CEPR - Center for Economic and Policy Research

Yes, It Was Greenspan’s Fault


Dean Baker
The Hankyoreh (South Korea), April 21, 2010

See article on original website

Alan Greenspan is trying to absolve himself of blame for the economic crisis. He again argued that the housing bubble in the United States was caused by factors that were beyond the Fed’s control. Furthermore, he claimed that Congress would have attacked him if he had done anything to slow the growth in homeownership that helped fuel the bubble. Neither of these arguments deserves to be taken seriously.

Greenspan attributes the bubble to the worldwide decline in long-term interest rates. He noted that there were serious run-ups in house prices in much of the world, not just the United States. Greenspan argued that if he had increased the short-term interest rate under the Fed’s control, it would have had little impact on the increase in house prices in the United States, therefore the bubble was beyond the control of the Fed.

Greenspan’s argument suffers from several serious flaws. First, the fact that there were housing bubbles in many countries doesn’t mean that Greenspan could not stop the bubble in the United States. Each central banker is responsible for ensuring orderly markets in the economy under their control. The fact that many central bankers may have made the same mistake does not mean that none of them made a mistake.

Low interest rates create an environment that is conducive to the growth of bubbles. However, low interest rates by themselves do not necessarily lead to bubbles. The United States and much of the rest of the world enjoyed a long period of low real and nominal interest rates in the two decades immediately after World War II. There were no notable housing bubbles in this period.

Greenspan certainly should have been cognizant of the risk of a housing bubble in the low interest rate environment in the first half of the last decade. If he did recognize the bubble at the time (a point on which he is still not clear), then the Fed had many tools with which to combat it. The first tool would have been to simply call public attention to the bubble.

This does not mean mumbling “irrational exuberance” as he famously did when the stock bubble was first taking off. Greenspan could have used the Fed’s enormous staff of economists to carefully document the evidence for a housing bubble and the likely impact on the economy and specific sectors from its collapse. The facts were very straightforward and easy to recognize even as early as 2002. There had been a sharp and unprecedented run-up in house prices that had no explanation in the fundamentals of the housing market. Furthermore, there was no remotely corresponding increase in rents, indicating that the run up in house prices was not driven by the fundamentals of the market. 

If Greenspan had used his congressional testimonies and other public appearances to highlight these facts, it almost certainly would have affected people’s willingness to buy homes and investors’ willingness to issue mortgages. Investors may not agree with the Fed chair, but they will not ignore him. And, there were no serious counter-arguments to the bubble explanation for the pattern in house prices.

Of course, instead of making these arguments, Greenspan did the opposite. He insisted that there was no bubble – that everything was fine in the housing market. He even encouraged people to take out adjustable rate mortgages at a time when the interest rate on fixed rate mortgages was near a 50-year low.

The huge growth in adjustable rate mortgages also contradicts Greenspan’s claim that the Fed was powerless because it only directly controls short-term interest rates. Adjustable rate mortgages follow the short-term rates that are under the Fed’s control. Of course the Fed also had ample authority to directly crack down on many of these loans, which were being issued by the millions without meeting traditional underwriting standards. Instead, Greenspan looked the other way.

This brings up the second point, that the Fed was constrained by pressure in Congress to support the increase in homeownership. The Fed has been deliberately structured to be independent of political control. Its governors serve 14-year terms during which they cannot be removed except in the case of serious misconduct.

If Greenspan had attempted to prick the bubble, and in the process slowed the growth of homeownership, it almost certainly would have angered members of Congress. However, Greenspan’s job was to maintain economic stability, not to please members of Congress. If he believed that the housing bubble presented a serious threat to the economy, then it was his responsibility to take steps to rein it in, even if it upset members of Congress. Perhaps Congress then would have tried to undermine the Fed’s authority, but this risk is no excuse for the Fed not to have done its job.

In short, Greenspan’s excuses are lame. The Fed had ample authority to counter the bubble before it grew to such dangerous levels. No one can say with certainty that they would have been successful, but we can say with certainty that Greenspan never tried. This was an inexcusable failure and the reason that Alan Greenspan will go down in history as one of the worst central bankers of all time.