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December 5, 2007

"Thanks Alan!"

Tito Boeri and Luigi Guiso discuss Alan Greenspan's role in the housing bubble [more on this topic in the post below this one]:

Subprime crisis: Greenspan’s Legacy, by Tito Boeri and Luigi Guiso, Vox EU: It’s difficult to predict how long the crisis in the world’s financial markets will last. Its dynamics recalls that of previous crises, such as that of 1998 (the Russian default and the collapse of LTCM), which have by now been forgotten by many. An excess of liquidity (i.e. an abundance of loans at low cost) has suddenly been transformed into a dearth of liquidity; many dealers find it hard to sell the assets in their portfolios. ...

Back to the present

It’s useful to disentangle the causes of the crisis. Three factors contribute to the current crisis that was triggered by the expectation of defaults on subprime mortgages in the US.

  • The low financial literacy of US households;
  • The financial innovation that has resulted in the massive securitisation of illiquid assets, and;
  • The low interest rate policy followed by Alan Greenspan’s Fed from 2001 to 2004.

The third cause is by far the most important. Without Greenspan’s policy, the present crisis probably would have never occurred.

Low Financial Literacy

The first ingredient of the crisis is a blend of bad information, financial inexperience and myopia of consumers/investors. They fell for the prospect of getting a mortgage at rates never seen before and then extrapolating these rates out for thirty years. This myopia was encouraged and indeed exploited by banks and other lenders eager to attract and retain clients. This is surprisingly similar to what has been seen in the past when banks and intermediaries have advised their clients to invest in financial assets ill-suited to their ability to bear risk. In both cases, a biased advisor is the reflection of a clear conflict of interest in the financial industry. Financial literacy is low not only in financially backward countries (as one would expect), but also in the US. Only two out of three Americans are familiar with the law of compound interest; less than half know how to measure the effects of inflation on the costs of indebtedness. Financial literacy is particularly low among those who have taken out subprime mortgages. The intermediaries exploited this financial illiteracy.


The second ingredient is the pace of financial innovation during the last ten years and the securitisation that it produced. Today it is easy to “liquidify” a portfolio of illiquid credits (typically a combination of bank loans or mortgages) so they can be packaged into investor portfolios. Any bank with distressed loans has used this technique to securitise its own credits. Like all financial innovations, this too has pros and cons. The advantage is that by making an illiquid credit liquid, one can achieve important efficiency gains; investors can take longer-term positions and so earn a higher return. It also spreads the risk of insolvency across a much wider group, reducing the level of risk exposure of any individual agent. But securitizations also have their disadvantages. They weaken the incentives of financial intermediaries to monitor the behavior of the original borrower. In addition, since a credit that has become risky can be liquidated more easily, banks have less incentive to screen borrowers carefully. This opens the credit-markets doors to poor quality borrowers.

Low interest rates

The first two factors aren’t new. Without the third factor – the legacy of the “central banker of the century” – the crisis probably would have never occurred.

The monetary policy of low interest rates – introduced by Alan Greenspan in response to the post-9/11 recession and the collapse of the new economy “bubble” – injected an enormous amount of liquidity into the global monetary system. This reduced short-term interest rates to 1% – their lowest level in 50 years. What’s more, Greenspan spent the next two years maintaining interest rates at levels significantly below equilibrium.[2] Interest rates were kept at low levels for a long time, and were often negative in inflation-adjusted terms. The result was no surprise. Low returns on traditional investments pushed investors and lenders to take bigger risks to get better returns. Financial intermediaries, in search of profits, extended credit to families and companies with limited financial strength. Investors with varying degrees of expertise duly reallocated their portfolios towards more lucrative but riskier assets in an attempt to increase their wealth and preserve its purchasing power. The low borrowing rates for both short and long-term maturity attracted throngs of borrowers – families above all who were seduced by the possibility of acquiring assets that for had always been beyond their means. At the same time, house prices soared, ultimately encouraging the additional extension of credit; the value of real estate seemed almost guaranteed.

The song of the Keynesian sirens

Thanks Alan! Today we’re paying the cost of your overreaction to the 2001 recession. The ECB was wisely prudent and only let itself be partially tempted by Keynesian arguments for reduced interest rates (which were already absurdly low) as a tool for attacking European stagnation. Many would like the ECB to lower rates now, arguing that to avoid a new “Great Depression” Europe needs Keynesian policy of the type followed in the USA, Great Britain and Germany after the 1929 collapse.

We think it is far better to avoid repeating Greenspan’s error, and to avoid monetary policies that are too accommodating for too long. At present, central banks are acting correctly by injecting liquidity into the system. In such crises, one must be afraid of fear. Expectations can unleash downward spirals that make the most pessimistic prophecies come true. In addition, the market crisis hits everyone indiscriminately – even those who did not make money by extending mortgages too readily. Last Friday’s press release of the Federal Open Market Committee didn’t clarify whether half-point cut in the discount rate as intended to merely prevent a downward expectations spiral or whether it was the prelude to yet another overreaction to the market crisis. It’s important to show soon that the lesson of Greenspan’s error has been learned. We should not overreact, as has been done so many times in the past, by sowing the seeds of a future crisis today.

Joseph Stiglitz agrees, but I would place more emphasis on the failure to regulate these markets, particularly the failure to crack down on irresponsible lending, and also acknowledge the Fed's fear of a deflationary episode, a low probability but highly negative outcome, as a reason behind the low interest rate policy. That doesn't mean that rates weren't too low for too long, especially looking back, only that there was a justification for a low interest rate policy for a period of time.

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