On Greenspan’s "Fed is Blameless" Canard

Greenspan decided to launch a frontal attack on critics of his tenure at the Fed, via a Financial Times comment, “The Fed is blameless on the property bubble.” Needless to say, his defense does not stand up to scrutiny.

Greenspan was happy to take credit for the commonly-held view that central bankers were responsible for the so-called Great Moderation, the 20 years of sustained growth and not-too-severe recessions that proceeded our current crisis. But you can’t have it both ways: either the Fed has influence (and its influence is admittedly limited) or it doesn’t. You can’t take credit for an economy’s gains and then disavow its subsequent performance, particularly when the problems all developed on your watch. But then again, it’s the regulatory analogue to the “privatize the gains, socialize the losses” posture of the financial services industry.

In the first paragraph, Greenspan notes that:

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.

This is clever, since Greenspan presents the US bubble as part of a global phenomenon, and by implication, the Fed could and should not have done anything to prevent it. Yet this account conveniently ignores the fact that the Fed deliberately created negative real interest rates, which is guaranteed to fuel speculation. In addition, Greenspan glosses over the large number of adjustable rate mortgages which played off short rates which were issued on his watch, an estimated $1.2 trillion subprime and $500 billion to $1 trillion of Alt-As.

Moreover, other central bankers did recognize the existence of a bubble and tried to let some air out of it. Australia’s Reserve Bank governor Ian MacFarlane made repeated statements warning consumer against the frothiness of the real estate market, and presumably also had some tough conversations with local banks. A couple of interest rate increases in 2004 led to a slackening of prices, particularly in the speculative market for units. So contrary to Greenspan’s assertions elsewhere, it is possible for central bankers to recognize bubbles and take judicious action.

Back to Greenspan:

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.

Mr De Grauwe asserts that “signs of recovery” (I assume he means sustainable recovery) were evident before 2004 and hence the Fed should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported that “conditions remained sluggish in most districts”. Moreover, low rates did not trigger “a massive credit … expansion”. Both the monetary base and the M2 indicator rose less than 5 per cent in the subsequent year, scarcely tinder for a massive credit expansion.

Greenspan again conveniently chooses to focus on the monetary base and M2 and ignores the massive growth in credit. Private estimates of the no-longer-published M3 has shown double-digit growth for several years. Similarly, the ratio of debt to GDP has rose to unprecedented levels, and consumer savings plunged to zero. These were all warning signs of an economy seriously out of balance, yet Greenspan chose to ignore them.

Greenpan’s defense gets even more ridiculous:

Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do bank regulators. Regulators, to be effective, have to be forward-looking to anticipate the next financial malfunction. This has not proved feasible. Regulators confronting real-time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act pre-emptively. Most regulatory activity focuses on activities that precipitated previous crises.

If you take Greenspan’s the regulated always knows more about his business than the government does” to its logical conclusion, there should be not regulation at all. And that was Greenspan’s ideological bias.

But even his statement, at least in terms of the housing bubble, is a baldfaced lie. Who, pray tell, are these “counterparties” of bank loan officers? He chooses to obfuscate because any straightforward statement would be patently ridiculous. Bank loan officers weren’t responsible for on-selling the mortgages; they make credit decisions. Bank loan officers, or in this case, mortgage brokers who met with customers and filled out loan applications, whether internal or external, knew close to nothing about their borrowers As Tanta has said repeatedly, the drive for efficient loan processing drove both prudent protection (like verifying income and employment) and the old practice of knowing your customer out the window. I am told by contacts in the industry that one of the impediments to modifying loans is that the servicers don’t know anything about the borrowers beyond their current FICO, their payment history, and the initial terms of the loan. The loan files, which historically were a valuable source of background information about borrowers, have very little information, and even that is largely inaccurate.

Moreover, despite Greenspan’s assertion otherwise, there are ways the regulators can have insight. One is that unlike any individual institution, they have a vantage on the entire industry and can look at activity and trends on an aggregate basis. Second is that they can (and should) have a different perspective on risk and rewards. Public companies have become fixated on short-term results, and thus dismiss the troubles that may show up in later reporting periods (after all, they will probably be on someone else’s watch). Regulators can serve as an important check (management can tell their equity holders they had to take certain measures).

Third, which is related to but distinct from two, is that the financial firms have little in the way of institutional memory and keep making the same mistakes over and over again (witness in the investment banking industry, how bridge loans proved to be a costly adventure in the last LBO boom yet the industry went and got themselves more deeply exposed to the contemporary version, leveraged loans, this time around). Again, a regulator can provide useful external discipline when the internal instincts for self-preservation are impaired.

