Alan Greenspan’s fingerprints are all over what is fast becoming the worst financial calamity since the Great Depression. Sensitive to mounting criticism that his stewardship of the Federal Reserve led to today’s wrenching crisis, the former Fed chairman has launched a massive public relations campaign to set the record “straight.” Greenspan does make an inarguable point in stating his case for the defense—that it is critical to get the lessons of this crisis right. I couldn't agree more.
But methinks the man doth protest too much. Unfortunately, Mr. Greenspan has been blinded by a dangerous combination of politics and ideology in his own search for those very lessons. It was much the same during the 18 ½ years he spent at the helm of the Fed, guided by the belief that the U.S. public wants rapid, albeit noninflationary, economic growth. A politically compliant central banker, he has stated in his best-selling memoirs that he believes the independence of the Federal Reserve is not set in stone—implying that there is always huge pressure to keep the growth machine humming. A market libertarian, he has long argued that regulatory intrusion slows the economy. Presto—the rest is history—and an increasingly painful one at that. Greenspan’s blend of politics and ideology led to bad economics and a succession of policy blunders whose severity is only now becoming clear.
Greenspan’s handling of the housing bubble is the smoking gun. The Greenspan mantra is that markets know best—that central bankers should not attempt to override the verdict of millions of market participants by declaring that an asset bubble has formed. After all, there are the costs to economic growth to consider if monetary policy is used to deflate such bubbles. And why should any modern economy have to incur those costs? After all, goes the script, the authorities always have the wherewithal to clean up any post-bubble mess. Maybe not. This time, the mess is almost beyond the realm of comprehension—most likely a good deal larger than any growth that might have been foregone had the U.S. housing bubble been handled more judiciously.
Yet the problem has never really been the bubble in the narrow sense of the word. One of the weakest links in the Greenspan defense is his fixation on whether a serious bubble was forming in America’s housing market. Never mind his earlier arguments that housing markets were local, not national, and that it was highly unlikely that home prices could ever fall nationwide. Whoops. Never mind also his equally irrelevant point that there were lots of housing bubbles in the world at the same time, and that America’s property market excesses didn't look so bad by comparison. Everyone’s doing it, so it’s not the Fed’s fault. Right?
Wrong. The trouble with America’s housing bubble was never its comparison with Ireland. The core of the problem lies in the distortions that asset bubbles created on the real side of the U.S. economy. Courtesy of the most rapid rates of sustained U.S. house price appreciation in the modern post-World War II era, along with innovative financing techniques that allowed American homeowners to extract equity with ease from their humble abodes, the new age of the asset-dependent consumer was born. Net equity extraction from residential property—ironically, derived from a statistical framework developed by Alan Greenspan, himself—surged from 3 to nearly 9 percent of disposable personal income in the first half of the current decade.
And so it went. Increasingly supported by the confluence of both property and credit bubbles, U.S. consumers spent well beyond their means. Personal consumption climbed to an unheard-of 72 percent of real GDP in 2007—a record for the United States and, for that matter, for any leading economy in modern history. At the same time, household debt soared to a record 134 percent of disposable personal income. America certainly achieved the rapid growth that Greenspan felt the body politic wanted. But it was growth based increasingly on fumes.
Unfortunately, the distortions of a bubble-infected U.S. economy didn't stop there. Consumers who saw their homes as a new piggy bank or ATM machine felt little pressure to save the old-fashioned way—out of their paychecks. Saving rates plunged to zero for the first time since the Great Depression. An increasingly asset-dependent U.S. economy then had to borrow surplus saving from places like China in order to keep growing—and run massive current account and trade deficits in order to attract the foreign capital. Greenspan and his disciple Ben Bernanke saw this situation exactly backwards. America, they insisted, was simply doing the rest of the world a huge favor by absorbing its surplus saving. Serious dollar risks were characterized as a problem for a distant day. Suddenly, that day doesn't seem so distant.
