In recent weeks, former Federal Reserve Chairman Alan Greenspan has found himself increasingly under public assault, both for his actions leading up to the current financial crisis, and for his attempts to defend these actions. In the April issue of the “Free Market” newsletter produced by the Ludwig von Mises Institute, economist Robert P. Murphy devotes an article to exploring what he sees as the failures of central banking systems generally, and Greenspan, specifically.
Murphy’s article, entitled “Greenspan’s Bogus Defense,” argues that Greenspan’s rate-setting policies destabilized the relation between federal interest rates and mortgage rates and “the reason that the correlation between the federal funds rate and the 30-year mortgage rate broke down during the housing boom was that Greenspan whipsawed short rates way down, then way up, in a fairly narrow window.”
This contention aims to repudiate a Wall Street Journal op-ed by Greenspan, published in March of this year, which argues that the artificially low interest rate responsible for the crisis was not the responsibility of the Fed. “It was indeed lower interest rates that spawned the speculative euphoria,” Greenspan wrote. “However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages.”
Greenspan argued that the mortgage rate failed to respond to economic pressure from the Federal Reserve-pressure which he tried to administer upon noticing its distorting effects. Murphy dismissed this claim, writing that Greenspan “stopped short of breaking through mortgage rates once the federal-funds rate plateaued in June 2006 at 5.25 percent. If [Greenspan] really had wanted to push up mortgage rates, he could have pushed up the federal-funds rate more.” Greenspan should, Murphy argues, have been more cognizant of the fact that his “ultralow interest rates” were only sustainable because of “injections of artificial credits into the banking system.”
At stake in this seemingly arcane dispute between Greenspan and Murphy are two sharply differing conceptions of the role of central banking in economic development. Murphy subscribes to a theory articulated by economists and politicians such as former Republican Presidential candidate Ron Paul-the view that, to quote a speech by Rep. Paul in September of 2002, “abolishing the Federal Reserve and returning to a constitutional system will enable America to return to the type of monetary system envisioned by our founders: one where the value of money is consistent because it is tied to a commodity such as gold. Such a monetary system is the basis of a true free-market economy.”
Greenspan had originally argued this view in his 1966 essay “Gold and Economic Freedom,” where he wrote “gold and economic freedom are inseparable…the gold standard is an instrument of laissez-faire…each implies and requires the other.” However, Greenspan has since embraced the monetary theories of the more quantitatively-based, though similarly market-oriented Chicago School of Economics. This methodological shift has led Greenspan to find himself on the receiving end of criticism from more purist free market advocates. In an article published in April of last year in the Financial Times entitled “An Answer to my Critics,” Greenspan dismisses his critics’ attacks as “counterfactuals from…flawed structures,” arguing that laying the blame for financial problems at the feet of regulators is fruitless as “new problems…are by their nature incapable of being anticipated with any degree of confidence.”
Yet, despite this argument, Greenspan is still drawing fire, even from ideological allies, for failing to understand the implications of his own actions as Fed Chairman. Appeals Court Justice Richard Posner has written that “[Greenspan] neither was aware that there was a housing bubble nor would have lanced it had he realized it, since it was and appears to still be his position that bubbles should be allowed to expand and burst, and then the Federal Reserve will wake up, step in, and clean up the debris…which we have discovered it cannot do.”
Unhappily for Greenspan, such criticism can only vindicate Robert Murphy and his damning assessment that “the Greenspan Fed was not a sufficient condition to cause the housing and stock bubbles, but it was almost certainly a necessary factor.”