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Wednesday, June 29, 2011

Charlie Rose talks to Alan Greenspan

Charlie Rose:  Do you think any of the decisions you made as Chairman of the Federal Reserve contributed to the financial crisis?
Alan Greenspan:  The '08 crisis? The answer is no. And I wrote a long part of a paper for the Brookings Institution (on this).  If anybody wants to take the paper and tell me where I am wrong. I will listen.
Source: Bloomberg Businessweek, June 27 - July 3, 2011

This was the last question in the interview. It should have been the first. It could have been followed up with: "does controlling prices distort resource allocation?"  The answer is yes - this is Econ 101 week 1, typically demonstrated with an analysis of the minimum wage (causes unemployment among the unskilled) and rent control (see any major long-term rent controlled area in any major city to see the impact).

The follow-up question would be "is the fed funds rate a price?" The obvious answer that even a professional obfuscator on the order of Alan Greenspan couldn't get around is "yes; it is, in fact, the most important price in the economy."  The fed funds rate affects the price of short-term money across the spectrum and even the price of long-term money. That's one reason why it is a 3-ring circus day on CNBC whenever there is a meeting of the Federal Open Market Committee. Interest rates are the link between now and the future. As such, they directly affect the price of housing, automobiles, and even every day purchases in a credit economy.

What decision did Greenspan (and Bernanke) make that not only contributed, but in fact caused, the '08 crisis? They pushed the fed funds rate to 1% in 2003 at a time when the housing market as well as the automobile markets were strong and unemployment was at a level we would kill for today.  They saw deflation lurking in the bushes and around corners and in the shadows. The imaginary deflation they perceived led them to pour gasoline on a roaring fire that raged out of control.

The problem isn't just with this particular time frame, although it is vital to understand exactly what happened in '03 that led to '08. The problem is policy-making in general. Artificially controlling prices via policy actions, both fiscal and monetary, distorts resource allocation. By sharply lowering the price of short-term money, Greenspan and Bernanke pushed the labor force into becoming carpenters, construction laborers, mortgage bankers, and, yes, even securitizers of toxic debt. These are the real effects of artificially manipulating the price of money.  Today many of these workers are superfluous given the ensuing collapse, and Bernanke and Obama wring their hands and wonder why unemployment stays stubbornly high. They don't get that you can't turn a carpenter or construction worker into a health care professional all that easily. It's not just a matter of manipulating prices.

This whole idea of how policy has real effects is apparently beyond the understanding of Congress and many in the press, so maybe a straightforward analogy would be instructive. Imagine (if any members of Congress are reading this please inform them that this is merely a thought exercise and is in no way a proposal!) if we convened a committee of smart economists (hopefully not too much of an oxymoron) to set the price of gasoline on the basis of their macroeconomic forecast.  If they saw a weakening economy, they would set the price at $2 gallon or lower. This would get consumers to drive more, take vacations, provide greater spending power, etc.  Alternatively, if the economy is overheating, the price of gasoline can be raised.

Now imagine our committee of smart economists forecast an economy so weak that they push the price of gasoline down to $.50/ gallon.

This basically is what the Greenspan/Bernanke Fed did in '08 with the price of money. For gasoline, driving the price to $ .50/gal. would have all kinds of unintended consequences - from leading to used car dealers pushing lemons, to gridlock on major roads increasing, to pollution levels rising, etc.  In the end, the policy makers a la Greenspan/Bernanke would come up with all kinds of convoluted reasoning why driving the price of gasoline to below market levels didn't cause the observed effects.

It is clear that Greenspan will never admit his role in the '08 crisis. This is understandable. Fed Chairman are not known for small egos. Still, it is critically important for Congress et al., if they are at all interested (and this is a legitimate question) in preventing the ongoing cycle of financial crises, to get a full understanding of the causes of '08.

For those interested in an econometric take on the period, an excellent book is

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