The Fallacy In Greenspan’s Self Defense

March 12, 2009 at 10:47 am  ·  Category: Business Culture and Current Events, Federal Reserve, Macro Economics

Mr. Greenspan ought to have used the pages of the Journal to apologize to the nation.  Instead, his piece will stand as a testament to his hubris, or perhaps his delusions.

Ian Shepherdson, Chief US Economist, High Frequency Economics

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.

As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition.  The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment.  That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.


Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble.

– Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble” (subscription required), The Wall Street Journal, March 11

In yesterday’s Wall Street Journal Alan Greenspan had a truly outrageous editorial: “The Fed Didn’t Cause the Housing Bubble” (subscription required).  I can’t even begin to tell you the level of obfuscation and disengenuity in this editorial.  The guy is just unbelievable.  When I was reading it last night and every time I think about it I can’t help but wonder:  Is he for real?  Is this some kind of practical joke?  Either Greenspan is pulling some huge hoax or he is so obsessed with his reputation and legacy that honesty and truth carry no weight for him.

Greenspan’s core argument is that there are two possible explanations for the global housing bubble: low interest rates from the Federal Reserve or a global savings glut.  Greenspan argues that it was entirely the latter. 

The Asian countries in particular structured their economies to export goods to the US creating current account deficits here and surpluses over there.  That is, we sold less to them then they sold to us, leaving them with an excess of dollars.  Those dollars got re-invested into US treasury assets, pushing down yields and mortgage rates.  These low long term rates were the cause of the bubble and were in fact disconnected from the federal funds rate which the Fed was tightening from mid-2004 to mid-2006.

Now there’s something to this but the fallacy is that the cause is entirely one of these or the other.  (For those of you who are interested in logic, this fallacy is called causal oversimplification and is a specific type of the false dilemma fallacy).

Does Greenspan truly believe that there was no connection between the obscenely low federal funds rate and low mortgage rates and the creation of exotic mortgage products at the beginning of the decade?  The Fed is the dominant controller of the world’s money supply and the low federal funds rate meant low rates for banks which means they could lower mortgage rates and still make a nice profit on the spread.

So here’s the basic bait and switch that Greenspan tries to pull in his editorial – with good success I might add as I found myself momentarily discomfitted in trying to figure out where his argument failed: The global housing bubble was a function of many causes.  One of those causes was indeed the export structured economies in Asia which subsidized low interest rates in the USA.  But that was only one of multiple causes and not the fundamental cause! 

The fundamental cause was the Fed’s low interest rate policy, which was the catalyst for the housing bubble in the wake of the tech bust.  The structure of the global economy (i.e. export oriented Asian economies) added fuel to the fire as US consumers tapped home equity and wealth from the boom to buy imported goods resulting in huge current account deficits which in turn played a role in keeping interest rates low and were a cause of some sort of disconnect between short and longer term interest rates in the middle of the decade.  But that was derivative and historically subsequent: the boom and all the housing related wealth that caused these huge current account deficits were fundamentally caused by the Fed’s low interest rates.

Greenspan even goes so far as to quote an editorial from Milton Friedman in early 2006 (2006!) praising his management of the Fed: “There is no other period of comparable length in which the Federal Reserve System has performed so well.  It is more than a difference of degree; it approaches a difference of kind.”  Of course this was before the financial crisis and before the full measure of Greenspan’s policies could be evaluated.  Would Friedman say the same thing today?  Highly doubtful.

Many have weighed in on Greenspan’s editorial with similar incredulity.  See, for example:

“Greenspan’s Denial”, Peter Boockvar, The Big Picture, March 11

“Allan Greenspan still hasn’t got a clue”, Tim Iacono, The Mess That Greenspan Made, March 11

“Greenspan Forgets Where He Put His Asset Bubble”, Caroline Baum, Bloomberg, March 12

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No Responses to “The Fallacy In Greenspan’s Self Defense”
  • Like many similar articles, this post makes a lot of strong assertions without any basic data. While Greenspan did many things wrong, he is right that the housing bubble wasn’t caused by the Fed’s actions. If anything, it was caused by the Fed’s inactions.

    I covered the credit market as a journalist during much of the credit bubble, and have studied these issues for hundreds of hours.

    The main cause of the housing bubble was 70 years of government support of homes as an asset class. For decades, various programs were in place to encourage detached houses and to promote ever easier forms of lending to finance them. For more, see this article:

    For instance, nowhere does the post above address the fact that securitization had completely transformed the mortgage market by securitization by the late 1990s. And, it was the government that fueled that process with the promiscuous use of Fannie and Freddie. See this article for more:

    The second cause was the massive amount of money being recyclied into the fixed-income assets because of trade and booming emerging-market economies. These countries simply had nothing else to do with their money, and MORE THAN HALF the US trade deficit was put into the US credit market during the bubble. See this posting for more:

    People need to understand how markets and trends actually work. Assets appreciate for long periods of time for “good” fundamental reasons. For instance, US stocks had good reason to rise for 10-15 years starting in the early 1980s. More and more people see the momentum and try to get exposure. This attracts ever growing amounts of new money. When you throw in a sudden liquidity event, the bubble reachs its final apogee.

    For stocks, this was the Asian crisis in the late 1990s, which caused foreign money to flood the US stock market, and then the Fed’s crazy rate cuts going into Y2K. For houses, it was the surge of money flowing into the US bond market that resulted from the surge in global trade that really exploded in 2004.

    Greenspan is correct that the Fed funds rate did not cause the housing boom. His real misdeed was allowing banks to become so reliant on securitization, which completely changed the way that lending was done in the US. His foolish belief that regulation was always bad also added to the problems.

    Japan has cut its interest rates for years, and failed to trigger any new asset bubbles in their own country. (Although it can be argued that fueled bubbles elsewhere, as can be seen by the close inverse correlation between the yen and “risk assets” like stocks and mortgage-backed securities in the 2005-2008 period.)

    To cure this problem, people should study the data more closely.

    David Russell  ·  Mar 19, 2009 at 7:59 pm  ·  Permalink
  • Excellent comment David.

    “The main cause of the housing bubble was 70 years of government support of homes as an asset class. For decades, various programs were in place to encourage detached houses and to promote ever easier forms of lending to finance them. ”

    I agree with you that government policies to encourage homeownership contributed to the bubble. Absolutely.

    I also agree, as I write in the post, that massive investment by Asian and Middle Eastern governments in our fixed income markets contributed as well.

    But my argument is that the FUNDAMENTAL cause was in fact Greenspan’s easy money policies. There are multiple causes but I believe the Fed’s easy money policy did most of the heavy lifting.

    For a fuller treatment of my position, which discusses the role of government policies encouraging homeownership, check out Lawrence White’s Cato Briefing Paper “How Did We Get Into This Financial Mess?”, November 18, 2008 (

    Thanks for the good comment 🙂

    Greg Feirman  ·  Mar 20, 2009 at 7:50 am  ·  Permalink

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