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Nov 10, 2008 8:29 pm

Causes of the Crisis

David Henderson's and my Cato Briefing Paper on Alan Greenspan's monetary policy has come in for some severe criticism. We will never be able to reply in detail to all the critics, but we do plan to take up some of the more serious or interesting challenges in due course. The economy's current downturn occupies only a part of the briefing, but it seems to be the most controversial part. So to put the controversy into context, I thought I would offer a preliminary summary of my general views about what brought on the current recession. (These remarks are a revised version of an email I sent to Liberty Fund historian Hans Eicholz, as a reply to his comments on my past post on "Recent Fed Machinations.")

The current financial turmoil is very complex, and no one knows the whole story yet. Anyone who claims otherwise is oversimplifying. The historian in me would like to wait five to ten years, until the dust has settled, to dispassionately analyze the causes. After all, not until Milton Friedman and Anna Schwartz published their MONETARY HISTORY OF THE U.S. in 1963 did we get a relatively complete understanding of the Great Depression, and economic historians are still debating details. All considered, I think a bit of epistemic humility is in order.

Moreover, no economist in my opinion has yet come up with a fully satisfactory theory of business cycles. If someone had, there would be more consensus within the profession, as there is today with respect to what causes sustained inflation. Sadly every one of over half a dozen theories that macroeconomists have put forward, including Austrian business cycle theory, have serious empirical or analytical weaknesses. David Friedman once commented that someone teaching business cycles in macro had a choice between a tour of a graveyard or a construction site.

Yet the economist in me has to do the best with the limited information and theoretical apparatus available. What we do know is that the two central precursors of the financial turmoil were (a) the housing boom and bust and (b) the widespread underpricing of risk. The mispricing of risk obviously generated malinvestment of some form. It is also a malinvestment that everyone agrees took place; they just disagree about the cause.

For those who are skeptical of explanations relying on irrational asset bubbles or pervasive market failure, there are three primary alternatives: (1) monetary expansion under Greenspan generating a self-reversing boom as in Austrian business cycle theory or something similar; (2) government-induced moral hazard from some combination of subsidized risky mortgages, implicit government guarantees, leaking deposit insurance, and the infamous"Greenspan put," which promised to use monetary policy to prevent any collapse of asset prices and bailout institutions too big to fail; or (3) a savings-glut coming from abroad, particularly China, that then started to recede. Notice that these three alternatives are not mutually exclusive, and two of them place some blame on Greenspan's monetary policy.

David Henderson and I do not believe that monetary expansion under Greenspan gets us very far. First, the behavior of the monetary measures cannot bear the weight that this explanation puts on them. Second, as many including Greenspan have asked, how can Federal Reserve policy starting in 2001 be the primary cause of a housing boom that began in 1997 and was worldwide, with higher price hikes in the U.K., the Netherlands, and Ireland than in the U.S.? We do not deny that Greenspan's monetary policy may have been SLIGHTLY more expansionary after 2001, making a MINOR contribution to a housing boom already in progress. As we state toward the end of our Cato Briefing:"Minor blips in total reserves under Greenspan may have played some poorly understood role in any of these three events [the recessions of 1990 and 2001 and the current one]." In fact, we go further within the body of the briefing, admitting:"Total reserves are also the one monetary measure that show a slight uptick into 2003, when interest rates were down."

But monetary expansion made at most a trivial contribution to the housing boom and underpricing of risk. I would put heavier emphasis on the Greenspan put as a potential source of moral hazard. Articles (here and here) by Cato economist Jerry O'Driscoll combine these two avenues through which monetary policy may have played a role, not always distinguishing between the two. Our Cato Briefing fully acknowledges the role of the second avenue. As we state on the first page:"Particularly alarming is the way the lender-of-last-resort function has been expanding the moral-hazard safety net and mispricing risk, a trend to which Greenspan no doubt contributed."

But even the Greenspan put, by itself, cannot be the entire story. Not only do you have to throw in the CRA, Feddie and Frannie, deposit insurance, past bailouts, capital requirements too rigid on the downside, misguided bankruptcy changes, and an array of other domestic interventions. But since the housing boom was international, the widely observed anomaly at the turn of the twenty-first century of savings flowing from poor to rich countries, opposite of its usual direction, also has to be brought into the mix. In other words, my full account would combine elements from the second and third alternatives above. If there is a traditional Austrian malinvestment story in this brew anywhere, I suspect the culprit will end up being Chinese monetary policy, not that of the Fed.

On top of all this, the actions of Ben Bernanke and Henry Paulson have been making matters worse, right from the outset of the subprime crisis, as Anna Schwartz has suggested in recent interviews (here and here). My own reasoning for this charge was sketched out in my post on"Recent Fed Machinations." Nonetheless, within this broad framework, there is much we do not understand, especially with respect to apportioning relative importance.

Correction: Originally I attributed the quotation above on"graveyard or construction site" to the wrong Friedman. David advised me that it was he rather than his father who made the comment, and so I have corrected that sentence.

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More Comments:

Brian Edward Macker - 12/2/2008

"David Henderson and I do not believe that monetary expansion under Greenspan gets us very far."

You are mistaken. The monetary expansion occured well before 1997.

The natural result of the Reagan/Thatcher revolution and the opening of foreign markets is price deflation. Productivity driven price deflation.

It was a price deflation that was not allowed to occur by Alan Greenspan via monetary inflation.

It doesn't matter whether it is foreign or local. Same process happened prior to the Great Depression. Productivity driven price deflation, a good thing, was being distorted by fractional reserve monetary inflation.

The attempt to "stablize prices" upwards from true market prices is what caused the bubbles.

Meanwhile the Fed changed the methods for calculating inflation in such a way that it placed far less emphasis on housing asset price inflation as a component of calculated inflation, along with other garbage hedonic adjustments.

Other assets were never included in price inflationary measures, such as stock and bond prices so that was also completely off their radar.

The Fed screwed up big time. It was quite clear what was happening at the beginning of the internet bubble. It became even more clear as time passed and as more and more the theoretical effects of a monetary bubble came to pass.

Didn't you notice the low savings rates, high borrowing rates, asset inflation, increased leverage, and increasing trade deficit? All classical signs of a Austrian boom.

Hans L. Eicholz - 11/17/2008

An interesting point about relative inflation, or as you note with respect to Greenspan's policies: "even if not as loose (nor as bad) as they were in earlier decades."

We live today in utter panic about the prospects of any downward movement in prices, yet we know from history, that such has fallen, not only during so called recessions, but as a result of increases in production. As Friedman and Schwartz said on page 15 of A Monetary History, such an instance "casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible." So what does it now mean to live in a regime where any adjustment downward is simply prohibited? Set upon a backdrop of steady inflation, what is implied by an even somewhat inflationary put?

William J. Stepp - 11/10/2008

The housing boom, which started in 1997 or so, at least in its early stages paled in comparison to the tech stock boom. There was an outsized productivity gain from 1995 to 2000, which coincided with the tech stock boom. However, if you accept Selgin's productivity norm standard of monetary policy, then the Fed should have tightened monetary policy. Instead, "When Genius Failed" and Long-Term Capital Management got bailed out by a consortium of banks in late 1998, the Fed exercised Easy Al's put and cut the discount rate three times, leading to even more "irrational exuberance." Later, when the Fed raised the discount rate, monetary policy was probably still too loose.
As for the international housing sector boom, all the countries mentioned started from lower bases, and one, Spain, outpaced them all and started from an even lower base.
Easy Al can run, but he can't hide.
Bill Fleckenstein and James Grant documented in great detail the Fed's policies of the 1990s, and they can only be called loose, even if not as loose (nor as bad) as they were in earlier decades.

As for the bankrupcy changes and how they affected the CDS market, this seems like small beer compared to the three reforms called for by The Economist ("The Great Untangling") this week, namely creating a central clearing house, making the market more transparent (more disclosure), and straightening out the back offices of the writers and counter-parties of these instruments.
More important, as it points out, is the realization that the CDSs themselves are not the problem. The real problem is the bad mortgage lending that constituted their shaky
foundation. That in turn was caused by the Fed's easy monetary policy.
The article also points out that the net amount at risk was only 3% of their notional value.

Bill Fleckenstein and James Grant documented in great detail the Fed's policies of the 1990s, and they can only be called loose, even if not as loose (nor as bad) as they were in earlier decades.
Easy Al can run, but he can't hide.