Greenspan Says Global Savings Glut Led to Housing Bubble and Crisis

Former Federal Reserve Chairman Allan Greenspan has just published a paper which serves as a defense of his economic stewardship during the bubble years. The thesis of the paper is that a global savings glut, not a low Federal Funds rate led to the housing boom and its subsequent bust. In addition, lax regulation allowed banks to take on risk that they couldn't support.

The paper is simply entitled The Crisis and is published on the Brooking Instituion website - view it here.

Greenspan seems most stung by criticism from Stanford economist John Taylor who has argued that a low Federal Funds rate was a cause of the housing bubble. One of Taylor's big contributions to monetary policy is the Taylor Rule. In short the Taylor rules says that (in Ben Bernanke's words):

"In its most basic version the Taylor rule is an equation that relates the current setting of the federal funds rate to two variables: the level of the output gap (the deviation of output from its full-employment level) and the difference between the inflation rate and the policy committee's preferred inflation rate. Like most feedback policies, the Taylor rule instructs policymakers to "lean against the wind"; for example, when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range."

A well regarded research paper by Richard Glarida, Jorde Galli, and Mark Gertler suggests the Taylor Rule was responsible for lowering GDP volatility since its use in the 1980s. So, Taylor seems to have some credentials.

He believes that the Fed did not follow the Taylor Rule during 2002-2005 and kept the Fed Funds rate too low for too long. The chart below shows what Taylor thinks the Fed should have done versus what it did do.

He then went on to model what he believes would have happened had the Taylor model been followed. The solid line represents actual housing starts. The small dashed line shows what Taylor's model would have predicted housing starts to be using the actual Fed Funds rates. The larger dashes show what the model would have predicted had the Fed followed the Taylor rule.

These models seem to show that Greenspan's low interest rate policy was a factor in the housing bubble.

Greenspan counters by saying the following:

"Taylor inappropriately equates starts (an increase in supply) with demand, the primary driver of home prices. The evidence suggests that it is not starts that drive prices and initiate the “upward spiral,” but the other way around."

He then takes issue with the model Taylor used, claiming the Taylor rule is not built to be expanded into housing starts:

"Housing starts, in any event, should be extraneous to Taylor’s explanation of the
bubble. It is employed because the Taylor Rule by itself is structured to indicate a proper
federal funds rate to balance the trade-off between inflation and unemployment. There
are no asset price inputs, especially home prices, called for in the Taylor Rule. Home
prices cannot be substituted willy-nilly for the CPI or core PCE price in the Taylor
paradigm. CPI could stand as a proxy for home prices if the correlation between home
prices and CPI were very high. But, it is not. The correlation between home prices and
consumer prices, and between asset prices in general, and product prices is small to
negligible or, on occasion, negative."

He also says that the Taylor rule would not explain the international scope of the housing bubble. The bubble was not centered just in the United States.

But perhaps most interesting is his analysis which shows that housing prices are much more highly correlated to long term bond yields than the Fed Fund rate.

"Between 2002 and 2005, monthly home mortgage 30 year rates led monthly U.S. home price change (as measured by the 20 city Case-Shiller home price index) by 11 months with an R2 (adjusted) of 0.511 and a t-statistic of -6.93; a far better indicator of home prices than the fed-funds rate that exhibited an R2 (adjusted) of 0.216 and a tstatistic of -3.62 with only an eight month lead.62 Regressing both mortgage rates (with an 11-month lead) and the federal funds rate (with an 8-month lead) on home prices yields a highly significant t-statistic for mortgages of -5.20, but an insignificant t-statistic for the federal funds rate of -.51."

It is, he believes a massive glut of cash caused by an inbalance in savings versus spending in places like China, mixed with lax regulation that led to the housing bubble.

So, why does any of this matter? Because even today, economists are debating whether a Fed Funds Fund rate of 0% is too low for too long. This low rate is causing pain to millions of savers who have watched the average rate on a savings account drop to below 1.5% APY. Bond yields are pitiful and mortgage rates have once again fallen to record lows.

Will this fuel future inflation or another asset bubble? My gut tells me that both Greenspan and Taylor are right. After all, the housing bubble started in 1998 when the Fed Funds rate was 6%+. Plus, the Fed Funds rate does not determine long term bond yields. Thirty-year mortgage rates are based on the 10 year Treasury bill, not the Federal Funds rate. Still there is no doubt that many ARMs did benefit from the low Fed Funds Rate. Plus, a low Fed Funds rate sends investors into longer term maturities for yield, driving those rates lower. A low Fed Funds rate helps to bring down longer-term Treasuries.

The super low Fed Funds rate may not have been the cause, but it certainly didn't help. Today, Bernanke and others needs to be vigilant that another bubble isn't forming from under an overly accomodative Fed Funds rate.