It has become commonplace to hear claims that Alan Greenspan actually caused the real estate "bubble" and subsequent credit crisis by reducing interest rates to 1%. The following article challenges that claim widely stated as fact but without a shred of evidence.

The American Industrial Revolution was one of the greatest examples of free market capitalism in world history. Yet, it was accompanied by the panics of 1814, 1819, 1837, 1857, 1873, and financial crisis of 1907. At that time there was no Federal Reserve to blame. Even on the gold standard, where money, credit, interest rates and inflation remained stable in this country for a century, we still had financial panics. Why?

The panics of the 19th century together with the 20th century panics like the stock market crash of 1987, the "Asian Contagion," the Long Term Capital debacle in the 1990's, and the dot com stock market crash of 2000 all have one thing in common: the business cycle. We've had more than two centuries of prosperity produced by the greatest economy mankind has ever known, and through it all, from the gold standard to the fiat standard, we have always had a business cycle that leads to panics, bubbles, booms, and busts.

It is fashionable to blame Alan Greenspan for the housing problems and credit crisis. The charge is that Greenspan took interest rates to an artificially low level that created wild speculation. On the face of it, the argument seems reasonable. After all, aren’t 1% interest rates, one of the lowest rates in modern history, artificial? Surely this unleashed waves of new home buyers and ignited artificial credit creation that couldn’t exist otherwise.

This is only an assertion however—not a complete argument. In science, statements of fact must not be contradicted by other evidence. To arrive at truth, one must eliminate all other possible explanations and all contradictions. Do that, and one has arrived at proof. I submit the following facts, which if just one were true would refute the contention that low interest rates were the cause of the housing boom and bust.

The facts are as follows:

1.) The fed funds rate was generally in line with the inflation rate.

The CPI actually fell by 4.47% in April of 2003. It then fell .65% in May, .65% in October, and 1.3% in November of that year. The fed lowered the funds rate to 1% in September of that year after the price level fell. This was the period when many economists were warning of a Japanese style deflation and recession occurring here. Inflation and the housing boom were the least of our problems. The Fed's job is to keep prices stable for the entire economy, not just a sector. Greenspan did that. He prevented a continuous deflation that may have otherwise taken hold. That is what he was mandated to do. It is not the Fed’s job to regulate the economy.

2.) The fed funds rate was generally in line with other market rates.

When the fed funds rate was lowered to 1%, the 3 month T bill was at .90%, which means the free market rate had already fallen dramatically before the Fed lowered its target rate. The 10 year bond was 4.15, also unusually low. There was nothing in the interest rate structure that indicated an easy monetary policy. All interest rates across the board were in simultaneous free fall due to the deflationary trend. This was also true worldwide as the long rate fell to the lowest worldwide rate on record.

3.) Money supply grew at normal historical levels during the period.

M1 declined 2.2% in 2001 then grew in 2002-2004 by 8.4%, 3%, and 6.4% respectively. The CPI grew by 2.9% in 2004, 3.4% in 05, and 2.5% in 06. Once again, we see no sign of artificial stimulation throughout the economy after the funds rate was dropped, except for the booming housing industry.

4.) The housing boom was worldwide.

At the time of our housing boom there were booms in 26 other countries, each with varying degrees of economic and monetary policies, all with much higher interest rates than the US. We were somewhere in the middle of the pack in terms of home price appreciation and duration. We were not the first to turn up or the last to turn down. Major housing booms occurred all over the world simultaneously. Obviously the worldwide housing boom transcended US interest rate policies.

5.) Japan had 1% rates for over a decade, yet not only was there no housing boom, there was a generalized deflation.

If low interest rates caused the housing boom, then why wasn't there a housing boom in Japan? During the Great Depression interest rates were 1% and deflation reigned for a decade—no housing boom. Is it possible that Alan Greenspan is responsible for keeping America out of a deflationary depression such as the US and Japan suffered through? I believe so, and I believe historians will argue the same years from now.

 6.) A 1% interest rate is not cheap when you have a 2% deflation rate.

If you are running at zero to 2% deflation rates, a 1% rate is a positive rate, which is to say it is a penalty rate. There are times when high nominal rates are lower than 1% rates. For example, in 1975 the CPI was 8%. But the Fed funds rate ran between 5 and 6% that year. This was a real negative interest rate. The prime rate was also negative at 7.5%. This is what real artificially low interest rates look like and the result was double digit inflation in the 70's. Greenspan only took the Fed funds rate negative temporarily in periods of extreme financial stress. But Greenspan also raised the discount rate for the first time in modern history to a penalty rate in the last years of his Chairmanship. It was Greenspan that took away the artificially low interest rate subsidy banks enjoyed for decades.

7.) Most mortgages around the world are tied to the Libor rate, which ranged between 4 and 5% during the boom years.

There was a greater housing boom in most of those countries than there was here in the United States at 1% rates. US 30 year fixed mortgage rates are tied to the 10 year bond rate—a rate the Fed had no control over. If you think otherwise, explain why nations that experience high interest rates don’t simply force them lower. Why? They can’t. The 10 year bond is set by investors throughout the world. The Fed can only influence short-term rates, like the prime rate. Zero percent teaser rates and artificially low adjustable rates which are what supposedly caused the real estate "bubble” are the domain of private lending institutions.

