Bridget Reidy, Dan Sherman, Travis Beal
Economics 272
Professor Cottrell
November 18, 2010
Greenspan’s Fed and the Financial Crisis
As Chairman of the Federal Reserve and overlord of the Great Moderation, Alan
Greenspan was hailed as “the greatest central banker who ever lived” (AP 2008). The
entire economy, and everyone directly involved with it, seemed to hang on his every
word. I once heard that several companies even hired consultants whose job it was to
analyze his appearance, right down to the color, length, and style of his tie, in order to
determine his mood and predict the actions the Fed might take. In short, he was the
maestro (Krugman 13) and nobody could undermine his power.
Then came the 2008 subprime crisis, and Greenspan’s reputation went down
almost as fast as the Dow Jones in September. Now, a man once virtually above criticism
has had to go on the defensive. He has faced scrutiny by everyone from Henry Waxman,
chairman of the House Committee on Oversight and Government Reform, to Tim Iacono,
editor of the blog entitled “The Mess That Greenspan Made.” While Greenspan now has
many detractors, there are still some who believe in him and the decisions he made as
Fed chair. Current Chairman of the Fed Ben Bernanke is perhaps Greenspan’s most
powerful ally; and while many would argue Bernanke could not realistically attack
Greenspan’s policies, an investigation of his recent speech (Bernanke 2010) leads us to
conclude that Bernanke genuinely supports his predecessor.
Yet, the question remains, as Waxman bluntly asked on Capitol Hill, was
Greenspan wrong (Cassidy 5)? Like many others, Greenspan undoubtedly played a role
in the financial crisis of 2008. However, through a comparison of aspects of the crisis that
were a direct result of Greenspan’s ideology and those that he has been unfairly blamed
for, it is clear that in many ways he has become a scapegoat. While all recessions are
multi-faceted in nature, this crisis in particular is more complex than any the country has
faced. This is mostly due to the intricate relationships among the financial institutions
that played a central role. When the crisis began, politicians, along with the public,
immediately looked to identify someone who could be held accountable; and that person
was Alan Greenspan.
When Alan Greenspan entered into his position as Federal Reserve chairman in
1987, President Reagan looked for Greenspan to provide such monetary policy actions
that would undo the high Federal Funds rate put in place by Greenspan’s predecessor,
Paul Volcker. Up until this point, the economy had experienced extreme volatility. It was
the conservative ideal that a lower Federal Funds rate would promote private sector
spending, thus increasing economic stability. The Greenspan Fed looked forward to
make their decisions, making predictions of the economy. Their main focus was on core
inflation and how to counteract it, and they had a goal to smooth interest rates. Originally,
it was believed that the Greenspan Federal Reserve followed the Taylor rule. The Taylor
rule compares the Federal Funds rate target against two economic variables: lagged
inflation and the output gap. Then the actual Federal Funds rate is adjusted to the target in
each period (Taylor 1993). This adjustment to the target rate during each implies that the
Taylor rule is “non-inertial,” or the Federal Reserve does not work to smooth interest
rates. Inflation, as quantified in the Taylor rule, is measured by the behavior of the GDP
deflator and the output gap and is the deviation of the log of real output from a linear
trend. Taylor (1993) shows that from 1987 to 1992, policy actions did not differ
significantly from the prescriptions of this simple rule. Hence, according to the Taylor
rule, the Federal Reserve, at least during the early part of the Greenspan era, was
backward looking, focused on headline inflation, and followed a non-inertial policy rule.
Figure 1
However, recent research argues that the Greenspan Fed modified its thinking to
become more forward looking in its inflation counterbalance, thus deviating slightly from
the Taylor rule. Greenspan’s policy actions after straying away from the basic Taylor rule
are better explained by an “inertial” Taylor rule reflecting the presence of interest rate
smoothing. The Greenspan Fed focused on a “core” measure of inflation in adjusting its
federal funds rate target. The “inertial” Taylor rule relates the current funds rate target to
“expected” inflation and output developments (Economic Quarterly). In choosing a
federal funds target rate, Greenspan’s thinking in his early days as Fed chairman
acknowledged the significance of having a rate that was just right. In a WSJ article, he
stated that it was his opinion that the Federal Funds rate needs to be low to increase the
money flow in the private sector (WSJ.com, Financial Crisis).
