Brad DeLong can’t decide whether or not Greenspan made a mistake when he kept interest rates low after the collapse of the dot.com bubble:
Sympathy for Greenspan, by J. Bradford DeLong, Commentary, Project Syndicate: In the circles in which I travel, there is near-universal consensus that America’s monetary authorities made three serious mistakes that contributed to and exacerbated the financial crisis. … US policymakers erred when:
-the decision was made to eschew principles-based regulation and allow the shadow banking sector to grow with respect to its leverage and its compensation schemes, in the belief that the government’s guarantee of the commercial banking system was enough to keep us out of trouble;
-the Fed and the Treasury decided, once we were in trouble, to nationalise AIG and pay its bills rather than to support its counterparties, which allowed financiers to pretend that their strategies were fundamentally sound;
-the Fed and the Treasury decided to let Lehman Brothers go into uncontrolled bankruptcy in order to try to teach financiers that having an ill-capitalised counterparty was not without risk, and that people should not expect the government to come to their rescue automatically.
I have argued the Fed’s decision to keep interest rates low contributed to the bubble, but was not itself the sole cause of it. As to whether the Fed made a mistake, I’ll just note that the tradeoff wasn’t quite as stark as Brad implies, i.e. there were other policy instruments that Fed could have used to limit the housing bubble. Regulation is certainly one means the Fed had to that end, but Fed communication could have helped too. If Greenspan had, for example, told people to stay away from mortgages because they were toxic rather than implicitly encouraging them to invest in housing, things might have been different.
Would limiting the bubble through regulation, communication, or other means have limited the employment response, the primary worry? I don’t think so, at least not enough to matter. The money would have been invested somewhere, housing had an opportunity cost after all, so the next best alternatives would have been pursued to the extent that they were profitable (and many would have been, just not as profitable – apparently anyway – as investing in housing and mortgages). So people still would have been employed somewhere as the money was invested, just not in housing, and that would have helped to insulate us from the housing crash. (And a lot of them might still have those jobs, unlike the people who depended upon the housing markets for employment.)
So narrowly, keeping interest rates low and employment high was the right thing to do. The mistake was letting all of the action brought about by those low rates, or most of it anyway, occur in a single sector, housing, rather than using regulation and other means to limit the flow of resources into the housing market in pursuit of profits based upon the misperception of risk. Those resources could have been redirected into other sectors and put to productive use rather than wasted building houses nobody wants, and achieving this result did not require the Fed to aggressively raise the target rate, it only needed to use the other tools it already had available.
Unfortunately, however, those tools were not used, and the ideology Greenspan brought to the Fed played a large role in this outcome.