Greenspan: The Fed Didn't Do It By Mark Thoma

Alan Greenspan takes on John Taylor's claim that the Fed caused the housing bubble, and he warns against "micromanagement by government" regulators. Greenspan says the Fed couldn't have caused the housing bubble because it lost control over long-term interest rates once financial markets became globalized, and those were the rates that caused the problem:

The Fed Didn't Cause the Housing Bubble, by Alan Greenspan, Commentary, WSJ: ...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...


[T]he presumptive cause of the world-wide decline in long-term rates was the ... surge in growth in China and a large number of other emerging market economies that led to an excess of global ... savings... That ... 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 ... the global housing price bubble. ... I would have thought that ... such evidence would lead to wide support for ... a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by ... John Taylor... Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust." This notion has ... taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical ... analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover,... the "Taylor Rule" ... parameters and predictions derive 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 sole basis for successful policy analysis or advice, with or without the benefit of hindsight. Given the decoupling of monetary policy from long-term mortgage rates,... the Fed ... could not have "prevented" the housing bubble. ...

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 ... heavy regulation. That would stifle important advances in finance that enhance standards of living. ... The solutions for the financial-market failures ... are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities. ... Adequate capital and collateral requirements ... will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management..., while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

We seem to have a disagreement on the scope of regulation. Ben Bernanke:

Bernanke Calls for Broader Regulations, WSJ: Federal Reserve Chairman Ben Bernanke said regulators should be given broad new powers to oversee financial markets... Among his recommendations were tougher capital requirements for big banks, limits on investments by money-market mutual funds, and the introduction of some mechanism that would allow the U.S. to wind down big financial institutions and possibly run them temporarily. ...

The recommendations were largely consistent with measures being pushed by House Financial Services Committee Chairman Barney Frank (D., Mass.), who is expected to be a key architect of the new financial regulation. ...

Mr. Bernanke ... also pushed for much tougher policies over ... big companies. "Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards," Mr. Bernanke said. ...

I'm in agreement with Greenspan's response to Taylor to the extent that following the Taylor rule wouldn't have stopped the crisis, but I think the low interest rate policy pursued by the Fed is part of the story and served to magnify other factors. As for regulation, relying mainly upon enhanced capital requirements as Greenspan proposes isn't enough, so I'm at least where Bernanke with respect to close supervisory oversight of firms who pose a systemic risk. But I'd go even further and - to the extent possible - break up the firms into smaller entities and sever their interconnections until they no longer posed a threat to begin with. This is harder than it sounds, or so I'm told, but I'd still pursue the option.