In this forum I have argued that Alan Greenspan's low-interest-rate policy after the dot-com bust and 9/11 attacks sowed the seeds for our current recession and the housing bubble. I have also criticized the alternate theory that a foreign "savings glut" was the true culprit, rather than the Fed. In the present article, I want to deal with a few empirical objections to the case against Greenspan. That is, several different economic analysts are familiar with the theory that "the Fed did it," and they claim that the facts just don't add up. In the space below, I hope to demonstrate that the evidence against Greenspan is indeed damning.
Greenspan's "Smallish" Injection?
One argument advanced in the attempted exoneration of Greenspan is that he didn't really pump that much money into the credit markets. For example, popular blogger Megan McArdle writes,
Both right wing Austrians and many liberals have a common theory of how all this happened: Alan Greenspan dunnit. The mechanisms by which he accomplished his foul task are different in the two cases, of course. Austrians, and many other free-market types, believe that by lowering short-term interest rates after 9/11, Alan Greenspan made the housing bubble, and its eventual bust, inevitable… Here's the problem: if markets are so great, how come the entire system can be brought low by a smallish injection of short-term capital? (emphasis added)
Brad DeLong makes a similar claim in his critique of Larry White, whom DeLong praises as the "best of the Austrians." (DeLong does not tell us who the best-looking Austrian is, though I hope to at least be nominated.) DeLong writes,
Moreover, I do not think that Larry White has gotten the part of the story that he does cover right…. From the start of 2002 to the start of 2006 the Federal Reserve bought $200 billion in Treasury bills for cash. This $200 billion reduction in outstanding bonds and increase in cash surely did lead to an increase in demand for private bonds. But recall the magnitudes here. We have $2 trillion of losses on $8 trillion in face value of mortgages that ex post should not have been made. Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans? Not likely. I can see how monetary contraction can make previously profitable loans unprofitable. But I see no way that this amount of monetary expansion can force private agents to make that amount of unprofitable loans. The magnitudes just do not match.
Similarly, David Henderson and Jeff Hummel1 write that monetary growth was tamed during the years of the housing boom, and so Greenspan can't be the culprit:
A better, although now unfashionable, way to judge monetary policy is to look at the monetary measures: MZM, M2, M1, and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20 percent to nearly 0 percent by 2006. During that same time, M2 growth fell from over 10 percent to around 2 percent and M1 growth fell from over 10 percent to negative rates. Admittedly the Fed's control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base since 2001 fell from 10 percent to below 5 percent in 2006 and by June of 2008 was around 1.5 percent, despite Ben S. Bernanke's alleged reflation. When all of these measures agree, it suggests that monetary policy was not all that expansionary during 2002 and 2003 under Greenspan, despite the low interest rates.
Greenspan Presented in a Less Flattering Light
I realize that these disputes may just further convince some readers that economics is not a science but rather an ideological contest in which each side throws its own set of lying statistics at the other. But even so, I will now use the same underlying data as the writers above, to reach the opposite conclusion: Greenspan allowed the monetary base to grow quite rapidly precisely when the housing boom shifted into high gear, and precisely when interest rates collapsed.
Before proceeding, I want to remind readers that my story is the textbook explanation of how the Fed operates. It is the writers above who are downplaying the Fed's ability to push down interest rates or to "stimulate" (however temporarily and artificially) the economy. During the boom years, Greenspan and his fans wanted to take credit for his "merciful" low rates which allowed the United States to avoid a painful recession, but now Greenspan and his defenders want to claim that he was an innocent bystander in the face of Asian thrift and shortsighted bankers. In any event, on to the data, this time presented by the "prosecution" as it were.
First, let's take McArdle and DeLong's discussion of the injection of base money, and how it was too insignificant to cause the effects we have seen. According to DeLong, there was a $200 billion injection through open-market operations, and yet we have to explain $2 trillion in losses. Well, my first thought is that — as DeLong no doubt teaches his principles-of-macro students — our fractional-reserve system has a built-in multiplier. In particular, if the required reserve ratio is 10 percent, then a given injection of new reserves (through Fed purchases of securities) allows up to a tenfold increase in the quantity of new money. So with that rule of thumb, a $200 billion injection would be expected to have an impact of … $2 trillion.
Now let me anticipate an obvious response from DeLong. He could say, "OK fine, but that still makes no sense. Why would expanding the quantity of money by $2 trillion lead private investors to make so many bad loans?" That's a good question, but it's different from the issue of magnitudes. Even if Greenspan flooded the economy with $100 trillion in new money, it doesn't automatically follow that investors should make dumb lending decisions. My point here is simply that this alleged (by McArdle and DeLong) quantitative mismatch is in fact perfectly adequate; Greenspan injected a lot more than a "smallish" amount of short-term capital, once we recall the nature of our fractional-reserve system.
Now when it comes to Henderson and Hummel, look again at their actual quotation above: they are trying to prove that monetary expansion was nothing unusual in 2002 and 2003, and to do this they quote the starting and ending annual rates of expansion in 2001 and then in 2006. But this is a bit like saying Keanu Reeves in the movie Speed didn't drive recklessly, because, after all, the bus's velocity was lower when he got off than when he first got on. To know if Greenspan had a tight or loose monetary policy during 2002 and 2003, it's not enough to know that the policy in 2006 (when the boom was winding down, after all!) was lower than in 2001.
