As the credit crisis teeters on the verge of full-blown catastrophe, the hunt for the culprit(s) begins. Quickly working his way to the top of the blame table is Alan Greenspan, former Chairman of the Board of Governors at the US Federal Reserve Bank. During his tenure and even into retirement, Dr. Greenspan received near-universal praise for presiding over the Fed during a record period of economic growth and price stability. In fact, he coined the term Goldilocks economy to describe the optimal economic situation in which growth is maximized and inflation is kept to a minimum.

Recently, public opinion has begun to turn on Dr. Greenspan for his perceived role in the current economic crisis. The extended period of easy money over which he presided, combined with his laissez-faire approach to regulation have been identified as two chief causes behind the inflation and subsequent collapse of the housing bubble. In the interest of truth (to preserve his legacy, say cynics), Dr. Greenspan has embarked on a media tour, defending his policies and his ideology. Ultimately, the onerous task of sorting out the causes of the credit crunch will be left to economic historians, but that doesn’t prevent us from scrutinizing the facts and coming to our own conclusions here in the present.

Low Interest Rates: Precipitated by the bursting of the technology bubble and exacerbated by the 9/11 terrorist attacks, the US economy slid into a recession that lasted for two years. The Fed, under the leadership of Dr. Greenspan, moved quickly to slash its bechmark Federal Funds Rate to 1%, the lowest level in nearly 50 years. At the time, Dr. Greenspan was acclaimed by economists for mitigating business cycle volatility and returning the economy back into a period of rapid growth. In hindsight, however, this period of easy money may have enabled the run-up in housing prices that caused the current housing crisis. According to a paper published by the European Central Bank, the Fed kept rates too low for too long. According to the paper, there exists a theoretical natural rate of interest, which "keeps output at its potential and inflation stable, once any shocks to the economy have played out." Witness the connection to Dr. Greenspan’s pursuit of the Goldilocks economy! The ECB used a sequential monte carlo algorithm to simulate the post-9/11 deteriorating economic conditions and the Fed’s subsequent response. Ultimately, it determined that 1% was below the natural cost of capital, and households were able to borrow at rates which failed to properly account for their creditworthiness- or lack thereof. It is ironic that the Fed’s response to the 2001 recession (which, itself was caused by the collapse of an asset bubble) was to facilitate another asset bubble – this time in housing – which, in turn, may precipitate yet another recession. Weak Dollar: The excessive easing of monetary policy from 2001 to 2003 yielded an unintended consequence: a weakening of the US Dollar. The Euro was already gaining acceptance, and a rising interest rate differential provided the necessary impetus for the Euro to surpass the Dollar, once and for all. As a result, oil prices, which are denominated in Dollars, have risen as the Dollar as fallen. A weaker Dollar has also made foreign imports more expensive for a nation that imports $800 Billion more than it exports. As a result, inflation is slowly creeping up; at 4%, it is certainly past the Fed’s comfort zone and is preventing the Fed from adequately responding to the current crisis. In the words of one analyst, "the Fed took a gamble on inflation to ward off what was perceived as a deflationary threat in 2001-02. The inflationary consequences of that gamble are now here, with the petrodollar monetary merry-go-round fueled by the weaker dollar." Even Dr. Greenspan believes that it’s "absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency." Loose Regulation: Many critics charge that in addition to low interest rates, loose regulation represents one of the smoking guns behind (the Fed under) Dr. Greenspan’s culpability. The former Chairman is well known for his laissez-faire approach to government regulation, his commitment to which comes across as doctrinaire and ideological. He has insisted that a loose regulatory framework is essential to a dynamic and growing economy, and has argued that "counterparty surveillance" is much more effective than government regulation. With regard to the housing crisis, the Fed’s regulatory failings fall under two subheadings: predatory lending and inadequate collateral. On the first point, the 1994 Home Ownership and Equity Protection Act "gave the Fed authority to monitor abuses and step in, if necessary, to restrict or stop lenders and their practices." Unfortunately, the Fed largely failed to take advantage of its newfound power. Credit rating agencies, charged with certifying that the repackaged mortgages were indeed investment-grade, were shocked to discover that some of the mortgage applications lacked even basic contact information for borrowers. In other cases, the borrower’s income wasn’t confirmed, such that it would be impossible for the counterparties – the loan officers that Dr. Greenspan insisted were most capable of regulating the system – to evaluate whether a particular mortgage was appropriate for a given borrower. Thus, over $250 Billion of worthless mortgages have already been written down (declared worthless) since the start of the credit crunch. If lenders had been properly regulated from the start, then perhaps most of these mortgages never would have been extended. The second point applies to the inability of the financial system to absorb the shock from the unexpectedly high default rate on subprime loans. This failure to anticipate can be traced back to 1998, if not earlier, when the Federal Reserve spearheaded a bailout of Long Term Capital Management (LTCM), a large hedge fund which lost nearly $5 Billion trading complex securities. Some would say that this created a moral hazard situation, whereby banks became comfortable taking larger risks because of the foreknowledge that they would be bailed out if their bets went sour. Sure enough, the current credit crunch was fueled by even riskier practices in the financial sector, whereby mortgages were repackaged into increasingly esoteric securities, held off-balance sheet for tax purposes. In sum, "there was nothing done to head off more such failures…The result a decade later has been the need for another, even more dramatic, bailout." Thus, the Fed found itself orchestrating an 11th hour sale of Bear Stearns, a near-bankrupt investment bank, to JP Morgan. While this was the only debacle that required the Fed’s assistance, most large investment banks have accepted large cash infusions, due to the Fed’s low collateral requirements.

