The recent passing of former Fed chair Alan Greenspan has elicited commentaries on his legacy, with his possible role in the financial crash receiving particular scrutiny. Ironically, some of my free-market economist colleagues have defended Greenspan on these lines, arguing either that (a) the Greenspan Fed was not responsible for the housing bubble and/or (b) the housing bubble wasn’t the cause of the 2008 financial crisis. In this two-part series, I will provide evidence that the criticism of Greenspan is well-founded. In this first post, I’ll argue that the Greenspan Fed fueled the housing bubble, and in the sequel I’ll tie the collapse of housing to the financial crisis / Great Recession. (This written series dovetails with InFi podcast episode #143.)
Henderson and Hummel: Asian Saving the Culprit?
In a 2008 Cato study, economists David R. Henderson and Jeffrey Rogers Hummel (H&H) argue that the Fed under Alan Greenspan shouldn’t be blamed for the housing bubble. For one thing, the bubble occurred in many countries; how can the Fed pump up home prices in Spain?
But beyond that, H&H argue that the unusually low interest rates in the early 2000s were not caused by loose monetary policy. On the contrary, H&H write:
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. …[E]ven 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.
But if it wasn’t excessive money-printing that caused the unusually low interest rates in the early to mid-2000s, what was it? H&H follow Greenspan’s own argument by blaming Asian savings:
The market ultimately determines interest rates. Although central banks are big enough players in the loan market (and the quintessential noise traders to boot) that they can push short-term rates up or down somewhat, that ability is increasingly diminished, even for a major central bank like the Fed, as globalization integrates world financial markets. In defending his actions, Greenspan is correct in attributing the unusually low interest rates early this decade mainly to a massive flow of savings from emerging Asian economies and elsewhere.
Now that I’m summarized the main points defending Greenspan’s Fed from the charge that it inflated the housing bubble, let me present evidence for the prosecution.
Interest Rates and US Home Prices
H&H agree that US interest rates were unusually low during the run-up in home prices, but let’s show how closely the two go together:
In the chart above, the blue line is the federal funds rate, which is the central policy rate. (It’s what the financial press is referring to when it says, “The Fed cut rates today.”) Specifically, the fed funds rate is the overnight interest rate (quoted on an annualized basis) for interbank loans of reserves. As the chart shows, the fed funds rate was at 6.5 percent going into late 2000. The Fed (under Greenspan at the time) began cutting aggressively, initially in response to the dot-com crash (not shown) which had begun earlier in the year, and then later of course because of the 9/11 attacks. The Fed’s target rate eventually bottomed out at 1 percent by June 2003. This was an incredibly low rate—you would have to go back to the 1950s for the last time this particular rate had been so low.
The Fed then held its target at this rock-bottom low for a full year, before it began gradually hiking in June 2004. As the “staircase” blue line shows in the chart above, the Fed raised continuously (but tepidly) all the way until July 2006, at which point the Fed held rates steady at 5.25 percent.
In the same chart above, we can see that conventional 30-year mortgage rates (green line) followed the same pattern as the Fed’s short-term policy rate, though not to the same degree. Specifically, mortgage rates by the mid-2000s were about two percentage points lower than a decade earlier, which themselves were lower than in the 1980s.
Finally, the red line shows the year/year growth in a Home Price Index for the US. Just as one might suspect, home prices experienced a surge in growth when interest rates fell to rock-bottom levels, and tapered as rates began to rise. Between the third and fourth quarter of 2007 the red line finally crosses the 0 point (right axis), meaning home prices were now down compared to 12 months prior.
Thus far we haven’t contradicted anything in H&H’s study, but I thought it important to first establish that US interest rates (a) were unusually low when the housing bubble took off, and (b) were brought back up as the housing bubble stabilized and then popped.
Are Foreign Savers to Blame?
As I’ve explained, H&H agree that low interest rates may have fueled the housing bubble; they simply deny that Greenspan dunnit. As we quoted above, they follow the lead of Greenspan himself by pointing the finger at an excess of foreign saving. But even if we look at a chart constructed by authors making the “Asian savings glut” claim (which is based on Table A16 from this IMF publication), we can immediately see a problem with the allegation:
According to these data, there was indeed a “savings glut” (meaning more savings than domestic investment) among emerging and developing economies that began in 2002. But notice that the gap between the two series just kept getting bigger from 2004-2006, even though that’s when the Fed was continuously raising its policy rate. Moreover, the size of the gap in 2008 was comparable to that of 2005; looking at this chart alone, you would have no idea that it was supposed to explain a massive housing expansion through 2006 which then flipped into a massive bust by 2008.
A Much Better Culprit: Federal Reserve Monetary Policy
In contrast to blaming foreign saving for the fall-and-rise of US interest rates, a much better culprit is the growth of various US monetary aggregates. Here is a long-range view of the year/year growth rates in the monetary base and M1:
H&H aren’t wrong about their statistics; both the monetary base and M1 had growth rates that steadily fell from the early 2000s onward. But that’s exactly what we’d need to see, if we are to attribute the housing boom and bust to Fed policy. (In contrast, foreign saving could explain the housing boom, but not the bust.)
So now the question is simply: Can the absolute levels of base and M1 growth in the early 2000s explain the housing bubble? Well, the range of these growth rates was between 5 and 10 percent. Is that a lot? It was in that same range back from 1975-1980, as the chart clearly shows. Does anybody deny that the stagflation of the 1970s was due to loose monetary policy?
Two Loose Ends
In the final chart above, there is a whipsaw in base and M1 growth around the year 2000. That was because of “Y2K,” when many feared legacy computer programs would fail. The Fed preemptively injected a massive amount of reserves into the system in late 1999 to reassure markets, and then withdrew once New Year’s passed without planes falling from the sky.
The other loose end was the question about a global housing bubble. I agree, a “savings glut” among developing and emerging nations seems tidier to explain a housing bubble hitting several countries, but there were other problems with that explanation. Since the USD is the global reserve currency, and especially because other central banks often coordinate their policies with the Fed to keep their exports secure, I don’t think it is a dealbreaker for my theory to say that the Fed under Greenspan could have fueled bubbles in multiple countries.
Conclusion
Notwithstanding the efforts of several of my colleagues to exonerate Greenspan’s Fed, I think both theory and evidence show that it played a crucial role in inflating the US housing bubble. There were certainly other government policies that led to absurdities in the US mortgage market, but the excess liquidity from the Fed exaggerated the impact of those interventions.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together the dependability of Whole Life insurance policies with the benefits of blockchain-based finance.
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