The Greenspan Defense

Have you had enough Alan Greenspan yet? Just in case his interview with Greg Ip today isn’t enough for you, I should also point out his 1,638-word "response to my critics" over at Martin Wolf’s forum. There are some reasonable points in there, and some unreasonable ones too:

Some argue that adjustable rate mortgage (ARM) originations fueled the bubble. Yet the ARM’s share of total originations is a very weak forecaster of home prices, implying ARMs, although a source of cheap financing, are not a determinant of home prices. If ARMs were not available from 2001 to 2004, home purchases presumably would have been financed with long term debt, which was also very affordable.

This is just another way of saying that low interest rates don’t cause housing bubbles, and it’s silly on its face. ARMs, in terms of monthly mortgage payments, were significantly cheaper than long-term debt – and, more to the point, they were generallyl available to subprime borrowers who wouldn’t never have taken out a long-term mortgage of that magnitude. Borrowers almost never took out mortgages with the intention of defaulting: they needed to think that they could make their monthly payments.

With ARMs, subprime borrowers could make relatively low interest payments for the first one, two, or three years. If they had been forced to take out a 30-year mortgage instead, they could never have made the higher initial interest payments: remember that the yield curve back between 2001 and 2004 was still steep enough that there was a significant difference between 30-year interest rates and 1-year interest rates.

You can get to the same place in a different way, by looking at the magnitude of declines in the housing market. The biggest drops aren’t where house prices rose the most, as you might expect if this was a simple case of a bubble popping. Rather, they’re where there were the most subprime originations. There were no subprime borrowers in Manhattan? The bubble’s still inflating there. House-price purchases were overwhelmingly made by subprime borrowers in California’s Inland Empire? That’s where the price declines have been harshest.

So when Greenspan says he’s not at fault because there were housing bubbles elsewhere in the world as well, he’s missing the point that those bubbles haven’t burst – not in nearly as harmful a manner as the US bubble, anyway. And the reason is that there might have been a housing bubble, but there wasn’t a subprime bubble.

Even if Greenspan’s not responsible for the housing bubble, then, it is fair to blame his low overnight interest rates (if not him personally) for the subprime bubble which was fueled by the fact that subprime borrowers invariably borrowed short on a long-term mortgage.

Still, you can see how Greenspan gets aggrieved by his critics. Just look at how Willem Buiter lays into him in the comments:

By overselling, at home and all over the world, the virtues of American-style transactions-based financial capitalism and light-touch regulation, Mr. Greenspan has done more to harm the cause of decentralised, competitive market-based financial systems based on private ownership, than even Charles Ponzi.

Alan Greenspan’s period as Chairman of the Board of Governors of the Federal Reserve System represents to me the nadir of central banking in advanced economic-financial systems during modern times. While monetary policy was only mildly incompetent, the regulatory failures were horrendous. The US and the world economy will pay the price for Mr Greenspan’s misjudgements and errors for years, perhaps decades, to come.


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