Dr. Greenspan’s response to these accusations has been uninspiring, arguing that the Fed probably could have done more, but not enough to avert the credit crunch. He has clung to the notion that the markets can police themselves more effectively then the government could ever hope to. According to Naked Capitalism, "the biggest problem with Dr. Greenspan’s posture is that he fails to accept the rationale for regulation. Banking is an industry that can create enormous externalities, namely, financial panics, asset bubbles (which suck investment out of more productive uses) and busts. Even a mere nasty credit contraction exacts a toll on the real economy." It is no wonder that the government’s official response to the current crisis has been to cut out, rather than impose more, regulations. Indifference to Asset Bubbles: During the height of the dot-com stock market bubble, Dr. Greenspan famously cautioned against "irrational exuberance." For an encore, why then did he willingly enable another bubble to form? Under Dr. Greenspan, the Fed became famous for its asymmetric response to asset bubbles, whereby the bursting of a bubble was softened by rate cuts, but the bubbles’ inflation was not dealt with through countervailing rate hikes. In this way, investors were encouraged to take larger risks, knowing that if/when the bubble(s) did burst, the Fed would ease monetary policy to cushion the fall. Dr. Greenspan was unbending in his defense of this policy, arguing that the Fed’s job is to deal with economic growth and inflation, rather than to influence asset prices. It is not as though Dr. Greenspan was unaware that a bubble was forming. In testifying before the US Congress in 2005, he, himself, commented that "signs of froth in some local markets where home prices seem to have risen to unsustainable levels." Even the IMF delicately offered that "some ‘leaning against the wind’ may also prove useful to limit the risk of a buildup of housing market and financial imbalances." In Dr. Greenspan’s defense, it is not clear that a more "symmetric" response to the inflation of the housing bubble would have produced a different outcome. This is because short-term rates, which the Fed controls, have slowly become disentangled from long-term rates (which the Fed does not control), such that the Fed cannot effectively set the risk premium that is built into mortgage rates. Greenspeak: Dr. Greenspan was famous for his abstruse way of communicating with investors, policymakers, and the news media, which has been nicknamed "Greenspeak." For example, the testimony listed above also included the following nugget of wisdom: "to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is beginning to add to the pressures in the marketplace." Dr. Greenspan claimed the ambiguity was deliberate, as it allowed him the flexibility necessary to zig and zag when conducting monetary policy for the world’s most dynamic economy. On one occasion, he poked fun at himself, suggesting to policymakers that "if I say something which you understand fully … I probably made a mistake." In hindsight, however, perhaps a little more clarity would have behooved the Chairman in communicated the long-term risks inherent in the housing bubble. ARM Recommendation: In a 2004 speech which has since reverberated around cyberspace, Dr. Greenspan offered the following piece of advice: "American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage." He also intimated that borrowers would benefit by using adjustable rate mortgages instead of fixed rate mortgages, although in the same breath, warned that this benefit would not inure to homeowners in a rising interest rate environment. This comment speaks to one of the key trends underlying the housing bubble: the proliferation of esoteric mortgage products. Adjustable-rate mortgages became especially problematic as the Fed began tightening in 2005, and many investors were unable to adjust to rising interest payments. When housing prices reversed course and began to decline, many investors were shocked to discover that their mortgages had also reversed, such that their equity was now negative. Dr. Greenspan’s de facto endorsement of complex mortgages products, such as those of the "interest only" and "pick a payment" variety, paved the way for the the millions of defaults on subprime mortgages that ensued.

Dr. Greenspan’s ideology has been a recurrent theme throughout this article. Those familiar with the former Chairman’s background should recall that he was an early admirer of Ayn Rand, a prominent novelist, whose works read like expositions on free-market economics. In addition, Dr. Greenspan was appointed by a Republican president, Ronald Reagan. Some degree of bias is to be expected, even accepted, and the fact that Dr. Greenspan was a staunch defender of free-market principles need not have precluded him from managing an institution which is supposed to be apolitical. Unfortunately, the story painted above suggests that Dr. Greenspan allowed his ideology to infuse his job. Ironically, the man famous for ambiguous "Greenspeak" was often deliberately unambiguous when opining on taxes, regulation, and other issues of policy. Two years removed from his position, Dr. Greenspan has argued dogmatically that increased regulation and an earlier tightening of monetary policy would not have prevented the housing bubble. According to an interview with the Wall Street Journal, "Mr. Greenspan says he doesn’t regret a single decision. In his view, many critics are ignoring evidence in his favor and failing to assess the process by which he made decisions." He insists that his comments on ARMs were taken out of context and that the people most qualified to police mortgage lenders are….mortgage lenders, themselves. Suffice it to say that if he is ultimately found guilty on the charge of inciting the current housing bubble, Dr. Greenspan will probably lodge an appeal.