Greenspan Shocked

In little more than two years Greenspan's legacy has been reevaluated. At hearings of the House Oversight Committee last week, he tried to save as much of his original reputation as possible. Chairman Henry Waxman set the tone by observing that the entire economy was paying the price for Greenspan's inattention to the risks in the subprime mortgage market.

Greenspan's defense reminded me of a famous scene in the movie Casablanca. The flawed, but ultimately heroic Captain Renault (played by Claude Rains) announces that Rick's was being shuttered until further notice. Asked why, Captain Renault stated (as he accepted his nightly winnings) that he was "shocked" to discover that gambling was going on. In a similar vein, Greenspan expressed to the House committee his "shocked disbelief" that risky lending had been going on during his tenure

The Maestro

As Fed chairman, Greenspan was the architect -- the "maestro" -- of a low-interest policy that flooded the economy with cheap credit after the collapse of the dot-com bubble in 2000-01. Real (inflation-adjusted) short-term interest rates were negative for several years. Risk premiums were driven down to historic lows, indeed they all but disappeared. These were the elements making for a classic asset bubble. As economic historian Gary Gorton recently noted (in his paper, "The Panic of 2007"), the whole subprime house of cards would have tumbled down if housing prices had simply stopped rising, much less begun falling. They stopped rising and then began falling in 2007 and into 2008.

Economists have been observing and analyzing asset bubbles for centuries. Adam Smith talked about the South Sea company (and its bubble) in The Wealth of Nations. The effects of credit policy, first of ease then restriction, were well-analyzed by nineteenth-century economists. And in the twentieth century booms and busts were the central focus of business-cycle theorists. These included such figures as the British economist J.M. Keynes and the Austrian economists Ludwig von Mises and Friedrich A. Hayek. Mises and Hayek in particular linked the development of asset bubbles to easy-credit policies of central banks. Later entire schools of economics, Keynesian, Monetarist, etc., wrote on the topic.

The elements of a classic bubble should not have eluded the Fed chairman. The Fed sets the Fed Funds rate, the rate at which banks lend to each other. That rate greatly influences other short-term lending rates. For three years, the Fed Funds rate was at or below 2 percent. For one year in that period the rate was 1 percent. That cheap-money policy fostered the leveraged borrowing and risk-taking that characterized the subprime mortgage market. Elsewhere I have called this "casino capitalism."

In an October 18 interview with The Wall Street Journal, Anna Schwartz, the eminent economic historian (and coauthor with Milton Friedman of the Monetary History of the United States), observed that asset bubbles -- "manias," as she calls them -- always have the same cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset." In the dot-com bubble it was equity shares of high-tech start-up companies. In recent years it has been residential real estate. The asset may change, but not the cause -- monetary policy.

Why do central bankers repeat the same mistakes over and over again? Dr. Schwartz has the answer: "In general, it’s easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well." I guess we could call this "feel good" monetary policy.

The Will of Congress

How did Greenspan answer the question of why he had been so accommodative, so loose? He told us he was merely following orders. He testified that he had been complying with "the will of Congress." He had done "what I was supposed to do, not what I’d like to do." This is followership, not leadership. It’s also just not so. Under Article I, Section 8, of the U.S. Constitution, Congress has the power "to coin money, regulate the Value thereof, and of foreign coin, and fix the Standard of Weights and Measures." Though at times controversial, courts have endorsed Congress's power under that clause to create a central bank and delegate to it the conduct of monetary policy. The Fed was designed and structured to have operational independence. While the seven governors are political appointments, the presidents of the 12 reserve banks are not. And the Fed has been self-financing and needed no appropriation from Congress. That design has maintained its operational independence.

The House hearing should have focused not on Greenspan's personal failings but on institutional failure. The Fed was created in 1913 to save the country from recurring financial panics. It was a bankers' bank that would provide liquidity to ordinary banks, so that credit squeezes would no longer bring economic activity to a halt. By the 1920s economists like Irving Fisher were arguing that central banks could manage money and keep its value more stable than did the gold standard. So the promise of central banking was stable prices and the end of panics and credit squeezes. The Fed got off to a rocky start. After World War I the economy was hit by the panic of 1920-21. By some measures it was the sharpest panic in U.S. history. The Great Depression followed, beginning in 1929 (full recovery from which did not occur until after World War II). Monetary policy was thought to have improved after the war. But then came the inflation of the late 1960s, 1970s, and into the 1980s. Some economists believed they detected a "Great Moderation" first in residential construction in the 1980s and later in real growth (GDP) and inflation. Every time observers thought central bankers had got it right, there was another mania, another panic, another recession.

Today, nearly 100 years after the founding of the Fed, we are in the midst of financial panic, experiencing a credit squeeze, and caught between inflationary and deflationary forces.

At some point even the most ardent supporters of central banks must question whether there is an institutional flaw in them. Some critics think the restoration of the gold standard would be the cure. Some think central banks themselves must be abolished. More of the same is unthinkable. Financial instability is, unjustly, undermining the case for free markets.

Show trials of principals like that of Alan Greenspan appeal to a sense of schadenfreude, but they are no substitute for some serious rethinking of our monetary institutions.