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A really must-watch episode of CNBC’s Kudlow Report last night as former Federal Reserve Chairman Alan Greenspan and (future Fed chair?) John Taylor debated what role the Fed played in causing the housing bubble and Great Recession.
Taylor argued, as he has before, that the Fed kept the fed funds interest rate below what the Taylor rule would have called for from 2002 through 2005. In other words, interest rates were too lowfor too long because of the Greenspan Fed. That reduced borrowing costs and juiced the housing boom into a bubble.
Greenspan, Fed chair from 1987 through January 2006, disagreed, as he has before. He again offered what Kudlow called the “Berlin Wall” scenario: The end of the Cold War added 500 million new workers to the global labor market. Incomes rose, as did savings. That in turn, as Greenspan has written, “induced a worldwide decline in real long-term interest rates that … produced home price bubbles across more than a dozen countries.”
A few points:
1. There is another explanation for the global fall in rates. The Fed is, as economist David Beckworth has written, “a global monetary superpower.” It runs the world’s reserve currency, many emerging market currencies are pegged to the dollar, and both Europe and Japan judge the strength or weakness of their currencies in relation to the dollar. Beckworth: “As as result, the Fed’s monetary policy gets exported to some degree to Japan and the Euro area as well.”
2. OK, given that transmission mechanism, was US monetary policy too easy back then? It very well may have been by 2003. From 2003 through 2006, nominal GDP growth averaged 6%. That is hardly the sign of an economy in danger of deflationary collapse and in need of exceptionally low interest rates. Yes, inflation was also low, but as Beckworth also argues, that low inflation was more likely the result of a a productivity rather than demand shock. Indeed, productivity growth average over 3% from 1998 through 2005 and reflected an IT-driven innovation surge. Beckworth:
The rapid productivity gains created structural unemployment that took time to sort out, something low interest rates would not fix. In short, it is hard to argue economic conditions justified the low interest rate by 2003.
2. In addition to the end of the Cold War, Greenspan also blames securitization and lax regulation of Wall Street. Beckworth:
Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way–via financial innovation, lax governance (both private and public), and misaligned incentives–into the housing market. Housing market activity was further reinforced by “the search for yield” created by the Fed’s low interest rates. The low interest rates at the time encouraged investors to take on riskier investments than they otherwise would have. Some of those riskier investments end up being tied to housing. Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.
4. Don’t forget that more than half of the decline in home prices came after April 2008 when Fed policy stayed on pause through October despite a deteriorating economy. Although the housing slump began in mid-2006, the economy actually weathered the decline quite well until 2008. So most of the housing collapse was caused by money being too tight than too loose. Scott Sumner:
In my view there is too much focus on the upswing part of bubbles. Housing prices also soared in the 1970s, but no one called that a bubble. The price of Microsoft stock soared in the 1990s, but that wasn’t a bubble either (except perhaps in 2000). Why not? Because prices didn’t collapse afterward. Housing prices kept rising in the 1980s, and while Microsoft stock has bounced around, it’s always maintained a pretty high market cap. To have a bubble you need a big rise followed by a big fall.
By now you know where I’m going with this. I believe the second half of the decline in housing prices was due to the very tight money policy of late 2008, which depressed NGDP growth about 9% below trend between mid-2008 and mid-2009.
So who is right, Greenspan or Taylor? In a way, both have parts of the story correct. But both miss the second half of the story where the Fed, mimicking its Great Depression mistake, was too tight, turning what may have been a modest downturn into economic collapse.
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