Alan Greenspan Misjudged the Risks in the Mid-2000s; Alan Greenspan Was Not a Coward

The standard explanations I have heard for Alan Greenspan’s policy of “benign neglect” toward the mid-2000s housing bubble–why he turned down the advice of Ned Gramlich and others to use his regulatory and jawboning powers against it–see Greenspan as motivated by three considerations:

1. Least important: that he would take political heat if the Fed tried to get in the way of or even warned about willing borrowers and willing lenders contracting to buy houses and to take out and issue mortgages.

2. Less important: a Randite belief that it was not the Federal Reserve’s business to protect rich investors from the consequences of their own imprudent folly.

3. Of overwhelming importance: a belief that the Federal Reserve had the power and the tools to build firewalls to keep whatever disorder finance threw up from having serious consequences for the real economy of demand, production, and employment.

Back in the mid-2000s Greenspan had a strong case.

I certainly, bought it by and large. The Federal Reserve had, after all, managed to deal with the 1987 stock market crash, the 1991 S&L crash, the 1995 Mexican crash, the 1997 East Asian crisis, the 1998 dual bankruptcy of Russia and LTCM, the 2000 collapse of the dot-com bubble, and 9/11–plus assorted smaller financial disturbances. And it had dealt with them well.

Thus the interpretation of Alan Greenspan’s actions in the mid-2000s that I have always believed in is: he misjudged the risks, and unknowingly made bad calls.

Now comes Sebastian Mallaby with a different interpretation. Mallaby’s interpretation of Greenspan in the mid-2000s is: he understood the risks, but was too cowardly to do his proper job:

Sebastian Mallaby: The Doubts of Alan Greenspan:

Mr. Greenspan was not complacent about potential catastrophes lurking in balance sheets—he had worried about them for decades. Far from being ignorant of these issues, he was the man who knew….

In Jan. 2004, with house prices starting to look frothy, Mr. Greenspan repeated his warning, predicting a repeat of the tech bust. “It sounds as though we’re back in the late ’90s,” he worried to his colleagues. “The potential snap-back effects are large.” In short, Mr. Greenspan’s youthful fear of finance stayed with him throughout his Fed tenure. Long before the 2008 crisis, he had understood the lessons that were celebrated as new insights in the wake of the crash…

This seems to me to be simply wrong as an interpretation of the mid-2000s.

Here’s the context of the Greenspan quotes, from the January 28, 2004 FOMC meeting. Greenspan is building the case for removing from the FOMC post-meeting statement the phrase that it will wait a “considerable period” before it will start to raise the Fed Funds rate from its then-current level of 1%/year, and to replace that with a reference to “patience” before it will start to raise the Federal Funds rate.

Greenspan:

President Broaddus, did you have a question? Are there any other questions? If not, let me get started. I must say after listening to this roundtable discussion that I find it hard to recall a degree of buoyancy like the one that comes across today. Unless I’m mistaken, Committee members have not reported on indications of a more unequivocally benign and positive economic outlook in a number of years. It sounds as though we’re back in the late ’90s or perhaps early 2000. That, I suspect, is a reflection of what is going on in the economy. Indeed, on the basis of both the Beige Book and today’s roundtable discussion of regional developments, the data that will be forthcoming from official agencies, if my experience serves me well, are going to come in surprisingly on the upside. The outlook seems extraordinarily benign, and I’ll get to the reasons why that bothers me shortly.

Profits margins are high though they may have peaked and probably will be edging downward. At this stage the usual lag between productivity growth and its effects on real compensation is likely to result in increasing incomes and thus provide a fairly solid base for further growth in consumer spending as the impact of earlier tax cuts fades. The wealth effect, which has been a drag on spending for quite a long period of time, is now back to neutral or possibly has turned positive; and in my view, the consumer debt service burdens that one hears about from most of our private-sector colleagues are really being overstated. If we look, for example, at the debt service burden on home mortgages, we find that a very large number of homeowners have refinanced and have locked in a very low coupon rate on average. That suggests that most mortgage credit servicing payments are going to be relatively flat irrespective of what we do in the marketplace. And while we likely are looking at an increase in the consumer credit part of household indebtedness, it is mortgages, of course, that dominate the overall household sector debt.

