The Fed and the Credit Boom: Greenspan, Others Reflect

Will the problems in the credit markets affect the broader economy? Former Federal Reserve Chairman Alan Greenspan suspects so. “There’s some evidence it’s beginning to affect present consumption expenditures, such as two months of softer motor vehicle sales,” he says in an interview.

Yet Mr. Greenspan doesn’t agree, as some critics do, that the Fed’s decision to keep interest rates low under his leadership earlier this decade was the main driver of the borrowing boom that preceded the current turmoil. Mr. Greenspan moreover suggests the policy must be evaluated against the environment and risks the Fed faced at the time, and that the innovations that fueled the boom are a net positive.

Greenspan

In 2003, inflation had fallen close to 1%, and the economy was operating well below capacity, creating the risk of inflation going into negative territory, that is deflation. Mr. Greenspan had once believed deflation was impossible with a paper currency, since the Fed, unconstrained by the gold standard, could simply print money until it created inflation. But Japan’s experience with deflation and economic stagnation in the 1990s had demonstrated otherwise, and impressed upon him the importance of avoiding that experience. Mr. Greenspan saw the choice as one of “risk management”: accepting some manageable risks now, such as higher inflation down the road (which seemed unlikely given the slack in the economy) in return for eliminating even the smaller possibility of far worse, potentially unmanageable deflation.

Mr. Greenspan explains: “We decided that in 2003 that though we judged the probability of severe deflation as small, were it to happen, its consequences were seen as devastating. So we chose to take out insurance against them, fully recognizing at the time that we were taking risks in the process. But central banks cannot avoid taking risks. Such tradeoffs are an integral part of policy. We were always confronted with choices.”

Some at the Fed argue its policy can’t explain the greater part of the housing and borrowing boom, which took place in 2005 and 2006 — after the Fed had moved short-term rates up considerably.

Mr. Greenspan agrees: “We tried in 2004 to move long term rates higher in order to get mortgage interest rates up and take some of the fizz out of the housing market. But we failed. We were overwhelmed by excess global savings that continued to press real long term rates lower.”

Mr. Greenspan believes that in spite of the current turmoil, the U.S. is better off for having had the expansion of credit markets, alternative investment vehicles and derivatives.

“History tells us it’s far better to have people periodically going to excess with its adverse consequences than to try to block it off in the beginning. These adverse periods are very painful but they’re inevitable if we choose to maintain a system in which people are free to take risks, a necessary condition for maximum sustainable economic growth. We have learned to move risk from the leveraged institutions which are the major lenders in this country to those far more capable of absorbing loss. It’s why our economy in recent years has developed the flexibility to absorb severe adjustments.”

Gramlich

Some former colleagues broadly agree, but acknowledge they could have done some things differently. Alfred Broaddus, president of the Federal Reserve Bank of Richmond from 1993 to 2004, backed the low rate policy, and says: “My main concern was to get past a situation where [the U.S.] would get into incipient deflation that might be very difficult to break, given the absence of a very clear Fed strategy to deal with it at the time. Even in retrospect we needed to address it and address it decisively. It may be that a side effect of those actions [is] that over the longer period, we helped to create excessive liquidity, possibly leading to some of the problems we have today. It may be in retrospect we should have begun to reverse that easing somewhat sooner… I would add, there were other things [contributing]. There was a lot of liquidity being generated across other channels across the world economy.”

As governor of the Federal Reserve from 1997 to 2004, Edward Gramlich spent a lot of time on consumer protection issues. He focused heavily on predatory lending but not, he now regrets, the expansion of risky mortgage products such as 2/28s (which offered a low starter rate for two years before adjusting higher for 28).

Mr. Gramlich backed all of Mr. Greenspan’s interest-rate decisions at the time, except once in late 2002 when he voted to cut rates sooner than Mr. Greenspan was prepared to do. He says he wouldn’t change any of those votes but wishes supervision of all mortgage lenders, not just the banks, had been stronger. The ability to “borrow money for 1%, made it very easy for the lenders to give these products [such as 2/28s] that would be absolutely misunderstood by borrowers. If we had had better supervision, that wouldn’t have happened. You could make the lender evaluate the loan, according to what is known as the fully indexed rate, but we didn’t have that. And we had sort of a wild west out there.” Supervision, he says, has to be improved before the next period of low rates occurs.