyman besides himself as the culprit for starting this crisis. He has in the past, and in this piece, blamed globalization, and now he has found a new boogeyman. The financial crisis was caused by extremely low mortgage rates. This is a dubious explanation on many levels. First, low mortgage rates didn't necessarily translate to low mortgage rates on sub prime. Just because prime mortgages were booming doesn't mean that banks wanted to necessarily go into sub prime. The nexus of this crisis was the explosion of subprime loans, not prime loans, and there is no explanation for why low prime rates would necessarily mean an explosion in sub prime.
All of this is very important because Greenspan says it is important.
How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.
If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.
Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.
However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system's precrisis success. The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities.
Greenspan attempts to give suggestions for moving forward. Here is something that Greenspan fails to mention. The prime rate has gone up and down no less four times over the last ten years. How in the world can any economy develop in anything near a reasonable way if the monetary policy that oversees it is so pschzophrenic?