Why Greenspan's Defense is Wrong

Greenspan launched another defense of himself in the WSJ today.

The meat of his argument is below and here is the full article.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

This is disingenuous. First look at these two charts (fed fund rates and housing price index).

Federal Funds Rate

From FinancialSense.com So here is what really happened:

a) we had a huge asset bubble in the largest sector of the consumer economy

b) because the Greenspan Fed did not believe in targeting asset bubbles and because the way CPI measures housing is insane and because of deflationary effect of Chinese manufacturing

c) Greenspan was able to keep Fed Funds at historical lows for years, while pretending inflation was tame, which of course it was not - all the easy money inflation was pouring into housing

Greenspan says:

Fed funds and mortgage rates de-correlated because of global liquidity fueling the securitization chain so there was nothing we could do about it

Why this is silly, in reverse order of importance

a) They could have clamped down on lending by both depository and non-depository institutions that were fueling the bubble with idiotic or fraudulent products

b) i suspect the reason that the correlation between short and long-term rates disappeared is because short-term rates were trading in such a small and low range. If you take short-term rates to 5 or 6% they were in the 1990s, the 4-6% long-term mortgages are obviously going to disappear.

But Greenspan never felt he needed to do that because we had reached some new golden economic paradise where easy money does not cause inflation.

c) most important:

What exactly does Dr. Greenspan think was fueling the massive liquidity and chasing for yield from all the institutional investors that held down long-term rates, except the amazingly low fed fund rates. Given the savings glut and very low yields, financial "innovation" was inevitable.

None of these excuses the various parties (homeowners, originators, securitizers, buyers) from the varied and sundry stupid or fraudulent things that they did, but for the Chairman of the Fed, who is supposed to take the punch bowl away when party gets going, to say that there was nothing he could have done, well, that is plain ridiculous.

Thanks to Josh for bringing the article to my attention and Larry for noting that nobody gets a free pass in this debacle.

Posted on March 11, 2009 and filed under Finance.