Which Way’s Up?

 

 

 

The ordeal of fixing the current financial crisis has fallen on President Obama.  He asked for it, he got it, and he will be judged by the results of his solution.

For those no longer in power (Bush, the Republican Congress, laissez-faire economics, conservative ideas in general, and Alan Greenspan) it has become a matter of survival to avoid blame.  Solutions are not their problem.  Dodging blame splatter is their first and most important concern.  Those that make it through to 2010 without much of a blame stain on their shirts will be well situated to point at the other side of the aisle with disgust at their inability to fix this mess (if it is not fixed by then).  If it is fixed, then at the very least they can claim to have been a part of the correction process.

Mark my words, if this is not fixed they’ll rail against the Democrats (obviously), if it is fixed they will claim to have “helped.”

This is true of politicians, but not Alan Greenspan.  He is covering his ass because he has a memoir to pimp and he doesn’t want “global financial meltdown” on his resume.  So what follows is a genuine attempt to cleanse his name and his conscious.  The following is from his Wall Street Journal Op-Ed and a translation: 

We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.

And my book sales.

There are at least two broad and competing explanations of the origins of this crisis. The first is that the “easy money” policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess.

Also know as the “it was Alan’s fault” explanation.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages.

That’s right “easy money,” lead to people speculating on mortgages using debt.  And by people I mean huge financial institutions.  But that speculation lead to a bubble in the housing market not the fed funds rate.  The fed funds rate led to people speculating.  See? 

Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

See.  Speculation was the cause, not the fed funds rate, which caused speculation.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates — such as the fed-funds rate — to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

Plus holding the fed funds rate low in a growing economy lead to banks being flush with “easy money” and therefore itching to invest it on something.  It just so happened that this time the thing they wanted to invest in was real estate.  

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier — in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

I didn’t create the securitization of mortgages, but I did put in place the mise-en-scène that made it look like the right thing to do.  

U.S. mortgage rates’ linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

I didn’t realize the dramatic change in the mortgage market and just let this thing ballon out of control.

As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

So that’s why I left fed rates so low.  In order to make the long term debt of the U.S. a much less attractive investment thereby forcing all that excess savings into a speculative bubble.  

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.) By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits — I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.

You idiots!  It’s just not my fault!  I’m surrounded by idiots!

However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his “Taylor Rule,” “it would have prevented this housing boom and bust. “This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.

Alan can name a rule after himself too.  That doesn’t make it true.  

[Skipping ahead]

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have “prevented” the housing bubble. All things considered, I personally prefer Milton Friedman’s performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: “There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.”

John Taylor is also officially off the invite list for my next water park birthday and Milton Friedman can now bring a friend.  

How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.

The difference between a Nobel Prize and 5 billion kicks in the ass.  

If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.

It case you were wondering if I thought this was my fault . . . I don’t.

[Skipping a little more.]

It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

I don’t think God himself knows what the fuck these guys were selling.  

However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system’s precrisis success.

Yeah.  Remember just how BIG that bubble got.  That was all me.  

[Skip some more.]

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

Regulation is still evil.  Especially regulation of derivatives. Although we do need to put this one regulation back in place that I took down.

Which Way's Up? Politics Economic Meltdown, housing, Politics, Republicans, risk-free investments