Is Greenspan Guilty?

04/10/2008 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

Will the court please come to order?

On the docket today: the people vs. Alan Greenspan. The former Federal Reserve chairman stands charged with crimes against the economy.

How do you plead, sir? Not guilty on all counts.

As the credit crunch grinds on, as mortgage delinquencies and foreclosures mount and we appear to be entering a recession, pundits, politicians, and the public have all looked for someone to blame. They seem to have found him in the once-revered ex-Fed chairman.

From sneering Joe Kernan on CNBC to permabear William Fleckenstein on MSN Money to even Greenspan's august predecessor Paul Volcker in a recent address in New York, the consensus seems to be that the Fed under Greenspan cut interest rates too low and kept them down too long early in the decade, and that it failed to curb subprime lending's excesses, leading to the current crisis.

Greenspan has mounted a spirited defense. In commentary in Monday's Financial Times and in extended interviews with the Wall Street Journal's Greg Ip and CNBC's Maria Bartiromo and Steve Liesman, the retired Fed chairman repeatedly has claimed he made the best decisions he could given what he knew at the time-and he wouldn't do much differently.

So, who's right? And if Greenspan isn't to blame, who is? We'll get to the verdict later, but first let the two sides present their cases.

Greenspan's critics claim that the Federal Open Market Committee cut the federal funds rate far too much early in the decade-from a target rate of 6.5% in January 2001 to a Japan-like rock-bottom low of 1% in June 2003. That, they argue, created artificially low interest rates that flooded the system with liquidity, encouraged financial speculation, and led to the housing bubble whose unwinding continues to this day.

They also argue that Greenspan and Co. waited too long to raise rates again while the housing bubble was forming. The FOMC raised short-term rates from 1% in June 2004 to 5.25% in June 2006, where they remained until Greenspan's successor, Ben Bernanke, began cutting them last year.

They maintain that the Fed did not use its oversight powers to halt subprime lenders' most egregious practices. Greenspan, they contend, should have focused more on the problem, saving a lot of homebuyers from much pain-and protecting the financial system, too.

Greenspan responds that the Fed acted wisely by cutting rates in 2001 and continuing to cut into 2004.  The country was struggling to emerge from a recession and bear market, and inflation continued to fall. He argues that housing prices were rising globally because of a decades-long decline in long-term interest rates-which the Fed doesn't control-and the US wasn't even the most overheated real estate market.

On regulatory oversight, Greenspan claims the issues of subprime mortgages and predatory lending barely came up during his tenure and that a supposed run-in with former Fed governor Lyle Gramlich on the subject was much exaggerated. At any rate, he argues, there's a limit to what regulators can do in a free-market economy, anyway, and people have to be realistic about it.

My own take: It's hard to fault the Fed's interest rate policies from 2001 to 2004. At the time, many so-called seers were demanding even more aggressive rate cuts. The central bank started cutting only when it was clear the broader economy was being hurt by the unfolding bust. September 11th, the Enron and WorldCom scandals, and a grinding bear market that didn't really end until March 2003 only underscored the tenuous nature of the recovery.

In fact, there was much speculation about price deflation. "During that cycle, the FOMC faced a worrisome trend of disinflation, a trend that if left unchecked might have brought the economy close to the zone of falling prices, or deflation," said one prominent economist.

Who was that? None other than Ben Bernanke himself, in a speech in Seattle in May 2004.

And the US recession, though technically moderate, coincided with the rise of India and China and much worry about the outsourcing of American jobs. Talk of a "jobless recovery" persisted into the 2004 presidential campaign, during which employment began to pick up-and the Fed started raising rates again.
I'm also not persuaded that the low rates of 2001 to 2004 were largely responsible for the subprime-mortgage catastrophe. True, lower short-term rates mean lower adjustable-rate mortgages, but the Fed's rate increases in 2004 already began to make ARMs more expensive

According to the Center for Responsible Lending, an advocacy group, subprime mortgage loans comprised only 8% of all mortgage originations in 2003. That had ballooned to 28% in 2006. By that time the Fed had finished its rate hikes. It's hard to blame the Fed for uneconomic subprime mortgages issued by unscrupulous and maybe criminal lenders.

Martin Wolf, the FT's erudite economics columnist, also argues that housing valuations rose even more dramatically in countries like Ireland, Spain, and Australia than they did in the US, despite widely varying interest rate policies by those countries' central banks.

Of course, lower US rates did help world economies boom earlier this decade and contributed to the liquidity that fed the housing bubble. But there was plenty of money left over from the economic growth and bull market of 1982-2000. Many institutions and wealthy individuals poured that money into hedge funds, private equity firms, and other vehicles that reinvested it widely.

And Greenspan himself persuasively argues in his book, The Age of Turbulence, that burgeoning growth from emerging economies also added substantially to the world's wealth and liquidity this decade.

On the other charge-Greenspan's unwillingness to regulate subprime lending-the evidence is more ambiguous. The Fed may have the technical authority to oversee mortgage lending, but it's awfully far from its traditionally purview, regulating commercial banks. Roughly half of all subprime loans were made by lenders not affiliated with banks.

As Greenspan wrote in the FT, "Regulators confronting real-time uncertainties have rarely, if ever, been able to achieve the level of future clarity required to act preemptively." That's technically accurate, but I wonder if it isn't begging the question: We've seen too many instances in recent years when regulators didn't see what was coming, and so they didn't act. Lack of awareness is no excuse for lack of foresight-although to be fair, when Greenspan ran the Fed, very, very few people anticipated how big this mess would get.

So, ladies and gentlemen of the jury, what's the verdict?

On the charge of keeping interest rates down for too long, not guilty. On the charge of not anticipating the subprime problems, a misdemeanor and a fine: Greenspan should donate some of the proceeds from his book sales to a charity helping homeless victims of the subprime debacle. The defendant has already worked out a plea deal on his many early claims there was no housing bubble; he now admits he was wrong.

But that leaves the question of who should be charged, and in his FT article Greenspan was quite explicit: "The core of the subprime problem lies with the misjudgments of the investment community." In other words, Wall Street.

I heartily agree. As in that infamous trial of the mid-1990s, the "real killers" are still at large.

Howard R. Gold is executive editor of The opinions expressed here are his own and do not necessarily reflect the views of InterShow.

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