Greenspan's "Smallish" Injection?

Many people argued that Alan Greenspan’s low-interest-rate policy after the dotcom bust and 9/11 attacks sowed the seeds for our current recession and the housing bubble. Robert Murphy, on the site, has also criticized the alternate theory that a foreign "savings glut" was the true culprit, rather than the Fed. In the article below, he explores "the Fed did it," theory and the claim that the facts just don’t add up.

One argument advanced in the attempted exoneration of Greenspan is that he didn’t really pump that much money into the credit markets. For example, popular blogger Megan McArdle writes,

"Both right wing Austrians and many liberals have a common theory of how all this happened: Alan Greenspan dunnit. The mechanisms by which he accomplished his foul task are different in the two cases, of course. Austrians, and many other free-market types, believe that by lowering short-term interest rates after 9/11, Alan Greenspan made the housing bubble, and its eventual bust, inevitable… Here’s the problem: if markets are so great, how come the entire system can be brought low by a smallish injection of short-term capital?"

Brad DeLong makes a similar claim in his critique of Larry White, whom DeLong praises as the "best of the Austrians." (DeLong does not tell us who the best-looking Austrian is, though I hope to at least be nominated.) DeLong writes,

"Moreover, I do not think that Larry White has gotten the part of the story that he does cover right…. From the start of 2002 to the start of 2006 the Federal Reserve bought $200 billion in Treasury bills for cash. This $200 billion reduction in outstanding bonds and increase in cash surely did lead to an increase in demand for private bonds. But recall the magnitudes here. We have $2 trillion of losses on $8 trillion in face value of mortgages that ex post should not have been made. Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans? Not likely. I can see how monetary contraction can make previously profitable loans unprofitable. But I see no way that this amount of monetary expansion can force private agents to make that amount of unprofitable loans. The magnitudes just do not match."

Similarly, David Henderson and Jeff Hummel write that monetary growth was tamed during the years of the housing boom, and so Greenspan can’t be the culprit:

"A better, although now unfashionable, way to judge monetary policy is to look at the monetary measures: MZM, M2, M1, and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20 percent to nearly 0 percent by 2006. During that same time, M2 growth fell from over 10 percent to around 2 percent and M1 growth fell from over 10 percent to negative rates. Admittedly the Fed’s control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base since 2001 fell from 10 percent to below 5 percent in 2006 and by June of 2008 was around 1.5 percent, despite Ben S. Bernanke’s alleged reflation. When all of these measures agree, it suggests that monetary policy was not all that expansionary during 2002 and 2003 under Greenspan, despite the low interest rates."

I realize that these disputes may just further convince some readers that economics is not a science but rather an ideological contest in which each side throws its own set of lying statistics at the other. But even so, I will now use the same underlying data as the writers above, to reach the opposite conclusion: Greenspan allowed the monetary base to grow quite rapidly precisely when the housing boom shifted into high gear, and precisely when interest rates collapsed.

Before proceeding, I want to remind readers that my story is the textbook explanation of how the Fed operates. It is the writers above who are downplaying the Fed’s ability to push down interest rates or to "stimulate" (however temporarily and artificially) the economy. During the boom years, Greenspan and his fans wanted to take credit for his "merciful" low rates which allowed the United States to avoid a painful recession, but now Greenspan and his defenders want to claim that he was an innocent bystander in the face of Asian thrift and shortsighted bankers. In any event, on to the data, this time presented by the "prosecution" as it were.

First, let’s take McArdle and DeLong’s discussion of the injection of base money, and how it was too insignificant to cause the effects we have seen. According to DeLong, there was a $200 billion injection through open-market operations, and yet we have to explain $2 trillion in losses. Well, my first thought is that – as DeLong no doubt teaches his principles-of-macro students – our fractional-reserve system has a built-in multiplier. In particular, if the required reserve ratio is 10 percent, then a given injection of new reserves (through Fed purchases of securities) allows up to a tenfold increase in the quantity of new money. So with that rule of thumb, a $200 billion injection would be expected to have an impact of … $2 trillion.

Now let me anticipate an obvious response from DeLong. He could say, "OK fine, but that still makes no sense. Why would expanding the quantity of money by $2 trillion lead private investors to make so many bad loans?" That’s a good question, but it’s different from the issue of magnitudes. Even if Greenspan flooded the economy with $100 trillion in new money, it doesn’t automatically follow that investors should make dumb lending decisions. My point here is simply that this alleged (by McArdle and DeLong) quantitative mismatch is in fact perfectly adequate; Greenspan injected a lot more than a "smallish" amount of short-term capital, once we recall the nature of our fractional-reserve system.

