The Fed Did It, and Greenspan Should Admit It

Email Print

In his Wall
Street Journal article from March 11, 2009, former Fed chairman
Alan Greenspan rejects the idea that the Fed’s low-interest-rate
policy between December 2000 and June 2004 fueled the housing bubble,
which in turn laid the foundation for the current economic crisis.

(The federal
funds rate was lowered from 6.5% in December 2000 to 1% by June
2003. It was kept at 1% until June 2004 when the rate was raised
by 0.25%.)

Greenspan holds
that what matters for the housing market is long-term and not short-term
interest rates. The Fed, however, doesn’t control long-term rates,
argues the former Fed chairman.

According to
Greenspan, the decline in long-term rates and mortgage rates took
place while the Fed had been tightening its interest-rate stance.
The federal-funds-rate target was raised from 1% in June 2004 to
4.25% in December 2005.

Yet in June
2005 the yield on the 10-year Treasury note fell to 3.92% from 4.58%
in June 2004. The 30-year fixed-mortgage rate closed at 5.58% in
June 2005 against 6.29% in June 2004.

How in the
world, asks Greenspan, can the Fed be blamed for the housing bubble
and the current economic crisis?

Who, then,
is to blame for this fall in long-term interest rates and
for the present economic crisis?

According to
Greenspan, the culprit is the savings glut from emerging economies,
such as China. This glut of savings was channeled to long-term US
Treasuries and other US financial assets thereby depressing their
yields, argues the former Fed chairman.

Ben Bernanke
concurs. In his speech at the Council on Foreign Relations on March
10, 2009 he said,

Like water
seeking its level, saving flowed from where it was abundant
to where it was deficient, with the result that the United States
and some other advanced countries experienced large capital

What Greenspan
and Bernanke call “savings” is nothing more than the amount of US
dollars that emerging economies accumulated.

The accumulation
of these dollars by emerging economies cannot increase the pool
of dollars. The accumulated dollars are part of the existing pool
of US money.

When a Chinese
exporter sells goods to an American importer, he is paid with dollars.
This means that the ownership of dollars is changed here,
not their quantity.

With all other
things being equal, a sustained decline in long-term yields requires
an increase in the pool of dollars. The increase in the pool of
dollars means that more American dollars will be employed as the
medium of exchange. As a result, the prices of goods and assets
move higher, while yields on assets are pushed lower.

However, if
the accumulated dollars of emerging economies are only invested
in US Treasuries, then it is tempting to suggest that a sustained
fall in long-term rates without an expansion in the pool of dollars
is possible.

We suggest
that this is highly unlikely. If the pool of dollars remains unchanged
while the quantity of goods and assets continues to expand, then
this will lead to the fall in the average price. (Remember, a price
is the number of dollars per unit of a good or asset.)

This means
that explicit and implicit yields will come under upward pressure.
(As a result, investors from emerging markets are likely to shift
their funds from less-yielding Treasuries to a higher-yielding asset
if the pool of dollars remains fixed, thus pushing yields on Treasuries

It is only
the monetary policy of the Fed – and not the accumulation of
dollars by emerging economies – that can set in motion changes
in the pool of dollars. Hence, the fall in long-term interest rates
and mortgage rates has to be the result of the Fed’s loose monetary

If what we
are saying is valid, then how are we to reconcile the fact that
in 2005 long-term rates had been falling while the Fed was tightening
its stance?

the 30-year fixed-mortgage rate and the federal funds rate have
had a tendency to display a very good visual correlation. This doesn’t
mean that the correlation is perfect – a discrepancy in the
movements between the federal funds rate and long-term rates can

The emergence
of a discrepancy doesn’t imply that suddenly the Fed’s policies
have nothing to do with the housing bubble or boom-bust cycles.

(Recall that,
because of a discrepancy during June 2004 and June 2005 between
the federal funds rate and long-term rates, Greenspan has concluded
that his loose monetary policy between December 2000 and June 2004
had nothing to do with the housing bubble.)

