In “The Fed Didn’t Cause the Housing Bubble appearing in today’s Wall Street Journal, Greenspan gives a unique defense of his Fed policy of lower interest rates during the housing bubble. At least some economists (see How Government Created the Financial Crisis) have laid at least partial blame for the housing bubble on lower interest rates from 2003-2005.
Ok, I’m no economist, but I’ll take a stab at analyzing Greenspan’s article.
- First, he says that the Fed Funds rate is a short term rate and doesn’t effect long term rates. So, since mortgages are long term, they are not affected when the Fed lowers it’s rate. While he admits that the Fed Funds rate and long term rates did at one point have some sort of correlation, he said long term and short term rates have now been “decoupled”:
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.
This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates — such as the fed-funds rate — to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.
The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier — in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.
.. U.S. mortgage rates’ linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.
Ok my only comment here is that while the mid-2004 short term interest rate hikes may have shown little or no correlation with long term rates, I don’t think he gives any evidence that the interest rate lowering has no coorelation. In fact, as he stated the historical evidence is the opposite (that there is some correlation, though a lagging one) and he’s pointing to the anomaly as a the rule. My guess is that the explanation is that the lower Fed Funds rates does eventually increase the amount of money in the US system available for long term borrowing so since the supply of money increases long term rates go down to attract more buyers (borrowers) at a lower price.
- Second,he states his explanation of the interest rate lowering, which as far as I can tell he blames on China becoming more capitalist leading to more people around the world having more money than they need to spend, leading to people saving too much:
As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.
That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.) By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits — I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.
As far as I can tell, and I state here I”m no economist, and I’d be interested in others’ views and what other analysis will state, he’s stating that since people around the globe were saving too much, this brought borrower’s demand for money down, and so as a consequence, the price for borrowing money went down. It effects the supply side also, since the more people save, the more banks have to loan, and so with so much money in the system interest rates go down to attract borrowers.
This is an interesting point but it certainly sounds like he’s grasping – there certainly is not a great deal of savings going on in the US and I’m not sure if a global increase in savings is going to increase lending in the US a great deal (even given the acknowledged fact of the increased globalization of finance).
- He then goes on to bash his friend Professor John Taylor of Stanford University (see “How Government Created the Financial Crisis, also The Financial Crisis and the Policy Responses: An Emprical Analysis of What Went Wrong ) who blames the housing bubble on, among other things, lower interest rates and Fannie and Freddie Mac (I think Prof. Taylor has a much more convincing argument). Excerpt from Greenspan’s article:
Aside from [Prof. Taylor’s] inappropriate use of short-term rates to explain the value of long-term assets, his [Prof. Taylor’s] statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.
Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble
Again, Greenspan gives no evidence that the “decoupling” during the increase in rates is anything but an anomoly or that it also occurs when rates decrease. By the way, Prof. Taylor does respond to Greenspan’s saving argument in The Financial Crisis and the Policy Responses: An Emprical Analysis of What Went Wrong saying
“The main problem with this explanation is that there is actually no evidence for a global saving glut. On the contrary, … there seems to be a savings shortage”.
- The BEST part of Greenspan’s article is when he effusively praises Milton Friedman ( inarguably a great economist, but also alas 6 feet under and in no position to reevaluate the data and to respond) for heaping praise on Greenspan:
All things considered, I personally prefer Milton Friedman’s performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: “There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.”
- Finally, and thankfully, Greenspan does at least put in a call for not meddling too much with the financial industry:
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.
All in all, an interesting and amusing read. I look forward to reading economists’ responses.