Now when it comes to Henderson and Hummel, look again at their actual quotation above: they are trying to prove that monetary expansion was nothing unusual in 2002 and 2003, and to do this they quote the starting and ending annual rates of expansion in 2001 and then in 2006. But this is a bit like saying Keanu Reeves in the movie Speed didn’t drive recklessly, because, after all, the bus’s velocity was lower when he got off than when he first got on. To know if Greenspan had a tight or loose monetary policy during 2002 and 2003, it’s not enough to know that the policy in 2006 (when the boom was winding down, after all!) was lower than in 2001.

For the following chart, I have taken the annual averages of the monetary-base series (as compiled by the St. Louis Fed), and plotted the growth rates:

There are a few interesting features of the above graph. First, note that the growth rate in 2002 (8.7%) was higher than in 2001 (5.6%). (Henderson and Hummel may have given the opposite impression, because of the units involved. The base bounced around like crazy because of huge injections and then drainages because of Y2K and 9/11.) Second, note that the base growth in 2002 was about as high as any year from the 1970s, except 1979 (when base growth was 9.2%). Everybody in this debate agrees that the 1970s were characterized by excessively loose monetary policy. It is hard to see then how Greenspan’s behavior during the serious onset of the housing boom can be described as moderate.

Before leaving this section, I should acknowledge that the graph above does seem puzzling in one respect: the growth in the base during the early 2000s is admittedly large by historical standards (even compared to the 1970s), but it is obviously not unprecedented. In particular, there were larger spikes during the 1980s and 1990s.

This is true, but I would remind the reader that there was a massive real-estate bust and stock-market crash in the 1980s as well, and of course the dot-com bubble in the late 1990s. The Austrians would blame those unfortunate events on the Fed (as well as other contributing causes) too.

The last claim we’ll analyze in this article is made by the excellent Chicago economist Casey Mulligan, who writes,

"Another version of the subsidy hypothesis says that public policy encouraged low mortgage rates, which raised housing prices. I believe that housing prices would not have gotten so high if mortgage rates had been higher, but low mortgage rates may not explain why 2006 housing prices were so high relative to housing prices in 2003 or 2008. 30-year fixed-mortgage rates were around six percent per year for most of the boom, and continue to be about six percent."

No one is denying that there must be some endogeneity to the explanation of the housing bubble; after all, the federal-funds rate right now is just as low as under Greenspan, and nobody expects a housing bubble to develop. But again, I think Mulligan’s breezy claims about mortgage rates might give the reader a false impression. He is making it sound as if mortgage rates really have nothing to do with the onset of the boom, because after all they "were around six percent for most of the boom." But in fact, the fall in mortgage rates fits in very well with the serious onset of the boom.

The following chart plots the 30-year conventional mortgage rate against year-over-year increases in the S&P/Case-Shiller Home Price Index:

Thirty-year mortgage rates plummeted from about 8.5% in mid-2000 to below 5.5% three years later. The connection certainly isn’t robotic, but this period also saw a spike in monetary base growth (thus leading us to suspect Greenspan’s influence, not just Asian savers) and the acceleration in the housing boom. On this last point, consider that mortgage rates dropped from about 7% down to about 5.5% from April 2002 to April 2003. Even with perfectly rational neoclassical consumers, that would be expected to raise home prices about 17%. And lo and behold, over this same period the home price index rose about 14.5%.

In a follow-up post in the same Cato Unbound symposium, Mulligan makes an odd claim in his disagreement with White:

"Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years. If so, he is on shaky ground. First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom. It’s not hard to find commentary from those years recognizing the low short-term rates were not expected to last."

Again, this is one of those casual claims in the debate over the housing bubble that is liable to mislead some readers. Check out the following chart of 30-year mortgage rates:

Some Austrians are concerned that empirical exercises such as I have performed above will fall into the mainstream habit of aping the physicists, rather than developing a priori theories. However, we all know what the logical, verbal arguments of Mises and Hayek are, regarding the boom-bust cycle caused by central banks. The critics are claiming that this story doesn’t fit the facts. Hence, the only way to respond is to argue that the Misesian theory really does fit the facts.

Despite claims to the contrary, it appears that Alan Greenspan’s ultralow interest rates – which went hand in hand with monetary growth rates comparable to those of the 1970s – were at the very least a large contributing factor to the housing boom. I feel confident in claiming that the housing boom would not have occurred if money and banking had been left in the hands of the private sector, as opposed to the state-organized cartel that we currently "enjoy."


Robert Murphy
for The Daily Reckoning
December 16, 2008

The above was taken from

Robert Murphy runs the blog Free Advice and is the author of The Politically Incorrect Guide to Capitalism.

Today could be a big day. The Fed could make history – cutting rates down to zero.

