Saturday, April 04, 2009

It Really Is All Greenspan's Fault

Alan Greenspan allowed/forced very low interest rates which encouraged excess home building which caused over supply, which melted down. Journalist Susan Lee cites John Taylor who uses his own measure to show the gap between the low interest rates and what would have been stable market rates. Self serving? Some what. But his Taylor Rule is widely used. It Really Is All Greenspan's Fault -
It's been quite a spectacle for those who have followed Alan Greenspan's career for decades. Gone is the financial rock star or even the statesman testifying before Congress in a measured baritone. Instead, over the past several months, Alan Greenspan has morphed into a totally new person. The first incarnation was the shaken Greenspan who was stunned that greedy and reckless short-term behavior could overwhelm long-term, rational self-interest. That was rather amazing all by itself. But now, there's a newer Greenspan--a decidedly prickly and whiny one. I'm talking about Greenspan's recent op-ed in The Wall Street Journal. A 1,500-word attempt to move blame for the financial crisis away from himself and onto ... China. It was, writes Greenspan, Chinese growth that led to "an excess" of global savings. That growth kept long-term interest rates low, which fueled the housing bubble. As for himself, the lowly chairperson of the Fed, he says he was helpless. He only had control over short-term rates. Why this recent incarnation as a self-pitying victim of historical forces? Most likely, it's because of John Taylor, a mild-mannered professor at Stanford and former colleague of Greenspan's at the Fed. In his Getting Off Track, a nifty little book, Taylor exposes, as plain as day, the culprit behind the financial boom-bust: Greenspan. His weapon of choice is the "Taylor rule" (discovered by Taylor--but not named by him, as he modestly points out.) (The Taylor rule is a recommendation about how the Fed should set the short interest rate--suggesting the amount it should be changed given economic conditions.) Here's Taylor's take. Short interest rates fell in 2001 in response to the dot-com bust. But--and here's the important moment--beginning in 2002, the Taylor rule indicated that Greenspan ought to have tightened. Indeed, from 2002 to 2005, rates ought to have climbed to a touch over 5% and then stayed there through 2006. But the Fed kept to a loose monetary stance, and rates kept falling during the period 2002 through 2004. Rates didn't start back up until middle of 2004 and didn't reach 5% until 2006. You can check this out in Figure 1, below. The result? The Greenspan Loose policy went on to fuel a boom, while the Taylor Tight would have avoided one. As Taylor says, all the Fed needed to do was follow "... the kind of policy that had worked well during the period of economic stability called the Great Moderation, which began in the early 1980s." The connection between Greenspan Loose and the housing boom is also clear. Housing starts took a sharp spike up in 2003 and then continued to climb through 2006. If the Fed had followed Taylor Tight, however, housing starts would have peaked at a much lower level at the end of 2003, and drifted down through 2006.
But Greenspan says he was powerless.
What about Greenspan's argument that he only controlled short-term rates? And that short rates became decoupled from long-term rates in 2002? Nonsense, says Taylor. Surely the existence of adjustable-rate mortgages (accounting for about one-third of mortgages starting in 2003) linked the mortgage market and short-term rates. Moreover, says Taylor, whatever minor decoupling occurred, happened because bond investors were flummoxed by the Fed's odd behavior. Taylor also takes on Greenspan's excuse that he was helpless in the face of a global saving glut. Cutting off the feet of Greenspan's excuse, Taylor says there wasn't a glut, there was a shortage. Figures from the International Monetary Fund show global saving rates, as a share of world GDP, were low during 2002 to 2004--way lower than rates in the 1970s and 1980s. In fact, the global saving rate fell at the end of 1990s, hitting bottom about 2003.

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