Greenspan vs. Taylor

Frank McCormick sent me the following WSJ article:

He said he is baffled by all the blame that has been piled on him. Since the recession, critics have said the increased money supply and low interest rates during his tenure at the Fed from 1987 to 2006 led to bubble investments. Mr. Greenspan first heard that theory, he says, in 2007, when John Taylor, a professor of economics at Stanford University who has advised Republicans, made the connection between easy money and the housing bubble. “It had absolutely nothing to do with the housing bubble,” he says. “That’s ridiculous.”

Instead, he says Prof. Taylor’s statement “served a lot of political purposes of people who have been picking on the Fed from both sides of the aisle.” Mr. Greenspan wrote a rebuttal in a paper for the Brookings Institution, going through Prof. Taylor’s points one by one. “I thought, that’ll kill it,” he remembers. “It didn’t, because nobody read the paper.”

Mr. Greenspan said he didn’t press the issue because Prof. Taylor is a friend, but he had no idea how far Prof. Taylor’s idea would go. “The trouble, unfortunately, with the argument is there’s no evidence that happened, but he’s won the battle, and his view is conventional wisdom,” he says.

Prof. Taylor stands by the paper in which he presented the idea. “The paper provided empirical evidence…that unusually low interest rates set by the Fed in 2003-2005 compared with policy decisions in the prior two decades exacerbated the housing boom,” he wrote in an email. Other economists have corroborated the findings, he added, and “the results are quite robust.”

Let’s investigate this like forensic scientists.  Common sense suggests that the housing “bubble” might have had at least three causes:

1.  Low interest rates.

2.  Bad regulation.

3.  Irrational exuberance among bankers and homebuyers.

By “bad regulation” I don’t mean any one thing, but a whole range of interventions that encourage excessive mortgage debt:  interest deductibility, the GSEs, too big to fail, the CRA, the moral hazard created by FDIC, etc, etc.

Of course low interest rates are not really an explanation, as one should never reason from a price change. If the low interest rates were caused by weak business investment, as in 2002, then they will tend to boost housing. But in that case it makes more sense to talk about low business investment boosting housing. After all, if the low rates are caused by the housing bust (as in 2008-09) then they obviously wouldn’t boost housing.

So which is it, were the low rates of the bubble years caused by easy money, or by weak business investment?  Let’s start with some basic principles.  If the Fed successfully targets inflation or NGDP then interest rates are 100% endogenous. In that case any interest rate –> housing causality would not involve monetary policy at all, at least if one assumes the macro targets were appropriate. If inflation and NGDP were on target during the housing bubble, then Taylor would be 100% wrong and Greenspan would be 100% right.

Reasonable people can read the evidence differently, but here’s what seems plausible to me:

1.  During 2002-04 Greenspan was 100% right and Taylor was 100% wrong.  The macro variables did not indicate an excessively expansionary monetary policy (from a dual mandate perspective), and hence the low rates were due to the business investment drought post-2000.  And perhaps partly the other “X-factors” driving real rates steadily lower for decades.

2.  During 2005-06 Fed policy might have been a bit too expansionary.  Marcus Nunes says it wasn’t and David Beckworth says it was.  Both have reasonable arguments.  NGDP growth and inflation were clearly a bit above target, but Nunes would reply that NGDP was close to target using a level targeting framework.

My view is that this isn’t an important argument.  I really don’t care whether money was about right during 2005-06, or slightly too easy.  Either way it wasn’t at all unusual compared to earlier periods of our history. Indeed during most of my life policy was far more expansionary during cyclical expansions than 2002-06.

To conclude, three factors seem to have contributed to the housing bubble.  The Fed may or may not have played a small role in one of the three factors.  Probably not at all during 2002-04, maybe a little bit in 2005-06.  Overall I’d say Greenspan is around 90% right and Taylor is perhaps 10% right, but only for the years 2005-06.  And that’s being generous to Taylor.  If Nunes is correct then Greenspan is 100% right.

PS.  Greenspan is right that Taylor has won the battle.  Just as those who thought easy money in the 1920s led to the Great Depression had won the battle by 1930. But of course they eventually lost the war, after Friedman and Schwartz showed that the real problem was tight money after 1929, not easy money before 1929.

PPS.  The most interesting part of the article is the opening:

Alan Greenspan, the former chairman of the Federal Reserve, goes to a lot of parties. He and his wife, the TV journalist Andrea Mitchell, “sort of get invited everywhere,” he says, sitting in front of the long bay window in his office on Connecticut Avenue in Washington, D.C. Lately, though, cocktails and dinners seem to have guest lists drawn almost exclusively from one political party or the other. “It used to be a ritualistic 50-50 at parties—the doyennes of culture and partying were very strict about bipartisanship,” he adds. “That doesn’t exist anymore.”

That’s right, the current members of Congress and other top officials are so emotionally immature that they are incapable of socializing with people of different ideologies.  What a bunch of babies!!

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