Who, Me?

Having had some time to reflect and to contemplate, having distanced himself in both space and time from the paper-strewn hallways of his former domain, having taken up the pen, published and bandied about the press junket with much fan-fair an ominously (if somewhat understated) titled memoir, having then gone so far as to seek what could almost be interpreted to be absolution upon the floor of the United States House of Representatives, Alan Greenspan, former and long-time chairman of the Federal Reserve, has finally emerged from the woodwork of retirement and general ignominy to offer us his final and resolute opinion about this whole financial mess:










"Go blow it out your noses, ya chumps!"

That's right, folks. Like a dedicated Jewish version of Mohammad Ali, Alan Greenspan isn't taken no punches from nobody! In this Wednesday's Wall Street Journal Greenspan laid the stone-cold truth all out on the table. And as he sees things:

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.

So just for the sake of clarification, this is explanation is the one where everyone blames Alan Greenspan, the chairman of the Fed before and during most of the post-9/11 housing bubble, for keeping interest rates too low for far too long and thus allowing too many people to get into too much debt and to buy too many houses which pushes their prices up way too high. So now that we're all clear that this first explanation is the one where despite the hazy static of moral ambiguity and byzantine financial complexity that overwhelms any discussion of the financial crisis, Alan Greenspan emerges in glossy technicolor as one of the only sure deliverers of our collective economic disintegration--an incompetent ideological anachronism, an aging conductor asleep at the switch, a financial hand of death, if you will--let's hear about that other explanation.

The second, and far more credible, explanation...

Okay, so you're saying it isn't the financial hand of death one...

...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.

Well, there you have it. It turns out the only interest rate that humble old Al was able to influence was the one that had nothing to do with mortgage rates. So there was a housing bubble: what's a chairman of the Federal Reserve to do?

First a primer for those who may be in need: the Federal-Funds Rate is the interest rate that banks charge when they lend money to one another overnight. Why only overnight? At any given moment, a bank may have trillions of dollars liabilities outstanding. Liabilities, all the money that the bank owes to someone else, might mean the money you deposited into your checking account last week, actual debt from financial institution, bonds, etc. While the bank supposedly also has more money tucked away in assets (that is, money that other people owe the bank), those assets may not be readily available at any one point in time. If, for any reason, a bunch of people decide to take money out of the checking accounts at once then, the banks needs cash and it needs it now. So it borrows the money, but just to tide it over to meet the depositors demand (or, in the U.S. but not in Canada, to meet a "reserve requirement," which is just a required amount of money you have to always have on the side equal to a certain percentage of the bank's liabilities). So the bank generally borrows this money from other banks. And it borrows it at the Federal Funds rate.

The Federal Reserve essentially manages the FFR by giving the entire banking system more or less money. When it gives the system more money (by buying securities from the federal funds market), the banks don't need to borrow from one another so much, so it becomes cheaper to borrow and the FFR declines. In theory, this cheapens the cost of borrowing for banks, which makes it so that they can lend out money cheaper to companies and individuals. Likewise, if the Fed takes money out of the system, the banks have to borrow more (perhaps even from the Fed directly), and this makes borrowing more expensive (which again, theoretically translates into more expensive borrowing for everyone).

But according to Alan Greenspan, his manipulation of the Federal Funds rate after 2001 had very little impact on the rates at which banks were lending to home buyers.

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.

And to give Greenspan his due, he's right. A few weeks ago and for no good reason in particular, Lion and I downloaded a bunch of data which, fancy that, happened to include time series for average 30 year fixed rate mortgages (the most popular kind of mortgage as far as I know, though increasingly less so in recent years) and the effective federal funds rate. Take a look at those wiggly lines and you can see, particular after the FFR increase in 2004, that the two don't seem to follow one another:





If you can't read it, the pink one is the federal funds rate and the blue one is the 30 FRM rate.






So what explains this "decoupling"? According to Alan Greenspan, it was (you guessed it!) those damn Chinese and their damn destabilizing frugality.

the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

This is not the first time this argument has been rehashed in this blog. The Chinese held their currency low, we bought a bunch of their stuff, they used all that cash to relend money to us, that made borrowing really cheap and American's can't say no to a deal.

So maybe that's true and maybe that isn't, but the fundamental point still remains: Greenspan was not in control of mortgage rates. Sure there was a bubble and Greenspan even tried to deflate it in 2004! What else can you expect of him?

A Caroline Baum opinion piece in Bloomburg doesn't buy it. Yes, she concedes, perhaps the mortgage rates were out of the Fed's control.

"Control, yes. Influence, no."

To say that the chairman of the Federal Reserve is little more than a high-titled technocrat who occasionally tweaks a solitary rate in the financial system is pretty unbelievable. An infamous example: in 1996, Greenspan gave a speech in which he claimed there to be "irrational exuberance" in stock market activity. Stock prices immediately fell world-wide. The Fed's bully pulpit is a far-reaching one. And throughout his lengthy tenure at the Fed, Greenspan said very little about, say, regulation of financial derivatives, oversight of rating agencies or excessive mortgage securitization.

And when Greenspan did speak up on such matters, it generally followed the predictable line:
US Federal Reserve Chairman Alan Greenspan on Thursday [2003] voiced his support for financial derivatives amid widespread scepticisms largely resulted from financial irregularities in recent years. (Source)

And then two years later...

Improved access to credit for consumers, and especially these more-recent developments, has had significant benefits. Unquestionably, innovation and deregulation have vastly expanded credit availability to virtually all income classes. Access to credit has enabled families to purchase homes, deal with emergencies, and obtain goods and services.(Source)

And then finally,

The appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living.

Actually, this last one is from the Wednesday WSJ article.

But to return just one last time to the nitty-gritty of it, while the fed funds rate and general mortgage rates did seem to be as "decoupled" as Greenspan wrote, we can't always and in every way blame the Chinese as much as we might wish to. Perhaps, as one article I dug up from the early 00s wrote, increased securitization of mortgages by providing banks with much more readily available cash at any one time, made it more difficult for the fed to influence bank behavior by manipulating reserve levels. Securitization in its most "innovative"/excessive form, by the by, that Alan Greenspan was so hesitant to warn us all about.

Or maybe the Fed Funds Rate was neutered by 2004, as Baum writes, because

The real funds rate, which is the nominal rate adjusted for inflation, was negative for three years, from October 2002 to October 2005, a longer stretch than in the mid-1970s.

In other words, after years of free money for the banking system, which certainly helped to pump up the housing bubble, a quick turn around in 2004 couldn't be expected shift general mortgage rates on a dime. By then, housing prices were already spiraling ever upward and so even if the mark-up between the cost of borrowing and the revenue from lending was slightly narrowed, the massive returns from lending to homebuyers justified the sticky mortgage rates.

And above all, even if Greenspan wants to blame Asia's savings glut, a pattern which he traces back to the early 1990s, why then keep borrowing rates low for so long? Even if the link between mortgage and fed rates was weaker than the historical precident, why add fuel to the fire?

So all in all, is Greenspan the boogyman of this financial crisis? Probably not. Does he deserve as much of the blame as so many want to shovel at him? Maybe not. Does it take chutzpah to write such an unspired self-justification in one of America's biggest newspapers? You still got it, Al!