Various discrepancies
between the movement in the federal funds rate and the mortgage
rate are the result of a variable time-lag effect from changes in
monetary policy on various markets.

Because of
the variable time lag, a situation can emerge where long-term rates
may ease despite the central bank’s tighter interest-rate stance.

Despite a tighter-interest-rate
stance, the previous loose-interest-rate stance may still
dominate economic activity. Consequently, in order to maintain a
given interest-rate target in the midst of still strong economic
activity, the Fed may be forced to push more money into the economy
to prevent the federal funds rate from overshooting the target.
(For instance, an increase in the federal funds rate from 1% to
2% is a tighter stance, yet the 2% rate can still be too low –
strong economic activity pushes the federal funds rate above the

As a result,
more money becomes available for financial markets, which puts downward
pressure on long-term rates, all other things being equal.

In November
2004, the yearly rate of growth of the Fed’s balance sheet jumped
to 6.9% from 4.3% in June 2004. Note that this increase in the pace
of monetary pumping took place while the federal-funds-rate target
was lifted from 1% in June to 2% in November.

Also note that
between December 2004 and June 2005 the average yearly rate of growth
of Fed assets stood at a still-elevated 6%.

Contrary to
Greenspan and other commentators, we suggest that what sets in motion
a boom-bust cycle is not a boom in a particular market such as the
housing market but the increase in money supply out of “thin air.”

Now let us
say that the dollars accumulated by emerging economies were to be
invested solely in Treasuries. While this might push long-term interest
rates temporarily lower, all other things being equal, it is not
going to set in motion a boom-bust cycle as long as the pool
of US dollars remains unchanged.

If, as a result
of lower interest rates, too many dollars are invested in the housing
market, it means that fewer dollars are invested in other goods.
As a result, the housing market will become overvalued while other
goods will become undervalued. This will set in motion an outflow
of money from the housing market to other markets.

In our writings
we have shown that the main source of boom-bust cycles is the Fed
itself. Thus, by aggressively lowering interest rates between December
2000 and June 2004 – and accompanying this with monetary pumping
– the Fed set in motion an economic boom.

The boom gave
rise to various nonproductive (bubble) activities that emerged on
the back of the loose monetary stance of the Fed. The increase in
money supply led to the diversion of real funding from wealth-generating
activities toward various nonproductive activities.

(Note that
these activities cannot stand on their own – they cannot fund
themselves. They are funded by diverting – by means of new
money created “out of thin air” – real savings from wealth-generating

From June 2004
through September 2007, the Fed adopted a tighter stance, which
slowed the diversion of real funding to nonproductive activities.

As a result
of this, various nonproductive activities came under pressure. (Without
real funding, these activities are forced to go under.)

Now, when money
is injected, it doesn’t instantly affect all the activities in an
economy. The money starts with the first recipients and then moves
to other recipients. It moves from one market to another market
– there is a time lag.

This means
that various nonproductive (bubble) activities are spread across
all the markets – the boom is everywhere. Once the Fed tightens
its stance it starts a bust, and this weakens various nonproductive
activities across all the markets. The severity of the bust is dictated
by the size of the boom.

percentage of nonproductive activities – the product of the
boom – determines the severity of an economic bust in a particular
sector of the economy.)

It follows,
then, that a bubble in a particular market cannot emerge without
the preceding increases in money supply. This in turn means that
a bubble cannot emerge without a preceding loosening of monetary
policy, which means it cannot occur without money pumping by the
Fed. Hence, what matters for the economic boom, i.e., the emergence
of bubbles, is the creation of money “out of thin air” and not the
level of long-term interest rates.

Contrary to
Greenspan, we can conclude that it is not long-term rates as such
that fueled the bubble but the loose monetary policy of the Fed.

We can also
conclude that the so-called savings glut in emerging economies had
nothing to do with the last economic boom or the current economic

The only institution
that can set in motion the expansion of money and a false boom is
the Fed.

This article
first appeared on

20, 2009

Shostak [send him
] is an adjunct scholar of the Mises Institute and a frequent
contributor to He is chief
economist of M.F. Global.

Email Print