On the business side it has already been mentioned that the financing gap has turned negative for the first time in quite a significant period, and we’re seeing the implications of an increase in cash flow on capital investment. We’re seeing it in the anecdotal information on capital appropriations and certainly in the new orders series, which are continually improving. Inventory investment has nowhere to go but up. The Institute of Supply Management reports that purchasing managers continue to view the inventories of their customers as exceptionally low. The implication is that new orders will strengthen, and we’re even hearing some discussions about a prospective pickup in commercial lending; that has not yet happened, but it would be another indication of a surge in inventory investment. The housing market is bound to soften at some point, but we’ve been saying that for quite a long period of time. In any event, it’s hard to imagine that housing activity will contribute very much in the way of strength to the expansion. Net exports will probably continue to be a small drag. Inflation clearly is stable.

I think the employment data are actually a good deal better than the latest payroll numbers suggest. If we look at the change in employment as the difference between gross hires less gross separations, the gross separation series as best we can judge is pretty much what we would expect given the GDP growth numbers that we have been looking at. Initial claims are down significantly as are job losses. What’s happening is that new hires are well below expectations in relation to economic growth, and I suspect that virtually all of that weakness is merely a mirror image of the increase in output per hour. Indeed, the question here is how much longer we can continue to get such rapid increases in output per hour. I do not deny that we may get additional quarters with 5 percent productivity growth rates, but if that goes on much longer, it will become historically unprecedented.

An economy characterized by cutting-edge technology such as in the United States does not seem capable of expanding much faster than 3 percent over the long run. Indeed, the level of intelligence is not high enough to foster appreciably faster growth over time. As I like to ask the question, why did it take so long to recognize the economic value of silicon among other things or to appreciate the desirability of reorganizing corporate structures the way businesses do now? Business firms could have done that fifty years ago, and they didn’t. The answer is that we’re just not smart enough. The reason that a lot of the emerging nations are able to sustain faster economic growth is that they are catching up. It’s not an intelligence issue. So there is something here that has to change, or we really are looking at a new trend in productivity that, as I see it, is remarkably fundamental. My impression of the employment data is that the probability of a significant upward revision in the December number or a pop in the January number is a good deal better than 50/50. And I would submit that, as of next week, we may—I say “may”—be looking at a somewhat different overall picture of the labor market.

The question that we have to ask ourselves is, What could go wrong with this extraordinary scenario, which the Board’s staff forecast extends through 2005? It involves the most extraordinary and benign economic performance that I have observed in my business lifetime. But then again all this involves a productivity world that I’ve never perceived or lived in, and it may be more real, if I may put it that way, than we imagine.

There are several developments, however, that I find worrisome. All have been mentioned in our discussion. The first is that yield spreads continue to fall. As yield spreads fall, we are in effect getting an incremental increase in risk-taking that is adding strength to the economic expansion. And when we get down to the rate levels at which everybody is reaching for yield, at some point the process stops and untoward things happen. The trouble is, we don’t know what will happen except that at these low rate levels there is a clear potential for huge declines in the prices of debt obligations such as Baa-rated or junk bonds. To put it another way, the potential snapback effects are large. We are always better off if equity premiums are moderate to slightly high or yields are moderate to slightly high because the vulnerability to substantial changes in market psychology is then obviously less. In my view we are vulnerable at this stage to fairly dramatic changes in psychology. We are undoubtedly pumping very considerable liquidity into the financial system. It is showing up in the Goldman Sachs and Citicorp indicators. We don’t see it in the money supply numbers or some other standard indicators. We’re seeing it in the asset-price structure. That structure is not yet at a point where “bubble” is the appropriate word to describe it, but asset pricing is getting to be very aggressive. I don’t know whether any of you have noticed that, while stock market prices have been rising persistently since March of last year, the rise in the last four or five weeks has been virtually straight up. That’s usually a sign that something is going to change and that the change is usually not terribly helpful.