Figure 2
Taylor may have been right about the Federal Funds rate in 2000. Following the
dotcom bubble, the Fed reduced the federal funds rate to spur investment and
consumption. In 2003, the federal funds rate was a mere 1%, far less what it had been 2
years previously (Figure 1).
Figure 3
While reducing the federal funds rate is a typical response to a recession or decreased
consumption, reducing the rate by such a large amount is unusual. Lowering the interest
rate to1% and keeping it there for so long can be considered “deviation from a policy rule,
such as the Taylor rule, and in that sense it is a deviation from a more rules-based policy”
(Taylor 2). Not for decades had the interest rate been so low, and this negatively affected
the housing market.
Such a low federal funds rate made borrowing easier, and encouraged the housing
boom. With lower rates, the banks could more cheaply borrow money from each other
which allowed them to make more loans. The increase in consumer loans seemed to
increase around the same time that the federal funds rate dropped (Figures 2 and 3).
Figure 4
Figure 5
This easy monetary policy encouraged and helped to stimulate the housing bubble which
was the stimulus for the recent financial crisis. Federal funds rates do have an impact on
such consumer behavior. According to an article in the Wall Street Journal,
“Researchers at the Organization for Economic Cooperation and Development have
provided corroborating evidence from other countries: The greater the degree of
monetary excess in a country, the larger was the housing boom” (Taylor 1). In this sense,
the Fed did aid in the housing boom and bust.
As can be expected, Alan Greenspan and Ben Bernanke defend their actions.
Bernanke states that the Taylor Rule, which is a guideline for the federal funds rate based
on output and inflation, is subject to limitations. The main limitation is its “implication
that monetary policy should depend on currently observed values of inflation and output”
(Bernanke 2). Bernanke believes that it is necessary to take into account future
expectations when making policy decisions. While this is true and seems reasonable,
there is one issue with how the “future” is defined. The future is completely
unpredictable. To take into account future inflation values requires that these values be
predicted using past values. As we have seen recently, the past is not necessarily a good
indicator of the future. Once again, we are falling victim to what John Cassidy calls
“utopian economics.” Had the Federal Reserve followed the Taylor Rule more closely,
perhaps things would have been different.
However, Greenspan’s actions were clearly affected by the financial environment
at the time. An interest rate so low in “normal” times (not during a housing bubble) may
not have had such an effect. Greenspan’s actions on their own are not what caused the
problem. It was the combination of his choices and the freedom of the financial
markets at the time.
It is easy to say in retrospect, but it is clear that Greenspan’s major flaw was a
classic case of disaster myopia, inspired by his faith in the advancement of the financial
industry. This can be seen in the now infamous “‘Greenspan Doctrine,’ which warmly
welcomed the development of new financial products, such as securitized loans and
credit default swaps” (Cassidy 22). While these terms are now synonymous with chaos,
at the time they represented innovation and lead to increased prosperity. The problem
with disaster myopia is that it is extremely difficult to recognize at the time of occurrence.
Since the Great Moderation was in full force for most of Greenspan’s tenure, it made no
logical sense to question his philosophy. To be fair, this does not completely absolve the
Fed of their responsibility, since they are often thought of as extremely rational and
impartial. Nonetheless, “As long as the music is playing, you’ve got to get up and dance”
(Cassidy 296) and the Fed was definitely dancing.
Deregulation also played a part in the crisis, and from early on in his intellectual
career Greenspan was a staunch opponent of regulation. Going back to the 1950’s,
Greenspan was involved with Ayn Rand’s “Collective,” and one can see that his
“libertarian, antigovernment instincts stayed with him throughout his long career”
(Cassidy 229). He believed that because of their motivation for profit, companies would
effectively manage risk without the intervention of the government. This may be so to
some extent, but as we now know many of the risk management tools that became widely
used were founded on either inaccurate assumptions or were not utilized in the correct
way. Once again, while Greenspan cannot be held personally responsible for the mistakes
made by others, he was an advocate of the principles that led to deregulation.
