The credit crisis must be endangering the Maestro's legacy. How else to explain Alan Greenspan's defensive analysis of how the markets went awry in "The Roots of the Mortgage Crisis," published in Wednesday's Wall Street Journal.
As Greenspan sees it, the Fed's post-dot-com crash easy-money policy is not to blame for the unsustainable housing boom and subsequent bust. Rather, the real culprit was the end of the Cold War and the victory of American-style market capitalism across the globe, (what Martin Wolf calls the "Anglo-Saxon model of capitalism").
As with all good cover stories, there's a kernel of truth in this one. The collapse of the Soviet Union and concurrent opening up to world trade of China and India resulted in the incorporation of billions of new workers into global labor markets, marking a profound change in the dynamics of the global economy. That is indisputable.
Greenspan is not alone in believing that one result of this epochal change was to keep inflation in check throughout the world, and thus exert downward pressure on longterm interest rates.
The surge in competitive, low-priced exports from developing countries, especially those to Europe and the U.S., flattened labor compensation in developed countries, and reduced the rate of inflation expectations throughout the world, including those inflation expectations embedded in global long-term interest rates.
The Fed was correct, says Greenspan, to lower interest rates all the way down to 1 percent in 2003 in an effort to avoid a major recession, but the real surprise came when the Fed started to move short term rates back up.
In mid-2004, as the economy firmed, the Federal Reserve started to reverse the easy monetary policy. I had expected, as a bonus, a consequent increase in long-term interest rates, which might have helped to dampen the then mounting U.S. housing price surge. It did not happen. We had presumed long-term rates, including mortgage rates, would rise, as had been the case at the beginnings of five previous monetary policy tightening episodes, dating back to 1980. But after an initial surge in the spring of 2004, long-term rates fell back and, despite progressive Federal Reserve tightening through 2005, long-term rates barely moved.
In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities.
It makes for a nice story. Capitalism triumphed all over the world, and then proceeded to eat itself. And the U.S. is no longer the supreme arbiter of its own fate -- it is now just another pawn moved about by far greater forces. And thus, Fed policy can't be blamed for inciting the current turmoil.
I do not doubt that a low U.S. federal-funds rate in response to the dot-com crash, and especially the 1% rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in U.S. home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.
There's a part that Greenspan is leaving out, however: his own role as a cheerleader for ARMs. In a speech to the Credit Union National Conference in February 2004, he lavished praise on adjustable rate mortgages, and in effect told American consumers that they were being financially imprudent by not signing on the ARM dotted line.
The relevant section is worth quoting in full: ( italics are mine)
One way homeowners attempt to manage their payment risk is to use fixed-rate mortgages, which typically allow homeowners to prepay their debt when interest rates fall but do not involve an increase in payments when interest rates rise. Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the "option adjusted spread" on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.
American homeowners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.
American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.
It would be silly to suggest that your average American would-be homeowner was paying such close attention to the Federal Reserve chairman's daily utterances that the day after his ringing endorsement of "mortgage product alternatives," they charged down en masse to the nearest broker and demanded a no-money-down Option ARM. But as a signal to those who do pay attention to every breath taken by the Fed chair -- Wall Street money men -- the message was loud and clear; it was the starting gun for the Indianapolis Exotic Mortgage 500.
In the larger scheme of things, the praise for ARMs is small beans compared to Greenspan's support of the proliferation of complex structured financial products, which were supposed to stabilize the world's financial system by widely dispersing risk. That hasn't worked out too well either.
Greenspan is doing a lot of wriggling, but the longer the current crisis lasts and the deeper the damage wrought, the harder it will be for him to get off the hook. He was there at the creation, his rhetoric supported it, and he did nothing whatsoever to stop it.