Greg Ip

Articles by The Economist’s U.S. Economics Editor

Greenspan had the power: should he have used it?

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The original post is linked here.

ALAN GREENSPAN’s defence of the Federal Reserve in the formation of the housing bubble restates a familiar argument—it raised short-term interest rates but long-term interest rates did not follow, and housing is most sensitive to long-term rates. His proof includes the fact that long-term rates were low worldwide, and that many countries had bigger housing bubbles than America. The housing bubble’s source must therefore be global.

I agree with this analysis but I don’t agree that it exonerates the Fed. In the earlier part of this decade Mr Greenspan asserted on a number of occasions that while America might have local housing bubbles, there was no national housing bubble. Yet he now asserts there was a global housing bubble. It has always puzzled me how he could go from seeing local bubbles to a global bubble without at some point diagnosing a national bubble. By failing to diagnose a national housing bubble until it was already well inflated, the Fed under Mr Greenspan escaped the obligation to do anything about it.

But had the Fed recognised it, should, or could, it have done anything about it? Mr Greenspan argues that irrespective of whether it should, it could not, because it did not control long-term interest rates. I disagree. The Fed affects economic activity through overall financial conditions. The only component of financial conditions it controls is the short-term interest rate, but the short-term interest rate influences long-term rates, the exchange rate, equity prices, credit spreads, and so on. Yes, the linkage between the short- and long-term rates weakened. But at some point, it probably would have reappeared. The Fed could have gotten the long-term rate up had it raised the short-term rate enough. And even if the long-term rate remained stable, the economy, and housing demand, would eventually have wilted as other components of financial conditions tightened.

How much is enough? It’s hard to say, but perhaps 8% or 10%. The problem is that this would have been so draconian, that the entire economy would have tanked. It is almost certainly more than the Taylor rule would have dictated, exposing a flaw in John Taylor’s critique. Unemployment would have risen and inflation undershot the Fed’s implicit target. In other words, the housing bubble would have been deflated but at the expense of violating the Fed’s statutory pursuit of stable prices and full employment. This is a legitimate defence of the Fed’s actions. But saying the Fed had the power to stop the bubble but chose not to exercise it is different from saying it was powerless.

Does the fact the Fed could have stopped the housing bubble mean it should have? I am not sure. Would it have been wiser to induce a recession to puncture a housing bubble five years ago to avoid the possibility of a much deeper recession later on? At the time, the answer seemed obvious: no. Now that we are in the throes of that much deeper recession, it’s a tougher call. That is how history gets rewritten.

There was, of course, an alternative between letting the bubble inflate and inviting recession. Had Mr Greenspan and his colleagues concluded housing prices were too high and there was value in taming them, they could have used regulatory tools instead of monetary policy. They could have insisted on a margin requirement for home purchases—no one could put down less than 20% unless they obtained mortgage insurance. (At the peak of the bubble, the widespread use of second liens made 100% loan-to-value mortgages without insurance commonplace.) This would have been politically difficult since it would have deprived lots of people the opportunity to own a home, in violation of America’s credo. It would have also contradicted Mr Greenspan’s own deregulatory impulses. He resisted raising margin requirements on stocks in the 1990s in part out of a conviction that only small investors would be affected; big sophisticated players would find a way around them.

There are many other regulatory steps that could have been taken over banks (requiring them to hold capital against off-balance sheet vehicles) and mortgage originators (requiring all of them to document income and to escrow insurance and taxes, for instance) that, while not stopping the bubble, would have mitigated the consequences. It’s worth noting that many of the countries that have had housing bubbles, like Australia and Spain, have not had banking crises in part because their regulatory regimes did not permit the same degree of leverage.

Unlike the bubble/recession trade-off, this trade-off may have been acceptable even if the current crisis had never happened. It is hard to believe that society would have been significantly worse off if we’d limited the growth in home ownership to, say, 66% instead of 69%, by excluding people unable to make a substantial financial commitment.


Written by gregip

March 14, 2009 at 8:54 pm

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