For the following chart, I have taken the annual averages of the monetary-base series (as compiled by the St. Louis Fed), and plotted the growth rates:
There are a few interesting features of the above graph. First, note that the growth rate in 2002 (8.7%) was higher than in 2001 (5.6%). (Henderson and Hummel may have given the opposite impression, because of the units involved. The base bounced around like crazy because of huge injections and then drainages because of Y2K and 9/11.) Second, note that the base growth in 2002 was about as high as any year from the 1970s, except 1979 (when base growth was 9.2%).2 Everybody in this debate agrees that the 1970s were characterized by excessively loose monetary policy. It is hard to see then how Greenspan's behavior during the serious onset of the housing boom can be described as moderate.
Before leaving this section, I should acknowledge that the graph above does seem puzzling in one respect: the growth in the base during the early 2000s is admittedly large by historical standards (even compared to the 1970s), but it is obviously not unprecedented. In particular, there were larger spikes during the 1980s and 1990s.
This is true, but I would remind the reader that there was a massive real-estate bust and stock-market crash in the 1980s as well, and of course the dot-com bubble in the late 1990s. The Austrians would blame those unfortunate events on the Fed (as well as other contributing causes) too.
Mortgage Rates Not Unusual?
The last claim we'll analyze in this article is made by the excellent Chicago economist Casey Mulligan, who writes,
Another version of the subsidy hypothesis says that public policy encouraged low mortgage rates, which raised housing prices. I believe that housing prices would not have gotten so high if mortgage rates had been higher, but low mortgage rates may not explain why 2006 housing prices were so high relative to housing prices in 2003 or 2008. 30-year fixed-mortgage rates were around six percent per year for most of the boom, and continue to be about six percent.
No one is denying that there must be some endogeneity to the explanation of the housing bubble; after all, the federal-funds rate right now is just as low as under Greenspan, and nobody expects a housing bubble to develop. But again, I think Mulligan's breezy claims about mortgage rates might give the reader a false impression. He is making it sound as if mortgage rates really have nothing to do with the onset of the boom, because after all they "were around six percent for most of the boom." But in fact, the fall in mortgage rates fits in very well with the serious onset of the boom.
The following chart plots the 30-year conventional mortgage rate against year-over-year increases in the S&P/Case-Shiller Home Price Index:
Thirty-year mortgage rates plummeted from about 8.5% in mid-2000 to below 5.5% three years later. The connection certainly isn't robotic, but this period also saw a spike in monetary base growth (thus leading us to suspect Greenspan's influence, not just Asian savers) and the acceleration in the housing boom. On this last point, consider that mortgage rates dropped from about 7% down to about 5.5% from April 2002 to April 2003. Even with perfectly rational neoclassical consumers, that would be expected to raise home prices about 17%.3 And lo and behold, over this same period the home price index rose about 14.5%.
In a follow-up post in the same Cato Unbound symposium, Mulligan makes an odd claim in his disagreement with White:
Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years. If so, he is on shaky ground. First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom. It's not hard to find commentary from those years recognizing the low short-term rates were not expected to last. (emphasis added)
Again, this is one of those casual claims in the debate over the housing bubble that is liable to mislead some readers. Check out the following chart of 30-year mortgage rates:
As the chart above indicates, mortgage rates during the peak of the housing bubble were the lowest in the entire 37 years for which the St. Louis Fed keeps records. Perhaps Mulligan had in mind inflation-adjusted mortgage rates, but if so we're stuck, because we don't yet know what the correct, inflation-adjusted rates on 30-year mortgages were for any mortgages granted after 1978.
I ask the reader to once again look at the chart above. Is it really such a leap to think that perhaps Fed manipulation of interest rates might have something to do with the housing bubble?
Conclusion
Some Austrians are concerned that empirical exercises such as I have performed above will fall into the mainstream habit of aping the physicists, rather than developing a priori theories. However, we all know what the logical, verbal arguments of Mises and Hayek are, regarding the boom-bust cycle caused by central banks. The critics are claiming that this story doesn't fit the facts. Hence, the only way to respond is to argue that the Misesian theory really does fit the facts.
Despite claims to the contrary, it appears that Alan Greenspan's ultralow interest rates — which went hand in hand with monetary growth rates comparable to those of the 1970s — were at the very least a large contributing factor to the housing boom. I feel confident in claiming that the housing boom would not have occurred if money and banking had been left in the hands of the private sector, as opposed to the state-organized cartel that we currently "enjoy."
- 1Incidentally, in my critique of Henderson and Hummel, I used some strong language that irked some readers. Let me state for the record that I did not intend to accuse these two authors of intentionally distorting the data. I apologize if my article gave that impression.
- 2Technically, the second- and third-highest annual growth rates in the 1970s were in 1973 (8.9%) and 1974 (8.8%), and these were also higher than the 2002 figure of 8.7%. But surely these growth rates are virtually equivalent for our purposes.
- 3At an interest rate of 7%, a $200,000 principal on a 30-year mortgage would require monthly payments of $1,330.60. At an interest rate of 5.5%, monthly payments of $1,331.47 would support an initial home price of $234,500.