Fourth, Greenspan assumes that objective outsiders cannot have any insight. If that were so, there would be no management consulting industry, since the consultant is in a similar position to the regulator, of not knowing the clients’ business as well as he does. Yet that industry grown enormously since it started in the 1920s (admittedly, like regulators, with some controversy). Its survival and growth indicates that companies recognize that they are often too enmeshed in their own assumptions and practices and can sometime use a disinterested party’s help.

But the biggest problem with Greenspan’s posture is that he fails to accept the rationale for regulation. Banking is an industry that can create enormous externalities, namely, financial panics, asset bubbles (which suck investment out of more productive uses) and busts. Even a mere nasty credit contraction exacts a toll on the real economy. We accept the rationale of regulating polluters, food producers, and drug makers because the costs to society when they get it wrong can be large.

Greenspan is basically saying we shouldn’t regulate banks because it’s hard to be smart enough about their business. That’s a pathetic excuse.

Let’s continue:

Aside from far greater efforts to ferret out fraud (a long-time concern of mine), would a material tightening of regulation improve financial performance? I doubt it. The problem is not the lack of regulation but unrealistic expectations about what regulators are able to prevent. How can we otherwise explain how the UK’s Financial Services Authority, whose effectiveness is held in such high regard, fumbled Northern Rock? Or in the US, our best examiners have repeatedly failed over the years. These are not aberrations.

I note that Japan. France, and Germany (aside from stupid investment by their banks in US paper) have been free of our credit binge problems. In Japan, you may be able to argue that its economic malaise is the main cause. However, all three countries share a different attitude towards regulation than ours. Our attitude is that everything is permitted unless specifically prohibited. Theirs hews more closely to everything is forbidden unless specifically authorized. Regulators can be quite powerful if they have the societal backing (and these countries also have a tradition of attracting members of the elite into regulatory positions, perhaps because they do enjoy real power). Greenspan may be unwittingly saying that the Anglo-Saxon regulatory model is ineffective.

More from Greenspan:

The core of the subprime problem lies with the misjudgments of the investment community. Subprime securitisation exploded because subprime mortgage-backed securities were seemingly underpriced (high-yielding) at original issuance. Subprime delinquencies and foreclosures were modest at the time, creating the illusion of great profit opportunities. Investors of all stripes pressed securitisers for more MBSs. Securitisers, in turn, pressed lenders for mortgage paper with little concern about its quality. Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle.

Oh, come on. This wasn’t “investors pressing securitizers” this was “securitizers pressing lenders” because they made such rich fees from this paper. And a lot of this paper was created to help generate more collateralized debt obligations. If anyone had properly disclosed that CDOs were more subject to massive downgrades (from AAA to junk in a single downgrade is not unheard of) would anyone have bought this stuff?

Greenspan next claims that there is no example of a central banker successfully leaning against the wind as regards asset bubbles. Guess he can’t find Australia, whose real estate market was twice as overvalued as ours circa 2004, on a map.

I could go on, but you get the point.

When Richard Nixon tried to rehabilitate his reputation, he didn’t dispute the horrific errors of judgment he made while in office. He instead made useful, substantive intellectual contributions on other fronts. But Greenspan is an ideologue and intellectually bankrupt, so this option may not be open to him.

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  1. Anonymous

    FYI: “privatize the gains, socialize the losses”

    is a lot snappier as

    private profits, common costs.

  2. Anonymous

    “When Richard Nixon tried to rehabilitate his reputation, he didn’t dispute the horrific errors of judgment he made while in office. He instead made useful, substantive intellectual contributions on other fronts. But Greenspan is an ideologue and intellectually bankrupt, so this option may not be open to him.”

    You get the Tanta “steel toed boot” award for snarkiness!

    Soldier on!

  3. RNL

    It’s funnier because even Greenspan realized that you need *some* oversight, or he would have fired himself and asked Congress to dissolve the Fed. He may believe that he’s a (Minarchist) “Libertarian Republican” (government only exists to protect from force and fraud, yadda yadda), but his action shows that like many of his peers, he’s just another Neoliberal (believe that central banks should exist and promote “low inflation” policies – along with all the Market Fundamentalist claptrap).

    Funny man, that Bubbles!

  4. anon

    He makes an interesting point about the asymmetry of unemployment rate changes:

    “The US economy has been in recession only one-seventh of the time. Yet the unemployment rate exhibits no trend. Hence the average rate of rise of unemployment has been far greater than its average pace of decline. Monetary policy in response has been more active during recessions than during periods of expansion”.

    The core issue is about the role of regulation and specifically the Fed’s role in relation to the prevention of asset bubbles. In order to cover this, you’ve got to change the Fed’s mandate and extend the inflation definition to include asset bubbles.

