Thought experiment for the maestro

Plenty of time has elapsed for people to digest and comment on Alan Greenspan's defense of his policies in the WSJ. Greenspan argues that it was not Fed policy--which affects short-term interest rates--that caused the housing and credit bubble. Rather, he argues, it was the disconnect between short-term interest rates and long-term, in this case, mortgage rates. He lays the blame for this disconnect on the high savings rates of developing countries as their economies expanded. He even manages to work in the ironic twist that the saving behavior by these countries was the result of a "tectonic shift in the early 1990s...from heavy emphasis on central planning to increasingly dynamic, export-led market competition." Well, of course! Market competition is to blame for everything.

The following thought experiment might be useful for evaluating Greenspan's thesis that he/the Fed isn't to blame for the housing bubble and collapse. First, imagine that all the influences that have been put forth as causes of the housing bubble--lax regulation, shoddy credit standards by lenders, the effect of the Community Reinvestment Act and others--had all been the same, but that the Fed had not expanded credit as rapidly as it did. Would a bubble still have occurred? I would suggest that even with all these public and private sector errors, without the Fed expansion of credit, the bubble would not have happened.

Next, suppose that none of the factors listed above had occurred--regulation was appropriately strict, lenders didn't qualify un-creditworthy borrowers, the CRA had not influenced bank lending--but that the Fed had still expanded credit in the way that it did. Would a bubble have occurred in some other sector? I suggest that it would have. It might not have been in tulips or in ostrich feathers, but it would have occurred in some other asset class.

This thought experiment is useful for evaluating arguments about the cause of the crisis--and the ways to prevent the next one--that are posed by both the right and the left. Whatever else one wants to attribute blame to, if the Fed hadn't permitted credit to expand too rapidly, a bubble still would have been far less likely to occur. And the only way to prevent the next bubble is to avoid the causes in the first place. More on that in another post.