Wednesday, December 12, 2007

Greenspan: "It wasn't me!" (amv)

Alan Greenspan has published an op-ed in todays Wall Street Journal, headed "The Roots of the Mortgage Crises." Quite naturally, he does not accept the responsibility for the crisis. "The crisis was thus an accident waiting to happen," he claims. Greenspan indeed seems to admit that the crisis is due to low long-run interest rates, but it was not the FED and not cheap-money ideology, but some inescapable historical happenings, incidents which the FED could not control:

First, risk was underpriced. The "seemingly insatiable desire for financial risk" which "came to an abrupt halt as the price of risk unexpectedly surged." Yes, it was not the wise Board of Governors creating moral hazard but "market euphoria." The great hero of the past, the Maestro, knows no better excuse than that people simply went crazy! But what exactly is the cause of this market euphoria, for the cluster of irrationality and error? Greenspan:

"The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.
A large segment of the erstwhile Third World, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: Fairly well educated, low-cost workforces were joined with developed-world technology and protected by an increasing rule of law, to unleash explosive economic growth. Since 2000, the real GDP growth of the developing world has been more than double that of the developed world.
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."
Mmmh. Low-cost competition caused inflation expectations to fall? Yes, but only because the FED, the economic profession and the prationeers all embraced the cost-push fallacy, according to which falling wages are deflationary. All forgot the cash constraint! If firms pay less to their workforce, they spend their money/budget on something else. Period. Some prices fall (here: wages), others rise. Cost-minimizing competition is about relative, not absolute prices. Low interest make borrowing easy and cost-minimizing activity in such a context is rarely motivated by the wish to redeem. Money supply does not contract and since inflation is always and everywhere a monetary phenomenon (given real output growth) there is no reason to believe in deflation or less inflation. Markets and central banks employed the wrong theory. Any central bank has to ignore reallocating developments. Further, if such changes in allocation indeed shift the national price levels, it is not the kind of inflation/deflation the monetary authority should target on. As the classical specie-flow-mechanism already has shown, these kind of changes are relative, not absolute. Be it as it may, it seems contrived - if not gutless - to put forward any inescapable motion of history or "world-shaking events" to hide the own responsiblity.

Greenspan's second line of defense and another reason for long-run rates of interest to fall: The myth of the saving glut.
"In addition, there has been a pronounced fall in global real interest rates since the early 1990s, which, of necessity, indicated that global saving intentions chronically had exceeded intentions to invest. In the developing world, consumption evidently could not keep up with the surge of income and, as a consequence, the savings rate of the developed world soared from 24% of nominal GDP in 1999 to 33% in 2006, far outstripping its investment rate.
Yet the actual global saving rate in 2006, overall, was only modestly higher than in 1999, suggesting that the uptrend in developing-economy saving intentions overlapped with, and largely tempered, declining investment intentions in the developed world. In the U.S., for example, the surge of innovation and productivity growth apparently started taking a breather in 2004. That weakened global investment has been the major determinant in the decline of global real long-term interest rates is also the conclusion of a recent (March 2007) Bank of Canada study."
In a fractional reserve system in which money can be created out of thin air, investment funds are not limited by consumption foregone (savings). As Keynes has shown, in such a world investment decisions do not depend on prior savings. Savings arise ex-post by income-effects. Of course, this is only true if resources are idle - just lying around and waiting for effective demand. This is indeed assumed by the logic of the new, that is, intertemporal IS-curve, and this is part of all modern approaches to monetray policy. All modern central banks operate on this (I think wrong) philosophy. But then it is quite arbitrary to argue, like Greenspan does, that savings were to high, depressing interest rates. Either-or! You cannot live in both worlds. Either the saving-glut-approach is true and you are in the neoclassical world with scarce resources and funds to be allocated among alternative uses, but then the models which the FED employs are wrong. Or you live in the world of the New Consensus which only mimics neoclassical methods but then you cannot find an excuse based on the saving glut. Furthermore, the saving glut theory is only true for a neoclassical world without fractional reserve banking. In a system without 100% reserve requirements, credit by the very nature of things expands beyond the funds offered by consumption foregone. The long-run interest rate is low not because Greenspan lost control over it but because he expanded money and expanded money and expanded money! In this case however, Greenspan is responsible. But Greenspan indeed builts his case on the ineffectiveness of monetary policy! He claims: "In retrospect, global economic forces, which have been building for decades, appear to have gained effective control of the pricing of longer debt maturities. Simple correlations between short- and long-term interest rates in the U.S. remain significant, but have been declining for over a half-century. Asset prices more generally are gradually being decoupled from short-term interest rates." Wow! So why didn't he quit his job back then? What exactly was he paid for? Why did he allowed the market to focus on him alone? Why he didn't say: "Hey market. If your inflation expectations are low because you believe in the FEDs ability to control inflation via interest rates, you better know that this believe is ill-founded! Do not be to optimistic in our ability to control the market!"

Finally, he concludes that since the fall in interest rates is not due to him but to the market going crazy and to excessive savings, the asset price bubble is not his fault either. And since the bubble on equity markets is held responsible for the housing bubble (wealth effect) Greenspan pledges for not being guilty by not being effective at all. He was just there. He did his best, but the crazy market ignored him. He only admits a minor impact of his decisions on the unlovely outcome:
"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 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."
To say it with our former secretary of foreign affairs: "Sorry Mr. Greenspan, I'm not convinced!"

Supplement: See also Krugman's comment on Greenspan's "breathtaking chutzpah."