  5. Anonymous

    Greenspan says in his typically long-winded fashion that a big reason for the “global” real estate bubble was the low levels of long-term interest rates worldwide. Granted this is indeed very true.

    The key issue here is the level of rates along the entirety of the maturity spectrum (not simply the Fed Funds rate). He wants to absolve himself of responsibility for what happened to the longer-term rates, because he doesn’t set those rates directly.

    When he was at the Fed he used to say that these low interest rates were a “conundrum”. In other words, he couldn’t pray tell understand what was causing these low rates. Apparently, he just couldn’t figure it out for the life of him. Not a clue.

    Now, he has taken to saying that the reason for the low rates was the “global savings glut”. This is following the line of BS that Bernanke had put out there a couple of years ago.

    Now what they both know perfectly well (and choose to conceal with deliberate deviousness) is that those rates were suppressed by the actions of foreign central banks. To this day, they are trying to play stupid and act like this stuff isn’t really going on.

    If foreign governments act to rig the interest rate structure of your own country, as head of the central bank, are you going to tell me that this is not your responsibility? It is utterly ridiculous. Foreign governments can take actions to completely distort the monetary policy of your own country and render it into something very different. This was a great infringement on the sovereignty of the country and has caused tremendous damage to the US economy.

  6. foesskewered

    When I first noticed that article on the FT, the first thought that came to mind was Yves in apoplectic mode…

    Frankly, Greenspan could have better salvaged his reputation if he just kept quiet and left it to his apologists/supporters.

    Why the anger against neo-liberals? I’m probably a neo-liberal though admittedly regulation has its place. Too much regulation and you end up strangling the trade but too little and you have rogues. The main problem with regulation is that by nature,it tends to look back, not forward. Unless you want an FDA style regulatory system where nothing is allowed until it is studied and approved- even then, there are loopholes to be exploited.

  7. Anonymous

    I really love the fact that this slob is working for a hedge fund now, like the whore he is!

  8. Anonymous

    Greenspan reminds me of Mark Foley:


    Florida Department of Law Enforcement Commissioner Gerald Bailey wrote to House Speaker Pelosi last month asking for help. The House counsel had said in July the agency could not examine the computers because they may contain legislative information that is protected by the Constitution unless Foley waives that privilege.

    Pelosi referred the letter back to the Office of General Counsel, and Deputy General Counsel Kerry Kircher issued another denial that Bailey received Tuesday, the Associated Press reported. Kircher suggested the Florida agency contact Foley’s lawyers.

  9. Anonymous

    Keynesians argue that in a modern industrial economy, many prices are sticky downward or downward inflexible, so that instead of prices falling in this story, a supply shock would cause a recession, i.e., rising unemployment and falling gross domestic product. It is the costs of such a recession that likely causes governments and central banks to allow a supply shock to result in inflation. They also note that though there was no deflation in the 1980s, there was a definite fall in the inflation rate during this period. Actual deflation was prevented because supply shocks are not the only cause of inflation; in terms of the modern triangle model of inflation, supply-driven deflation was counteracted by demand pull inflation and built-in inflation resulting from adaptive expectations and the price/wage spiral.

    In the end, built-in inflation involves a vicious circle of both subjective and objective elements, so that inflation encourages inflation to persist. It means that the standard methods of fighting inflation using either monetary policy or fiscal policy to induce a recession are extremely expensive, i.e., meaning large rises in unemployment and large falls in real gross domestic product. This suggests that alternative methods such as wage and price controls (incomes policies) may be needed as complementary to recessions in the fight against inflation.

  10. a

    “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.”

    I think this is the crucial point. Greenspan (and I think, for that matter, DeLong in is response to you a little while back) is making the point that there is no theoretical model showing that low Fed interest rates caused the bubble *and* which also has predictive value. I think this is probably correct. There is no economic model with both these features. But then again, there are *no* economic models with just the second feature, i.e. which have predictive value, in the strong sense that Greenspan has laid out. *No* economic model can correctly predict when recessions occur or when financial marekets will collapse. That’s pretty obvious, isn’t it? If there were a good model about when financial markets collapsed, financial markets would collapse a month earlier, because everyone would use the model and start selling beforehand…

    So Greenspan is being disingenuous and is setting the bar too high, excluding models which would tend to show that the Fed’s actions were mistaken, by claiming these models don’t work – even though, by the standards he has set out, *no* model works.

    I would just point out that Greenspan was famous for being a guy who decided interest rates, not by using models, but by his nose, presumably because he didn’t trust models. IMHO he was right in that; I don’t trust the models myself. But he had a bad nose; it smelled roses, when there really was manure in the garden.