I think we have to be wary of the possibility of a somewhat different outcome than is suggested by the model we may be looking at. The main issue here is what will happen in the event of a decline in the rate of growth in output per hour. In the context of the strength in aggregate demand that we are experiencing, we should get a big surge in employment. We should also get, as the staff forecast suggests, the first significant increases in unit labor costs. It is not price that we ought to be focusing on. It is not core PCE, although I think that’s ultimately where we’re going. The first signs of emerging trouble are likely to be in the form of increases in unit labor costs; and with profit margins currently at high levels, those increases may be absorbed for a while in weaker profit margins, which is probably not a bad forecast at this stage. But there is also a difficult question regarding what has caused the decline in inflation in recent years. It has been global and not confined to the United States, and it cannot simply be the consequence of monetary policy. I realize that a lot of people think that world monetary policy has suddenly gotten terrific and that it is the reason for the global decline in inflation. I’d love to believe that is true. I don’t believe it for four seconds. I think that what we’re looking at is, to an important extent, the consequence of a major move toward deregulation, the opening up of markets, and strong competitive forces driven in large part by technology. I don’t know how long this very significant downward pressure on prices is going to last. With regard to deregulation, I do know that the lowering of trade barriers is coming to a halt. All of the low- hanging fruit involved in trade negotiations has probably been picked, and we will be very fortunate if we can just stabilize the situation here without experiencing a rise in protectionism.

There has been a lot of discussion about the gap issue here, and I think for good reason as Ben Bernanke and Bill Poole have indicated. I might add that random walk does not mean that the inflation in 2004 is necessarily going to be the same as in 2003. That’s the expected value, but the outcome could very easily be 1½ points higher under foreseeable circumstances. What I think we have to ask ourselves is which of the various alternatives for policy can give us the most significant trouble if we are wrong. In that regard my judgment is that the expected value of inflation is in the area of its current level as far out as I can see. I also think that if we wanted to retain the “considerable period” language, we would be able to do that for a significant period of time. Indeed, I would guess that the most likely forecast of when we will have to move is not too far from when the futures market is currently anticipating that move will occur. We need to remember that we are talking very largely about a move in a tightening direction. There is a small probability that we might have to move rates lower should we suddenly run into some deflationary problems. That in my judgment is a very small probability, but it is not zero.

We are, therefore, essentially looking at the question of doing nothing or tightening. In that regard, the most costly mistake would be for us to be constrained by the “considerable period” phraseology at a time when inflationary pressures were building up fairly rapidly. If the probability that we will have to drop the “considerable period” reference is very high, which I think it is, it’s not clear to me what we gain by waiting. If, indeed, the economy is as buoyant as the discussion around this table has just described, then we are going to be pressed relatively quickly by market developments to start moving. In that event, the futures bulge now ten months out would very likely start to move closer in time. I don’t think that’s the most probable outcome, but it is a sufficiently large part of the probability tail to suggest to me that we ought to drop the “considerable period” language and adopt some reference to “patience.” The latter would in my view give us greater leeway to take action. We probably will also have to tack against the amount of liquidity that we’re pumping into the financial system. As Governor Gramlich rightly mentioned, it’s probably wise to call in the fire engines.

It’s one thing to look at the degree of liquidity after rates have been this low for this long and another to presume that the structure of the economy is going to stay this way if we continue to hold rates at this level for, say, another year and a half. So my view as far as policy is concerned is that it would not be a bad thing if we referred in some way to “patience” rather than to “considerable period” in our press statement and the markets responded in a negative way by moving up funds rate futures and long-term bond yields. Unless what I’ve heard this morning about business conditions and business sentiment is going to be dramatically reversed by the time of the next meeting, interest rates are too low. One may ask how that can be because a large number of market participants are aware of all these developments and in the past they presumably would have moved market rates higher by now. I would suggest that there is a very significant danger that they have listened to us! [Laughter] We have convinced them that the earlier simplistic view of our response to an upturn in economic growth and the associated risk of rising inflation does not apply under prevailing circumstances and will not lead us to tighten monetary policy in the near term. We have succeeded in demonstrating that such a view was now wrong. When we first argued that it was wrong, they didn’t believe us. We argued again, and they said, “Well, maybe.” We continued to argue that they were wrong, and they now believe us.

