In his words:
“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. “
“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.”
Which is no doubt true, but the Fed must still bear some of the fault as had it seen the dangers more clearly, the warning could have been sounded to the banks to tighten credit standards. ANd to further defend the Fed, at least as early as May of 2005, Fed governor Roger Ferguson commented on (and in hindsight looks remarkably clairvoyant) the potential impact of Real Estate prices on the overall economy:
“Clearly central bankers would benefit from a better understanding of asset price movements–particularly more extreme movements–so that we do not mistakenly facilitate in some way potentially harmful outcomes…..The past decade has been marked by episodes of financial volatility that have had the potential for trouble at a systemic level. Linkages between financial markets and real economic outcomes have become more complex, periodically presenting policymakers with surprises and puzzles…. A particular phenomenon that touches on all these issues is the movement of asset prices, especially the prices of equities and residential real estate. Because these assets are the most widely held by the general public, price changes, even when not exceptional, can significantly affect the macroeconomy. Rising asset prices support household consumption, whereas falling asset prices damp consumption. In a scenario of collapse, the damage to balance sheets and private wealth could go as far as undermining the soundness of the financial system and threatening stability of the real economy. Apart from such outcomes, policymakers might also take special interest in asset price movements because it has been alleged that badly designed or poorly implemented policy (even if well intended) sometimes has helped feed unsustainable movements in asset prices….”
It is noteworthy that he was speaking on the impact of the money supply and not interest rates and that he also mentioned that in a global economy, the central bank of any country is limited:
“Among other complications is the possibility that financial globalization may be changing the links between liquidity and asset prices. Movements in asset prices across countries now appear to be more synchronized. This synchronization could arise in a number of ways…. it also is quite possible that greater international diversification of portfolios now allows developments affecting assets in one country to spill over into markets of others–both at the level of particular industries and more broadly. If synchronization of asset price movements comes about mainly in this way, the suggestion is that excess liquidity in one country could move asset prices in another, perhaps significantly, even if liquidity was well contained in the latter.”
Which is consistent with Temple University’s Ken Koplesky in The Economic Policy Examiner:
“We need to understand the implications of the high savings rates in Japan and China. The opposite side of the US deficit on current account is savings exceeding domestic investment in countries like China and Japan. How did this influence the onset of the world-wide recession? Are they the principal cause in the sense that very high savings in China and Japan were responsible for very low long-term interest rates, which in turn induced very risky lending/borrowing behavior?””
Which I guess is my defense of Greenspan as well. There was a real estate bubble. Should the Fed have done more to prevent it? Definitely. But its options were not without costs and even when tried (raising short term rates) of little success.
If it were 2004 all over again, what would you do if you were the Fed?
(Gee wouldn’t that make a great essay question?!)