2007 August 15 Wednesday
Greenspan: Fed Couldn't Prevent Housing Bubble

Does anyone believe the US Federal Reserve lacks the tools needed to raise mortgage interest rates in the United States? To put it another way: Has globalization neutered central banks?

Mr. Greenspan explains: “We decided that in 2003 that though we judged the probability of severe deflation as small, were it to happen, its consequences were seen as devastating. So we chose to take out insurance against them, fully recognizing at the time that we were taking risks in the process. But central banks cannot avoid taking risks. Such tradeoffs are an integral part of policy. We were always confronted with choices.”

Some at the Fed argue its policy can’t explain the greater part of the housing and borrowing boom, which took place in 2005 and 2006 — after the Fed had moved short-term rates up considerably.

Mr. Greenspan agrees: “We tried in 2004 to move long term rates higher in order to get mortgage interest rates up and take some of the fizz out of the housing market. But we failed. We were overwhelmed by excess global savings that continued to press real long term rates lower.”

The Fed has a few tools for regulating money supply growth: Interest rates it charges to loan money to banks, Buying and selling securities, and setting of reserve requirements for some types of bank requirements (see here for a more detailed run-down of Fed money supply management tools). Greenspan is arguing either that those tools are not powerful enough (really?) or that a Fed policy designed to cut housing demand would have had side effects on the rest of the economy that would have been too costly. If he's arguing the second point then does he really mean it and is he right? If he's arguing the first point then he really could have taken the fizz out of the market but didn't think the benefit was worth the price.

My guess is that he's not being totally honest and his response is defensive. Yes, the Fed could have stopped the housing boom. Might have cost the economy a recession though. So he opted to hope the excesses would correct without too much cost a few years later. Well, we are waiting to find out if he was right.

Share |      By Randall Parker at 2007 August 15 05:51 PM  Economics Housing

John S Bolton said at August 16, 2007 12:10 AM:

They could have prevented the zero-down payment loans
and mortgages for those using fake ID's and still could.
They could have imposed a cap on how many additional dollars could be
added to China's dollar support operations per year, and still could.

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