One implication in my judgment is that we can’t necessarily look, for example, at a chart showing the one-year maturity for the ten-year Treasury note nine years out, which is trading steadily at a little over 6 percent, and say that the market does not expect a rise in inflation. That may be what the numbers tell us. What I don’t know is whether that chart is based on market factors or whether I’m looking in a mirror. And I fear that it’s more the latter than the former. It is a terrific vote of confidence in the System or what Al Broaddus likes to call our credibility, but I’m not sure that we’re wise to sit here and allow that view to persist if indeed that is the case.

As a consequence and in line with our discussions at this and previous meetings regarding the desirability of taking gradual steps, I think today is the day we should adjust our press statement and move to a reference to “patience.” I think the downside risks to that change are small. I do think the market will react “negatively” as we used to say, but I’m not sure such a reaction would have negative implications, quite frankly. If we were to retain the “considerable period” wording, I would hate to find us in the position of seeing Citicorp’s forecast of a 300,000 increase in January employment number actually materialize in next week’s announcement. We would be in a very uncomfortable position. If we go to “patience,” we will have full flexibility to sit for a year or to move in a couple of months. I don’t think we’re going to want to do the latter, but I’d certainly like to be in that position should a rate increase become necessary. That’s my view. Who’d like to comment? Governor Kohn.

Greenspan doesn’t think the economy is in a bubble.

Greenspan is not sounding the alarm.

Greenspan does not even want to raise the Fed Funds rate above 1%/year. Greenspan wants “patience”.

Greenspan is painting a picture of an extraordinary “degree of buoyancy…. Committee members have not reported on indications of a more unequivocally benign and positive economic outlook in a number of years…” The “back in the late 90s” is not Greenspan saying “this is another bubble”–Greenspan says, explicitly, that “bubble” is “not yet… the appropriate word”. It is, rather, an assessment that the economy is currently performing well. After giving that assessment, Greenspan then segues to considering tail risks: saying “the outlook seems extraordinarily benign, and I’ll get to the reasons why that bothers me shortly”. That’s where the “snap-back” phrase comes from.

So Mallaby’s basic thesis–that Greenspan believed in January 2004 that the economy was in a dangerous bubble and on the edge of catastrophe–is directly falsified by a five-minute look at the document from which Mallaby got the two phrases he quotes.

Mallaby continues:

Of course, this begs a question: If Mr. Greenspan understood the danger of bubbles, why did he nonetheless permit them–even rationalizing his policy with a public insistence that the best way to deal with bubbles was to clean up after they burst?…

Since Greenspan did not understand the dangers in the mid-2000s, Mallaby is asking a false question. He then gives an answer to his false question, and it is an answer that would be greatly to Greenspan’s discredit, were it to be true:

Most of the explanation lies in the political environment…. Greenspan was a hardened Washington veteran… calculated that acting forcefully against bubbles would lead only to frustration and hostile political scrutiny. And his caution was vindicated. When he did try to rein in risk-taking—calling, for example, for restraints on the government-sponsored housing lenders—he felt the heat. The housing-industrial complex denounced him for failing to understand mortgage finance and ran devastating TV ads to deter members of Congress from supporting Mr. Greenspan’s calls for regulatory intervention.

As Mallaby paints the picture, Greenspan didn’t do what he clearly knew to be his clear job. Why not? Because he “felt the heat”. Because he was “denounced for failing to understand mortgage finance”. Plus there were those “devastating TV ads”!

All this is to set up Mallaby’s conclusion as to who are the real culprits here:

It is too easy, and too comforting, to blame Alan Greenspan’s supposed intellectual errors for the 2008 crisis…. The origins of the crisis lay not in the maestro’s failure of understanding–which would be easy to correct. Rather, it lay in the failure of our politics. Who in this electoral season would bet that we are safer now?

But this is wrong: Alan Greenspan made a bad call in the mid-2000s. Alan Greenspan was never a coward.