And while the fed does have a certain influence over the prime rate, it has no control over the lending practices that exist in financial institutions regardless of what the interest rates are. The Fed certainly has no control over fraud, abuse, false home appraisals, false mortgage ratings, the marketing of these loans, ignorance, or incompetence. The credit problems that have occurred are a private market creation. This happens from time to time as part of the business cycle. The resulting problems should be met with free market solutions wherever possible, and handcuffs wherever appropriate. Instead we looked for a scapegoat.

8.) Finally, during the Greenspan years, the price of gold, which is usually associated with cheap money and inflation, remained stable and even declined during most of his tenure.

Gold was 461 on August 11, 1987 when Greenspan took office and fell to about 250 during his term. Eighteen years later, the day he left office, it was 569. These prices are consistent with sound monetary policy. Also during his term the dollar hit modern day highs and its strength became a factor during his term. Deflation was an issue during his term, but never inflation. This also is consistent with sound monetary policy and inconsistent with alleged inflationary finance.

No matter who or how many say Greenspan set rates artificially low creating easy money, the housing bubble, and the subsequent credit crisis; they cannot get away from the evidence above. Every one of the points above contradicts these allegations. Greenspan was in line with all other market interest rates and the inflation rate, which is to say, he followed the market. If it was indeed low interest rates that caused the real estate boom and credit crisis, the market was the cause, not Alan Greenspan.

 

The Real Cause of the Real Estate and Credit Crises 

The cause of the real estate boom was a combination of irrational exuberance among investors and home buyers mixed with demographics. Baby boomers started positioning themselves for retirement and bought second homes throughout the world. The baby boom happened in every nation that fought in WWII. In addition to the 77 million boomers in the US, foreign boomers were also buying real estate around the world, a large part of why 26 other nations experienced real estate booms at that time.

The greatest appreciation of real estate occurred in vacation areas such as San Diego, Miami and Las Vegas. Very little, if any, appreciation occurred in Kansas, Nebraska, or Minnesota. This was also true in other countries where people wanted homes near their favorite mountains and beaches.

Investors, especially retirement focused boomers, had shifted away from a “risky” stock market due to the tech crash of 2000. They moved their investment money into "safe" real estate where prices were less likely to fall. Many home builders and professional investors soon became real estate speculators. The general population that actually needed to move to another home simply got caught up in the frenzy.

Years before when Greenspan was asked why we were not experiencing recessions as in the past, he answered, "To my knowledge, the business cycle has not been repealed." He was reminding us it’s when things look rosiest we should prepare to duck. But it is not the job of the Fed to prevent booms. Their job is to ensure a stable national price level, provide liquidity in times of financial stress, and act as a bank of last resort to protect against systemic failure.

The business cycle is a product of free markets. It's inherent in capitalism. Since markets are the reflection of all individual's values, emotions, perception, and expectations, it follows that these factors will always be in flux. It has been said that the stock market moves between greed and fear. Well, all markets do that. Markets act like a pendulum, and swing back and forth over long periods of time between complacency and optimism, exuberance and panic, and then after a long healing process they swing right back to comfortable complacency. This arises from human nature. The business cycle is as natural as the changing seasons.

The period we've just come out of is typical. We went from the pessimism created by the dot com crash (no one wanted to touch a stock out of fear), through a five year stagnant stock market (complacency), replaced by a period of real estate investment (optimism), and then just as you’d expect—we dove into real estate speculation (euphoria). Investors jumped from the stocks they’d just taken a beating in, to real estate, something that they "knew" could not go down in value.

Since default and bankruptcy rates were nil and investment gains were unusually high, lending and borrowing practices grew lax. The use of leverage increased and fraud and deception grew unchecked. In effect, good times begat bad times. Complacency led to stability, and because things were so good for so long, stability led to euphoria and, of course euphoria led to mal-investment, over-consumption, and the misallocation of resources. This kind of market behavior can be a product of government's ability to create artificial booms, but it can also result from human response to any kind of boom--real or not. Hence, the business cycles of the 19th and 20th centuries.

Add to this one more unusual factor. China and the other emerging markets were in their greatest period of growth in history. Wealth was being created at an unprecedented pace. As wealth increased, savings increased. This new supply of savings helped finance the world real estate boom. The money supply in the US was growing normally but the world money supply was exploding. Interest rates fell to their lowest level in history. This had nothing to do with Fed policy.

But the credit crisis in the US was unique and the cause was massive nationwide fraud, incompetence, and ignorance, combined with unprecedented leverage. Fraudulent mortgage underwriting by financial institutions and applicants, false appraisal values by appraisers, buyers en masse ignoring the terms of their adjustable rate contracts, and sellers enticing them with teaser rates and liar loans, all set the stage for systemic failure. But the death blow came from a recent marketing invention in the form of packaging sub-prime loans by banks and non bank institutions. In the past loans were made by the banks that kept the loan. But the packaging of loans became popular during the boom and soon prime loans were sold together with sub-prime and fraudulent loans. Normally the market would re-price suspect loans and they would be discounted to a price that would clear the market. But because they were bundled into a package and sold as AAA loans, they were not visible to the market.