So far, the feds have tried trillions worth of stimulation techniques. But the economy seems strangely indifferent. Unresponsive. Frigid, even. Every week brings more evidence that the animal spirits that are supposed to make it frisky and full of life are completely missing.

More layoffs, more bankruptcies, more frauds, more incompetence, more bad news…day after day…

Yesterday, for example, the Dow lost 65 points. And it was reported that houses lost more than $2 trillion of value in ’08.

Today, the bad news keeps pouring in. The Commerce Department reported this morning that homebuilders slashed construction of new homes, pushing November housing starts far below the worst levels in 50 years.

What can the feds do? They’ve cut rates…they’ve bailed out…they’ve lent…they’ve bought…they’ve sent out checks. Altogether, the bill for all this stimulation is stretching up to $9 trillion. But so far, all this stimulus has gotten us nowhere.

But the feds aren’t going to give up. No siree. They have no other theory…no other idea…no other concept than those given to them by Keynes, Friedman and Gon Spend, Cut Rates, Print Money.

Today, the Fed will cut rates – maybe 50 basis points…maybe the whole enchilada…the entire 100 basis points they have left.

Yesterday, we urged you to sell the dollar. We hope you followed our advice. The dollar is falling. It’s at a 13-year low against the yen. And it fell to $1.36 against the euro yesterday. Against gold, it lost another $16, bringing the price of the yellow metal to $836…an 8-week high.

What a delight! Our Trade of the Decade is now in profit on both ends. ‘Sell stocks, buy gold’ has been our advice for the last eight years. This year, the ‘sell stocks’ half has done beautifully…but the ‘buy gold’ part looked a little tired. But lo and behold, cometh the Christmas season and Santa Claus comes around; gold begins to shine again. It is now UP for the year! Only about 1%…but at least it’s in positive territory.

What else is up for the year? We can’t think of anything. Once again, gold has come through. Ol’ reliable.

And today, the Fed only has 100 basis points left. It will probably cut half of them. But it might go for broke by cutting all hundred. Never before has it cut rates to zero, but heck…never before has it been confronted with a global depression.

This is not just a recession and a bear market, says Bill Gross, this is a "transgenerational" downturn. Gross manages the largest bond fund in the world, PIMCO. He believes stocks are well priced. Measured either by P/E or the Q Ratio (price compared to replacement costs) U.S. stocks are at a historic low, he says, "implying extreme undervaluation."

This is not normal. But then, neither is the circumstance. Government is muscling into the economy…pushing out private business. Government borrowing will take up almost all of the world’s savings next year. Next year will bring more regulation too. Cheap financing is gone…and the elites are turning against free-market capitalism and globalization. In this new world…government spending "crowds the private sector into an awkward and less productive corner," says Gross.

What is the appropriate level for stocks in this world, he wonders. Dow 5,000? He raises the question, but doesn’t answer it. So, we will answer it for him.

Yes, Dow 5000…it’s coming. And gold $2000.

*** Here at The Daily Reckoning we have a different theory entirely. It’s not our invention…but we like to take credit for it anyway. We saw the crisis coming not because we have better eyes, but because we are able to stand on the shoulders of giants: Adam Smith, Adam Ferguson, Jacques Rueff, Friedrich Hayek, Murray Rothbard, Josef Schumpeter and Kurt Richebächer. Not that we’ve done a thorough study of the field. It’s just that there is something so transparently superficial about the Keynesians and the Friedmanites…not to mention the Gonoists.

At the bottom of it, we don’t think the economy works like a machine. You can’t tinker with it to make it run better, in other words. You can’t turn a screw to eliminate mistakes. And you can’t trick consumers into thinking they have more money – at least, not without adverse and unexpected consequences.

No, in our mind, an economy is a living thing…organic…natural…subject to moral laws rather than mechanical rules. In our theory, people don’t get what they want or what they expect…they get what they’ve got coming. Sooner or later.

Of course, that’s why economists, government planners, and world improvers don’t much care for our pensee. The clumsy mechanics have their own jackass theories; they stick with them no matter how many times they prove not to work.

*** A remarkable issue of Newsweek offers advice to the President-Elect:

"How to Fix the World" promises the cover.

What makes the magazine remarkable is that it has managed to put between its covers more claptrap ideas and silly ‘blah, blah’ humbug than we ever seen assembled in one place.

Of course, you know what’s coming when you read the headline. If you’re going to "fix" the world, you must believe that there is something wrong with it…and that if the Obama Administration would listen to the editors of Newsweek, it would be improved. We know you can fix a fight…or fix an election…or even fix a flat tire. But whenever people want to fix the whole world, they are looking for trouble. What they really mean is "change" the world – bend it into a new shape, more to their own liking…but hideous to everyone else.