These faults are minor when compared to the amount of blame that has been
hurled at Greenspan since 2008. In Time Magazine’s list of the “Top 10 Collapses of
2008,” Greenspan’s reputation was number nine, and the only entry on the list that
referred to an individual (Iacono 2008). At the time the public did not think highly of the
newly retired Fed chair, but much of the criticism he faced, and continues to face, are
vast generalizations that have little validity. In an article titled “Alan Greenspan, Meet
Reality (Part II),” Michael Hurd condemns Greenspan for not being an advocate of the
free market since his early years with Ayn Rand (Hurd 2009). As previously discussed,
Greenspan was without a doubt an advocate of the free market while at the Fed, and
others have found great fault with him because of it. Hurd also fails to realize that in
many ways Greenspan has been forced to change, or at least adjust, his opinions on free
market ideals to defend the little respect he has left.
Attempting to point out inconsistencies with Greenspan’s ideology that do not
exist seems to be a popular way of attacking him. In a piece that classifies Greenspan as a
“Party Boy,” Fred Sheehan tries to make the point that Greenspan should no longer
appear on television because he is always wrong, and cites that he once said, “I don’t
think [home prices will] decline from here. In other words, they seem to be bottoming
out” and “The recession is over” (Sheehan 2010) on the same day in February 2010 as
proof that Greenspan is somehow crazy. Perhaps Sheehan believes that if we are not in a
recession we should be having double-digit growth in GDP, or some other strange
definition but realistically house prices bottoming out was a good sign that the end of the
recession was near. Greenspan’s argument is further supported by that fact that in
September of 2010, seven months after Greenspan’s comments, the Center for Business
and Economic Research announced that the recession officially ended in mid-2009
(NBER 2010), just about a year before his comments. Sheehan was wrong in his
accusations of Greenspan, and Greenspan was in fact correct in making these statements.
In a blatantly standoffish manner, Greenspan was called to testify before the
Committee of Government Oversight and Reform on October 23, 2008 to justify the
actions he took as Chairman of the Fed. He was essentially cornered into admitting that
he was wrong, becoming the scapegoat for the recession. Analysis of his testimony
allows reveals that Greenspan truly did not see the crisis coming. He said, “those of us
who have looked to the self-interest of lending institutions to protect shareholder’s equity
(myself especially) are in a state of shocked disbelief” (Greenspan 2). Next, he went on to
claim, rightfully so, that what precipitated the crisis was risk management models that relied
only on data from the past two decades (Greenspan 3). While he may have promoted the
legalization of such models, he was not the person designing them, nor the person incorrectly
using them and their predictions. Therefore, he should have no sense of obligation in regards
to their place in causing the crisis.
Interest rates played an important role in the subprime mortgage aspect of the
recession, and because everyone knows of the connection between interest rates and the Fed,
fingers were quickly pointed at Greenspan. The flaw here is that while the Fed controls the
federal funds rate, they cannot fix the rates offered to consumers, or more specifically
homeowners. The rate of long-term mortgages is obviously extremely relevant to the
2008 subprime crisis, but because he was removed from that portion of interest rate
determination, Greenspan could not have drastically changed the situation. In his
personal rebuttal of this issue, he stated, “No one, to my knowledge, employs overnight
interest rates such as the fed-funds rate to determine the capitalization rate of real estate”
(Greenspan WSJ). Yet again it becomes clear how unfair it is to claim that the actions of
the Fed and Greenspan caused the crisis.
While Chairman of the Federal Reserve, Alan Greenspan was praised as an
economic genius and congratulated for instituting policies that helped ensure an extended
period of economic growth for the United States. His fall from grace has not been
pleasant, and in the eyes of many he quickly went from being an icon to a villain. With
the length and scope of the 2008 subprime crisis, there is plenty of blame to be placed.
Politicians, businessmen/women, and economists are all at fault on some level.
Greenspan is no different, and he can be faulted for his disaster myopia. However, as we
have seen, much of the criticism he has faced is unfounded and nonsensical. He may not
be the prophet-like ruler of the US economy we once thought he was, but he is still a
great economist and should be respected as such.
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