In this forum I have argued that Alan Greenspan’s low-interest-rate policy after the dot-com bust and 9/11 attacks sowed the seeds for our current recession and the housing bubble. I have also criticized the alternate theory that a foreign "savings glut" was the true culprit, rather than the Fed. In the present article, I want to deal with a few empirical objections to the case against Greenspan. That is, several different economic analysts are familiar with the theory that "the Fed did it," and they claim that the facts just don’t add up. In the space below, I hope to demonstrate that the evidence against Greenspan is indeed damning.
Greenspan’s "Smallish" Injection?
One argument advanced in the attempted exoneration of Greenspan is that he didn’t really pump that much money into the credit markets. For example, popular blogger Megan McArdle writes,
Both right wing Austrians and many liberals have a common theory of how all this happened: Alan Greenspan dunnit. The mechanisms by which he accomplished his foul task are different in the two cases, of course. Austrians, and many other free-market types, believe that by lowering short-term interest rates after 9/11, Alan Greenspan made the housing bubble, and its eventual bust, inevitable… Here’s the problem: if markets are so great, how come the entire system can be brought low by a smallish injection of short-term capital? (emphasis added)
Brad DeLong makes a similar claim in his critique of Larry White, whom DeLong praises as the "best of the Austrians." (DeLong does not tell us who the best-looking Austrian is, though I hope to at least be nominated.) DeLong writes,
Moreover, I do not think that Larry White has gotten the part of the story that he does cover right…. From the start of 2002 to the start of 2006 the Federal Reserve bought $200 billion in Treasury bills for cash. This $200 billion reduction in outstanding bonds and increase in cash surely did lead to an increase in demand for private bonds. But recall the magnitudes here. We have $2 trillion of losses on $8 trillion in face value of mortgages that ex post should not have been made. Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans? Not likely. I can see how monetary contraction can make previously profitable loans unprofitable. But I see no way that this amount of monetary expansion can force private agents to make that amount of unprofitable loans. The magnitudes just do not match.
Similarly, David Henderson and Jeff Hummel write that monetary growth was tamed during the years of the housing boom, and so Greenspan can’t be the culprit:
A better, although now unfashionable, way to judge monetary policy is to look at the monetary measures: MZM, M2, M1, and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20 percent to nearly 0 percent by 2006. During that same time, M2 growth fell from over 10 percent to around 2 percent and M1 growth fell from over 10 percent to negative rates. Admittedly the Fed’s control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base since 2001 fell from 10 percent to below 5 percent in 2006 and by June of 2008 was around 1.5 percent, despite Ben S. Bernanke’s alleged reflation. When all of these measures agree, it suggests that monetary policy was not all that expansionary during 2002 and 2003 under Greenspan, despite the low interest rates.