Greenspan's Risk-Based Monetary Policy

A new book by economist John Taylor called Getting Off Track assigns the cause of the current financial crisis to monetary policy errors starting in the early 2000s rather than “any inherent instability of the private economy.” This argument is a direct attack on Greenspan’s account of the crisis, who argues the cause was not low rates but misguided ideology. Taylor argues Greenspan should have never strayed from the Taylor Rule (Fed funds rate=1.5*(inflation rate) + ½(gap btwn actual and trend GDP)+1). Greenspan set the fed funds rate significantly below the Taylor Rule only three times: during the ‘87 crash and S&L crisis shortly after attaining office, during the Asian/LTCM financial crisis of 1998, and after the dotcom bubble as shown below.

None of his previous deviations were nearly as severe as the one from 2001-2005. This is by no means a new criticism. Greenspan has taken a lot of heat for these policies since as far back as 2005.

In the early 80s, when Paul Volcker had just started on his onerous task of tackling inflation, there was a debate among economists what policy he should follow. Milton Friedman advocated a non-activist, strict rules approach. However, Volcker and Greenspan both followed a rules-based approach with discretion. What this translates to is a rules-based policy except during crises. Taylor argues strict policy gets better results because Greenspan and Volcker's approach surprises economic agents or leaves them guessing about what the government intends.

Greenspan’s response to Taylor in a recent post on the FT’s economist’s forum is, “Taylor and others derive their simulations from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. This suggests important missing variables. Counterfactuals from such flawed structures cannot form the basis for policy.” Greenspan's response stresses the uncertainty involved in economics and the need as a policymaker to incorporate these risks into policy.

It’s too easy to criticize Greenspan after the fact as many have done. Greenspan’s loose monetary policy was based on a “risk-based” approach. In the early 2000s, the “lost decade” of the Japanese hung heavily over Greenspan’s head. Greenspan saw how a failure to act promptly by monetary policymakers to remove deflationary expectations sent the country into a ten-year malaise. After the dotcom bust, Greenspan recognized a small possibility this could occur in the US. Though the risk was small, the huge negative effects this would have on the country was worth the inflationary policies. In this way, Greenspan created a black swan to protect from another one.

If Greenspan is to be criticized, it is for what he calls his “ideology,” his unflinching belief in free markets. Greenspan had the power to regulate Wall Street, derivatives, and mortgage lenders. The Gramm-Leach-Bliley Act (the one that repealed Glass-Steagall) made the Fed the “umbrella supervisor” of financial holding companies, giving Greenspan all the power he needed. Paul Krugman said, “(Greenspan’s) rate cuts helped make the bubble possible, but I’m not sure there was an alternative…What Greenspan did not do was listen to warnings about subprime. The Fed had substantial regulatory and moral-suasion power. They could have done a lot to limit the excesses.”

Greenspan’s deep skepticism of the abilities of regulators and strong belief in the self-regulatory effect of communal self-interest caused him to ignore the apparent excesses in these industries. Testifying recently on Capitol Hill, Greenspan conceded, “I made a mistake in presuming that the self-interest of organizations specifically banks and others was such that they were best capable of protecting their own shareholders…Loan officers of those institutions know far more than…our best regulators at the Fed were capable of doing.” This “solid edifice” of free markets broke down.

It is puzzling to me how Greenspan could have looked at the Case-Shiller Housing index and not realized it was a dangerous bubble. Greenspan probably thought the increase in asset prices was a good thing. He said in a speech at the Federal Reserve Bank of Kansas City in August 2005, “Lowered risk premiums—the apparent consequence of a long period of economic stability—coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds, and more recently, homes have engendered a large increase in the market value of claims, which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions markedly have been facilitated by the financial innovation that greatly has reduced the cost of such transactions.”

The problem with this theory was that as asset prices grew, consumers started saving proportionally less since they viewed themselves as wealthier. Now that this wealth has come crashing down, Americans are worse off than before. Therefore, by hedging against deflation with loose monetary policy, Greenspan unknowingly created even more risk of deflation by decreasing consumer purchasing power.

In the context of rules vs. risk-based monetary policy, it is interesting to look at the distinctly different ways with which central banks have handled the current crisis. With its aggressive rate cuts and use of quantitative easing, the Fed and Bank of England have embraced a risk approach. The ECB on the other hand, has been much more cautious, lowering rates to only 1.25%. In a recent interview with the FT, Trichet alluded to how “excessive pessimism” after the dotcom bubble pressured central banks to lower rates too far - a clear reference to Greenspan's low rates.

Naturally, Trichet also faces a different political situation since the Eurozone can’t implement a fiscal stimulus. But there is a strong argument for quantitative easing. Paul McCulley in a recent speech posted on the PIMCO website said, “What intrigues me the most right now is the concept of global Competitive QE, rather than competitive tariff hiking or competitive currency depreciation. If all countries, or most major countries anyway, “go QE,” then the global game changes from fighting for bigger slices of a too-small global nominal aggregate demand pie to actually correlated efforts to enlarge the nominal pie…There need not necessarily be any explicit coordination between countries, because those that choose not to play will likely experience a rise in their real effective exchange rate, a deflationary impulse to their underutilized economies. Thus, there need not be an explicit enforcement mechanism to propel Competitive QE, merely individual countries acting in their own best interest. This is the best kind of cooperative behavior, explicitly because it need not be coordinated, but rather brought about by, you guessed it, Adam Smith’s invisible hand!” QE has gotten a lot more attention recently in the financial media; central bankers should do as well in a global economy beset with deflationary risk.