In effect, there was no effective market to deal with bundles of loans. There was no way that the market could identify and price these suspect loans. The loans were not transparent. There was no way for the market to know how many bad loans there even were, or to what degree they should be discounted. The market hates uncertainty, and that’s what we got. The market for all mortgage backed securities dried up. What cannot be seen or defined cannot be dealt with. The credit markets froze. In a nutshell this is what caused the financial panic and contagion that ensued.

 For a more in depth explanation of what caused the crisis please see The Lesson of the Elephant in the Room. 

 

Greenspan the Gradualist

The Fed is charged with maintaining price stability and that it did during Greespan’s tenure. However, there is one charge against Alan Greenspan that may be true. It has been suggested that the Fed took too long raising interest rates--they should have moved faster in raising rates from 1% to the 5.25% that Greenspan eventually moved them to. Greenspan is a gradualist. He believes in allowing the markets to adjust gradually to monetary policy, hence, he raised the federal funds rate one quarter percent at each fed meeting.

It is possible that rates were kept lower than they would have been if they were free to float. It is possible that a free market in the fed funds would have led to a quicker return to the 5 percent range Greenspan eventually took the fed funds rate to. Yet, given the fact that almost all rates immediately turned down again and are back at the levels that prevailed during the Greenspan period, and less, only history will judge the merits of that argument.

Economics in general and monetary policy in particular are as much an art as a science. Gradualism may need to be debated. Floating fed funds rates may need to be debated. Terminating the Federal Reserve Board, and even the system, may need to be debated. Economic historians will eventually revue the Greenspan years and the causes and effects of monetary policy on the housing boom and the ensuing credit crisis. I believe the facts will show Alan Greenspan acted reasonably during his term and in the end preserved monetary stability while preventing a deflationary depression. I think history will look kindly on the Greenspan years.

And finally I want to defend Alan Greenspan's character. I challenge anyone to show me a more honest government official. Especially one with the power and influence Greenspan wielded. How many politicans other than Greenspan have stood before congress and said "I was wrong?" And he did so without having to be cross examined or pressured into taking responsibility for a mistake. Greenspan openly admitted anytime he was wrong and voluntarily offered his surprise and astonishment at events when they went differently than he expected. Ever the realist, Greenspan eloquently put it this way, "It is not to my interest to hold wrong ideas in my head as true when they're not."

Yet, this man of great integrity and honesty is accused of creating bubbles, manipulating the money supply, interest rates and the economy to the point of bringing America to its knees. All without a hint of remorse.

Why has Greespan become the nation’s wiping boy and scapegoat accused of being responsible for the greatest financial crisis of our times? I believe it’s because of his views on capitalism. He is for true free market capitalism, which means deregulation, monetary stability, and fiscal responsibility. Both the left and the right condemn him. The left accuses him of being an extremist for free markets and the right claims he violates them.

 I've presented my evidence here and Greenspan has presented his. He has publicly stated that he has gone back and re-checked the record and the actions he chose and see's nothing to support accusations against him. I concur. His critics will claim he is either stupid or dishonest. Perhaps it is the reverse, and his critics are either stupid or dishonest? You judge, but before you do, consider the opinion of Milton Friedman, the foremost authority on money supply, inflation, capitalism, and freedom:

 

Over the course of a long friendship, Alan Greenspan and I have generally found ourselves in accord on monetary theory and policy, with one major exception. I have long favored the use of strict rules to control the amount of money created. Alan says I am wrong and that discretion is preferable, indeed essential. Now that his 18-year stint as chairman of the Fed is finished, I must confess that his performance has persuaded me that he is right—in his own case. His performance has indeed been remarkable…There is no other period of comparable length in which the Federal Reserve System has performed so well…

 

Inflation averaged 3.7% per year from the end of World War II to the Volker era, but only 2.4% per year during the Greenspan era. Even more important, inflation was much less variable. ... greater price stability had far-reaching effects. By greatly reducing the uncertainties, enterprises could use their resources more efficiently and steadily. Price stability fostered innovation and supported a high level of productivity. ...

 

…It has long been an open question whether central banks have the technical ability to maintain stable prices. Their repeated failures to do so suggested that they did not -- whence, in part, my preference for rigid rules. Alan Greenspan's great achievement is to have demonstrated that it is possible to maintain stable prices. He has set a standard. Other central banks around the world, whether independently or by following his example, are following suit. The timeworn excuses for central bank failure to stem inflation will no longer do. They will have to put up or shut up. -Milton Friedman WSJ essay Jan 31, 2006

 P.S. It is now 2015 and interest rates are zero and have been for years, and yet, there is no real estate boom. We have had the longest period of slow growth in America's history with the lowest interest rates in American history. So, how does the theory that Alan Greenspan created a real estate boom look today to theorists?

I suggest in time Alan Greenspan's reputation will survive, and the theories that condemn him will not.

 Paul Nathan
Paulnathan.biz