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Monday, December 24, 2007

Alan Greenspan Tries to Rewrite History

One of my least favorite things about the mortgage business is how everytime something goes wrong each party blames another party. Almost never does someone take responsibility and fix the error. Instead, they try to blame someone else and act as though fixing the error is someone else's responsibility.

I bring this up because Alan Greenspan wrote a column in today's Wall Street Journal. Greenspan laid out a very interesting and detailed version of the events that lead up to the crisis...

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.

A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: Fairly well educated, low-cost workforces were joined with developed-world technology and protected by an increasing rule of law, to unleash explosive economic growth. Since 2000, the real GDP growth of the developing world has been more than double that of the developed world.

The surge in competitive, low-priced exports from developing countries, especially those to Europe and the U.S., flattened labor compensation in developed countries, and reduced the rate of inflation expectations throughout the world, including those inflation expectations embedded in global long-term interest rates.

Now, this might be the height of my own hubris, however I find his entire narrative to be nothing more than intelligent sounding nonsense. The reason is that he is trying desperately to avoid his own responsibility in the mess. I pointed out his responsibility in this piece. While Greenspan would like us to take the roots back twenty years, I think we can find something more important much closer to.

This is a chart of the Federal Funds Rate which as Head of the Federal Reserve Greenspan controlled until recently. As you can see between the middle of 2001 and the middle of 2003, the rate was absurdly low. It reached below one percent for a period of time. Greenspan can try and re write history however by lowering the rate that much he created loose and easy money. While he may not have predicted the mortgage mess per se, he should have anticipated the law of unintended consequences. He should have known that it was irresponsible to leave rates that low for that long. He should have known that if banks could borrow from the Fed (which is the purpose of the Federal Funds) for so little, that they were bound to act irresponsibly with the money.

He can pin this on some sort of a complicated alter universe in which a sophisticated network of globalization combined with asleep at the wheel credit agencies, arbitrage players, and poor savings. He can do this, but it still isn't going to tell the whole story. To add insult to injury, Greenspan actually tries to justify his irresponsibility while paying nothing more than passing lip service to what it actually caused.

and my colleagues at the Fed believed that the potential threat of corrosive deflation in 2003 was real, even though deflation was not thought to be the most likely projection. We will never know whether the temporary 1% federal-funds rate fended off a deflationary crisis, potentially much more daunting than the current one. But I did fret that maintaining rates too low for too long was problematic. The failure of either the growth of the monetary base, or of M2, to exceed 5% while the fed-funds rate was 1% assuaged my concern that we had added inflationary tinder to the economy.

The entire piece is full of technical language and it is told in a manner only fit for an expert. I don't know if Greenspan hoped to impress anyone or if he merely actually believes the load of bull that he is selling. I do know that China, credit ratings, and poor savings rates played a much smaller role in the crisis than the irresponsible and precipitous drop that the Fed took on the Fed Funds Rate.

The root of the crisis as I see it was loans that were created for irresponsible borrowers. These loans were created because banks suddenly had an infusion of loose money that they were able to borrow from the Fed. Because the rate was so outrageously low, banks felt more room to take risks. They did and that started the ball rolling. While Greenspan painstakingly tried to explain the root cause going back to right after the Cold War, he conveniently overlooked his own responsibility in the crisis. Unfortunately for Greenspan, I don't think that history will have such oversight.

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