    Final point: actually, I don’t think it’s the fact of low interest rates per se that led to the bubble. I think it’s more that, every time the economy looked like it might fall into recession, interest rates were lowered drastically in order to avert recession. This caused a backup of bad practices, a sense that asset prices could go only one way (because they did only go one way), and ultimately led to the mess we are in today.

  11. Anonymous

    Perfectly argued Yves. Well done. I should point out that at least one of the GSE’s, Fannie Mae, met with the Fed to warn it about the insane underwriting practices happening at its banks (I was there). Of course, it was self-serving of Fannie MAe to do this, as it was losing market share rapidly because of its refusal to insure these loans through its MBS or buy them for its portfolio. So, the Fed had a clear market signal through the giant GSE’s, who largely refused to particpate in this insane underwriting (meantime, lenders were getting their short term fees, and the private label securitizers were getting their volume & fees, and the rating agencies fell asleep, and many free market economists wrote the GSE’s off as anacronistic and irrelevant). Even the housing section Fed white paper writers showed the same ideoloogical stripe you so correctly highlight in Greenspan– several of them spent their intellectual capital bashing the GSE’s instead of observing what was happening at the banks right under their noses). Incredible the power of ideology.

  12. Richard Kline

    What I find interesting about this self-serving obfuscation from St. Alan the Mendacious is how completely it reveals his almost malevolent malfeasance while in office.

    The former Chief Banking Regulator: “Regulation never works to prevent [fill in the blank].”

    The former Chief Banking Examiner: “How could I possibly presume to question heroic financial innovators SO much smarter than I am. I trust in their ability, and so should you.”

    The former Chief Interest Rate Micromanager: “Interest rates didn’t balloon they money supply: I kept money close fisted. By the way, credit has nothing to do with money.”

    The former Chief Economic Trend Sentinel: “It was malinvestment by ill-educated product buyers which got us in a fix. Who’d a thunk it. It couldn’t have been the products: these were made by genius heroic innovators who are rich so they must have been right. Right?”

    Alan Greenspan is and always has been a stranger to the truth with zero sense of personal responsibility. Calling this carpetbagger an ideologue is too kind: his pockets are too well-lined for the weighting in his personal worth to be in his ideas. His pretentions to ideology are, well, pretentious; the man’s a greedy fox who wants to look like he did it ‘for the cause.’ His cause is himself, end of story.

  13. Anonymous

    I very much like this blog – definitely my favourite of all the economics/financial blogs I’m currently following. Well done!

    And this post was very interesting. However, I wouldn’t press the case of Australia being a good example of a place that is avoiding a house price bubble too hard. By many measures, Australia has one of the biggest bubbles in the world, and it’s still inflating, unlike those in Ireland, Spain, UK and the US.

    I’d recommend particularly graph 1 and 7 here – http://www.rba.gov.au/Speeches/2008/sp_so_270308.html

    That said, you could say they are “leaning against the wind” (and have in the past), but I don’t really think it’s had much effect.

  14. Anonymous

    There is only one way for Greenspan to rehabilitate his reputation and honor: seppuku.

  15. Anonymous

    Folks need to realize that when it comes to making sure Main Street is healthy, economists, accountants, and lawyers are as useful as tits on a boar hog. The Fed is more often doing harm than good -> Need to downsize the Fed and it’s minions significantly.

  16. betruthful

    Why was Greenspan not able to pressure the financial community into just 1 rule: “All borrowers must have written documentation that they can repay a loan before it is given, and all appraisals must be done by an employee of the institution giving the loan.” This would not have solved all the problems but would have been significant. Was the most powerful man in finance not able to see that undocumented loans on assets appraised by an independent company were a time bomb? He knew these loans were becoming more popular and ignored the consequences. Is he admitting the Fed does not have the power to institute even this simple change? What a shame that he was our hero in the early years and later either became a political puppet or lost touch with the real world.

  17. Richard Kline

    On Greenspan and personal redemption via seppuku: nah, that would just leave a mess for someone else to clean up. Like, well, NOW. St. Alan should take a loonnng cruise, and at mid-ocean go over the rail with the deadweight of his ego tied around his neck. Straight to the bottom fer sure.

  18. Anonymous

    Greenspan incorrectly asserts (or lies) that M2 was not telling him anything. In fact, M2 had been growing much faster than nominal GPD over this period, as expected when rates fall, but did not slow down when rates rose. On net, M2 velocity plummeted. Greenspan would have been well aware of this, and all the materials he presented to Congress over those years show it.

    Too much money IS a glut in the sources of funds available to lenders, which is a glut in credit. How could you not have noticed?

    It is hard to get a read on M2 over shorter periods, but when something continues for multiple years, ignoring it is either arrogant or stupid.

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