"The world needs smart management," say the editors. No kidding. That’s shows the height of bar Newsweek editors set for themselves. But what is "smart management?" And why should tomorrow’s managers be smarter than today’s?

And how is it possible to manage the world anyway? If the editors would only reflect for a minute they would realize that so far the "management" of the global economy has been disastrous. The last thing the world needs is more of it.

"Foreign policy requires adult supervision…" is another of the newspaper’s empty bon mots. Who do they have writing this stuff, we wondered? Tom Friedman maybe.

Then, in a piece entitled "How to save democracy" the authors suggest "technical assistance" and "training programs" setting "clear conditions" before the United States gives away any more money. They think that if foreign governments promise to work on "women’s rights" and "transparency," the world will be a better place.

Tom Friedman must have had a hand in this, we conclude. It is all so childishly simpleminded. ‘Democracy is a good thing,’ the editors must have said to themselves, ‘What can we do to get more of it?’

You see, dear reader, it’s the same kind of drivel that you find in economics. ‘Credit is a good thing; how can we get more?’ Or, ‘consumer spending makes the economy grow; how can we get consumers to spend more?’

The Newsweek team even offers to "fix Islam." Again, we didn’t know there was anything wrong with it. But here is where we begin to get in the spirit of this whole world-fixing scheme. It’s a shame they don’t turn their attention to Christianity. How could that be fixed, we wonder? For example, maybe the 10 Commandments could be lightened up, so as not to exclude so many people. How about just 8 Commandments…or 5…so they are easier to remember? Or, how about "Thou shalt not commit adultery very often?" Or, "thou shalt honor thy father and mother except when they are annoying?" See how easy it is to improve someone else’s religion? Maybe they could go right to the heart of the Christian dogma and improve "Love Thy Neighbor" to "Like thy Neighbor." That would make the whole thing a lot easier to live with, don’t you think?

Now that we’re in the mood to fix the planet, we will take up Newsweek’s next challenge with greater grace. Yes, dear reader, the magazine wants to fix relationships between men and women. They don’t seem to like it when women wear those black outfits that cover them from head to toe, for example.

Now here is where we can make common cause. We don’t like those black outfits either…except on women who look dreadful. But we don’t know which women look dreadful and which don’t, so we will make a suggestion; let’s fix this black bag thing with the following edict: women’s clothing should be inversely proportional to their age and beauty. The more young and attractive they are, the less they should wear. There…that should help!

And while we’re at it, we humbly and respectfully propose a simple code of ‘rights’ for women: women should be able to do anything men can do…only better. Except chew gum in public…we draw the line there. We hate to see a woman chewing gum…or swearing. Women should never swear; it makes them sound like low-bred washerwomen. Also, since we’re taking the initiative here, women should wear dresses. We know this will seem a bit retrograde, but sometimes you have to go back before you can go forward. We like to see women in dresses, and we are sure it will be a better world if women wore dresses…except, that is, for the women who wear black bags.

But we’re probably going a bit far afield from the world improvements the Newsweek team had in mind.

Let’s return to their agenda.

"Markets can’t rule themselves" says Joseph Stiglitz. We need "better regulation," he says. Now there’s a novel idea. The SEC was set up by the Roosevelt administration 70 years ago. They were actually watching over Bernie Madoff’s company…and actually did a review of it in 2005 and 2007. Somehow, these ace regulators didn’t notice the biggest Ponzi scheme in world history…a scheme approximately 5,000 times bigger than the scheme of the eponymous Ponzi himself.

Better regulation? We know how to get more regulation. But what we don’t know is how to get better regulation. We don’t even know what it means. There were thousands of regulators on the job in New York City. Not one of them seems to have caught on to any of the great scams that were going on. Even when they were so obvious even we poor scribblers here at The Daily Reckoning warned about them for years. We said sub-prime would be a disaster. We told the world that hedge funds were a rip-off. We whined about high executive salaries and bonuses. We explained how the profits going to the financial industry were an aberration. We laughed at the pretentious nonsense of the investment engineers, the pious complicity of the rating agencies, and the reckless greed of the mortgage lenders. Housing…finance…private equity…hedge funds…the dollar – what did we miss? And a subscription to The Daily Reckoning is free!

Newsweek presses onward in its delusions:

"More government is the solution" says Brazil’s President Lula da Silva. The solution to what? We would like to know what problem – that was not caused by government itself – has ever been solved by government. We can’t think of any. But so the magazine lurches on…from one bit of claptap to another…from mass delusion to popular fantasy…from farce to dada.

*** Poor George Bush. At a press conference in Iraq, a journalist called him a dog, in Arabic, and then threw his sized-10 shoe at the president. Dubyah ducked.

What’s wrong with America’s journalists, we wonder. Have they no shoes?

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning