Economics272ProfessorCottrellNovember18Greenspan#39sFedandtheFinancialCrisisdoc.docx
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Economics272ProfessorCottrellNovember18Greenspan#39sFedandtheFinancialCrisisdoc.docx
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Economics272ProfessorCottrellNovember18Greenspan#39sFedandtheFinancialCrisisdoc
BridgetReidy,DanSherman,TravisBeal
Economics272
ProfessorCottrell
November18,2010
Greenspan’sFedandtheFinancialCrisis
AsChairmanoftheFederalReserveandoverlordoftheGreatModeration,AlanGreenspanwashailedas“thegreatestcentralbankerwhoeverlived”(AP2008).Theentireeconomy,andeveryonedirectlyinvolvedwithit,seemedtohangonhiseveryword.Ionceheardthatseveralcompaniesevenhiredconsultantswhosejobitwastoanalyzehisappearance,rightdowntothecolor,length,andstyleofhistie,inordertodeterminehismoodandpredicttheactionstheFedmighttake.Inshort,hewasthemaestro(Krugman13)andnobodycouldunderminehispower.
Thencamethe2008subprimecrisis,andGreenspan’sreputationwentdownalmostasfastastheDowJonesinSeptember.Now,amanoncevirtuallyabovecriticismhashadtogoonthedefensive.HehasfacedscrutinybyeveryonefromHenryWaxman,chairmanoftheHouseCommitteeonOversightandGovernmentReform,toTimIacono,editoroftheblogentitled“TheMessThatGreenspanMade.”WhileGreenspannowhasmanydetractors,therearestillsomewhobelieveinhimandthedecisionshemadeasFedchair.CurrentChairmanoftheFedBenBernankeisperhapsGreenspan’smostpowerfulally;andwhilemanywouldargueBernankecouldnotrealisticallyattackGreenspan’spolicies,aninvestigationofhisrecentspeech(Bernanke2010)leadsustoconcludethatBernankegenuinelysupportshispredecessor.
Yet,thequestionremains,asWaxmanbluntlyaskedonCapitolHill,wasGreenspanwrong(Cassidy5)?
Likemanyothers,Greenspanundoubtedlyplayedaroleinthefinancialcrisisof2008.However,throughacomparisonofaspectsofthecrisisthatwereadirectresultofGreenspan’sideologyandthosethathehasbeenunfairlyblamedfor,itisclearthatinmanywayshehasbecomeascapegoat.Whileallrecessionsaremulti-facetedinnature,thiscrisisinparticularismorecomplexthananythecountryhasfaced.Thisismostlyduetotheintricaterelationshipsamongthefinancialinstitutionsthatplayedacentralrole.Whenthecrisisbegan,politicians,alongwiththepublic,immediatelylookedtoidentifysomeonewhocouldbeheldaccountable;andthatpersonwasAlanGreenspan.
WhenAlanGreenspanenteredintohispositionasFederalReservechairmanin1987,PresidentReaganlookedforGreenspantoprovidesuchmonetarypolicyactionsthatwouldundothehighFederalFundsrateputinplacebyGreenspan’spredecessor,PaulVolcker.Upuntilthispoint,theeconomyhadexperiencedextremevolatility.ItwastheconservativeidealthatalowerFederalFundsratewouldpromoteprivatesectorspending,thusincreasingeconomicstability.TheGreenspanFedlookedforwardtomaketheirdecisions,makingpredictionsoftheeconomy.Theirmainfocuswasoncoreinflationandhowtocounteractit,andtheyhadagoaltosmoothinterestrates.Originally,itwasbelievedthattheGreenspanFederalReservefollowedtheTaylorrule.TheTaylorrulecomparestheFederalFundsratetargetagainsttwoeconomicvariables:
laggedinflationandtheoutputgap.ThentheactualFederalFundsrateisadjustedtothetargetineachperiod(Taylor1993).ThisadjustmenttothetargetrateduringeachimpliesthattheTaylorruleis“non-inertial,”ortheFederalReservedoesnotworktosmoothinterestrates.Inflation,asquantifiedintheTaylorrule,ismeasuredbythebehavioroftheGDPdeflatorandtheoutputgapandisthedeviationofthelogofrealoutputfromalineartrend.Taylor(1993)showsthatfrom1987to1992,policyactionsdidnotdiffersignificantlyfromtheprescriptionsofthissimplerule.Hence,accordingtotheTaylorrule,theFederalReserve,atleastduringtheearlypartoftheGreenspanera,wasbackwardlooking,focusedonheadlineinflation,andfollowedanon-inertialpolicyrule.
Figure1
However,recentresearcharguesthattheGreenspanFedmodifieditsthinkingtobecomemoreforwardlookinginitsinflationcounterbalance,thusdeviatingslightlyfromtheTaylorrule.Greenspan’spolicyactionsafterstrayingawayfromthebasicTaylorrulearebetterexplainedbyan“inertial”Taylorrulereflectingthepresenceofinterestratesmoothing.TheGreenspanFedfocusedona“core”measureofinflationinadjustingitsfederalfundsratetarget.The“inertial”Taylorrulerelatesthecurrentfundsratetargetto“expected”inflationandoutputdevelopments(EconomicQuarterly).Inchoosingafederalfundstargetrate,Greenspan’sthinkinginhisearlydaysasFedchairmanacknowledgedthesignificanceofhavingaratethatwasjustright.InaWSJarticle,hestatedthatitwashisopinionthattheFederalFundsrateneedstobelowtoincreasethemoneyflowintheprivatesector(WSJ.com,FinancialCrisis).
Figure2
TaylormayhavebeenrightabouttheFederalFundsratein2000.Followingthedotcombubble,theFedreducedthefederalfundsratetospurinvestmentandconsumption.In2003,thefederalfundsratewasamere1%,farlesswhatithadbeen2yearspreviously(Figure1).
Figure3
Whilereducingthefederalfundsrateisatypicalresponsetoarecessionordecreasedconsumption,reducingtheratebysuchalargeamountisunusual.Loweringtheinterestrateto1%andkeepingitthereforsolongcanbeconsidered“deviationfromapolicyrule,suchastheTaylorrule,andinthatsenseitisadeviationfromamorerules-basedpolicy”(Taylor2).Notfordecadeshadtheinterestratebeensolow,andthisnegativelyaffectedthehousingmarket.
Suchalowfederalfundsratemadeborrowingeasier,andencouragedthehousingboom.Withlowerrates,thebankscouldmorecheaplyborrowmoneyfromeachotherwhichallowedthemtomakemoreloans.Theincreaseinconsumerloansseemedtoincreasearoundthesametimethatthefederalfundsratedropped(Figures2and3).
Figure4
Figure5
Thiseasymonetarypolicyencouragedandhelpedtostimulatethehousingbubblewhichwasthestimulusfortherecentfinancialcrisis.Federalfundsratesdohaveanimpactonsuchconsumerbehavior.AccordingtoanarticleintheWallStreetJournal,“ResearchersattheOrganizationforEconomicCooperationandDevelopmenthaveprovidedcorroboratingevidencefromothercountries:
Thegreaterthedegreeofmonetaryexcessinacountry,thelargerwasthehousingboom”(Taylor1).Inthissense,theFeddidaidinthehousingboomandbust.Ascanbeexpected,AlanGreenspanandBenBernankedefendtheiractions.BernankestatesthattheTaylorRule,whichisaguidelineforthefederalfundsratebasedonoutputandinflation,issubjecttolimitations.Themainlimitationisits“implicationthatmonetarypolicyshoulddependoncurrentlyobservedvaluesofinflationandoutput”(Bernanke2).Bernankebelievesthatitisnecessarytotakeintoaccountfutureexpectationswhenmakingpolicydecisions.Whilethisistrueandseemsreasonable,thereisoneissuewithhowthe“future”isdefined.Thefutureiscompletelyunpredictable.Totakeintoaccountfutureinflationvaluesrequiresthatthesevaluesbepredictedusingpastvalues.Aswehaveseenrecently,thepastisnotnecessarilyagoodindicatorofthefuture.Onceagain,wearefallingvictimtowhatJohnCassidycalls“utopianeconomics.”HadtheFederalReservefollowedtheTaylorRulemoreclosely,perhapsthingswouldhavebeendifferent.
However,Greenspan’sactionswereclearlyaffectedbythefinancialenvironmentatthetime.Aninterestratesolowin“normal”times(notduringahousingbubble)maynothavehadsuchaneffect.Greenspan’sactionsontheirownarenotwhatcausedtheproblem.Itwasthecombinationofhischoicesandthefreedomofthefinancialmarketsatthetime.
Itiseasytosayinretrospect,butitisclearthatGreenspan’smajorflawwasaclassiccaseofdisastermyopia,inspiredbyhisfaithintheadvancementofthefinancialindustry.Thiscanbeseeninthenowinfamous“‘GreenspanDoctrine,’whichwarmlywelcomedthedevelopmentofnewfinancialproducts,suchassecuritizedloansandcreditdefaultswaps”(Cassidy22).Whilethesetermsarenowsynonymouswithchaos,atthetimetheyrepresentedinnovationandleadtoincreasedprosperity.Theproblemwithdisastermyopiaisthatitisextremelydifficulttorecognizeatthetimeofoccurrence.SincetheGreatModerationwasinfullforceformostofGreenspan’stenure,itmadenologicalsensetoquestionhisphilosophy.Tobefair,thisdoesnotcompletelyabsolvetheFedoftheirresponsibility,sincetheyareoftenthoughtofasextremelyrationalandimpartial.Nonetheless,“Aslongasthemusicisplaying,you’vegottogetupanddance”(Cassidy296)andtheFedwasdefinitelydancing.
Deregulationalsoplayedapartinthecrisis,andfromearlyoninhisintellectualcareerGreenspanwasastaunchopponentofregulation.Goingbacktothe1950’s,GreenspanwasinvolvedwithAynRand’s“Collective,”andonecanseethathis“libertarian,antigovernmentinstinctsstayedwithhimthroughouthislongcareer”(Cassidy229).Hebelievedthatbecauseoftheirmotivationforprofit,companieswouldeffectivelymanageriskwithouttheinterventionofthegovernment.Thismaybesotosomeextent,butaswenowknowmanyoftheriskmanagementtoolsthatbecamewidelyusedwerefoundedoneitherinaccurateassumptionsorwerenotutilizedinthecorrectway.Onceagain,whileGreenspancannotbeheldpersonallyresponsibleforthemistakesmadebyothers,hewasanadvocateoftheprinciplesthatledtoderegulation.
ThesefaultsareminorwhencomparedtotheamountofblamethathasbeenhurledatGreenspansince2008.InTimeMagazine’sl
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