Must-Read: Ben Bernanke: Sebastian Mallaby’s Biography of Alan Greenspan

Must-Read: Ben has this right of it here.

Mallaby appears to have forgotten what 2003-2005 was like, and has been cherry-picking from the record of those years:

Ben Bernanke: Sebastian Mallaby’s Biography of Alan Greenspan: “Mallaby’s argument that Greenspan should have known that a tighter monetary policy was appropriate in 2004-2005 (if that was in fact the case!) strains credulity…

…In 2003 the Fed was navigating a deflation scare and a jobless recovery from the 2001 recession—no net payroll jobs were created in the U.S. economy over 2003—which had led the Federal Open Market Committee to cut the fed funds rate to a record-low 1 percent. The FOMC did not stay at that level for long, however; Greenspan began to prepare the ground for a rate increase in January 2004….

As Brad DeLong has pointed out, citing the FOMC transcript, at that point Greenspan was far from certain that the rise in housing prices was a nationwide bubble or that it could pose a threat to financial stability. Indeed, much of the increase in housing prices was still to come: According to the Case-Shiller 20-city index, house prices, which had risen 12 percent in 2003, would rise an additional 16 percent in 2004 and 15 percent in 2005 before peaking in early 2006. After Greenspan’s signaling, the Fed began a well-anticipated rate-hiking campaign in June 2004, at which point the unemployment rate was still 5.6 percent. The FOMC would go on to raise the federal funds rate at seventeen consecutive meetings.

With that background, how much credence should we give to Mallaby’s argument that Greenspan’s personality – the product of an absent, “pale” father and the presence of a “vivid” mother – was the basis of his monetary policy choices? It seems awfully implausible to me. People in Greenspan’s position (I can say, with some authority) put great weight on their reputation and legacy—how they will be regarded even after they leave office. Mallaby’s assessment of Greenspan rests on his contention that relatively modest changes in monetary policy, notably in 2004-2005, would have significantly reduced the risks of a destructive financial crisis, doing so without significant macroeconomic side effects in the near term, and that Greenspan should have recognized that….

The reason that Greenspan took the monetary actions he did, I am sure, is because at the time he thought they were the best policy. He was far from sure that the increase in house prices posed a danger that could not be managed; he would have been skeptical about the Fed’s ability to pop a bubble, at least not without large collateral damage; and he surely did not anticipate that losses in mortgage markets would touch off a global liquidity panic, which arguably made the crisis and its economic effects much worse….

The tightening cycle that began in June 2004 was arguably the most aggressive of any since the early 1980s. Perhaps Greenspan and the FOMC should have tightened even more quickly—we are still debating the issue, more than a decade later—but the fact that the pace of rate hikes in 2004-2005 was not sufficient to stop house price increases does not fit well with the view that minor tweaks in monetary policy would have done the job.

I find Mallaby’s psychological hypothesis puzzling, not only because it is at best weakly supported, but also on Occam’s Razor grounds—it’s not necessary to explain Greenspan’s policy choices. Indeed, The Man Who Knew provides us, in its narrative, a much better motivation for Greenspan’s approach—namely, his experience, as Fed chairman, in dealing with periods of financial instability…. Greenspan responded to each episode of instability during his chairmanship—the 1987 crash, the 1990s credit crunch, the Asian crisis, the collapse of Long-Term Capital Management, the Russian default, the tech bubble—either through direct measures (such as standing ready to lend through the discount window following the 1987 stock crash, or the negotiations that saved LTCM in 1998) or through monetary policy responses after the fact. Greenspan would have seen all these episodes as successful, in that none involved serious damage to the broader economy…. The factors that would make the 2007 crisis so unprecedentedly catastrophic, including the collapse of key funding and securitization markets, were not foreseen.

As Mallaby shows, Greenspan believed that financial instability poses significant risks…. But… in 2004-2005, he had every reason to think that targeted measures or after-the-fact monetary responses could limit the consequences of financial stresses on the broader economy. That Greenspan’s policies were conditioned by his experiences in coping with financial instability as Fed chairman seems the right conclusion…