The Hindu Business Line : In defence of Alan Greenspan

Critics who link the former Fed chief, Mr Alan Greenspan’s policies and the sub-prime crisis couldn’t be more wrong, says G. RAMACHANDRAN, arguing that it was the declining economy, a fallout of the Iraq war, that turned prime borrowers into sub-prime casualties.

Everyone worshipped Mr Alan Greenspan as the central banker of the century while he was in office. He was the chairman of the US Federal Reserve Board — the US Fed — with a record tenure. He was ‘Fed chairman’ from August 1987 until his retirement in January 2006. His springy vocabulary matched his sparkling intellect and earnestness. He had pulled America out of trouble early in his tenure. Thereafter, he did everything to keep it from getting into trouble.

He wielded enormous influence over other central bankers, the business media and academics, though he had no agenda in wielding such influence. Other central bankers hung on to every word he uttered. The business media quoted him in their news stories and broadcasts day and night. The academics cited him in their classrooms and seminars. Then, one by one, they let him defend himself against the criticism that he was among the three principal causes of the sub-prime crisis. The other two were Wall Street and the credit rating institutions.

Wall Street, the rating institutions and Mr Greenspan are now the world’s preferred whipping boys. They have been picked to bear the cross for the sub-prime crisis. Wall Street comprises the big, global institutions. They make big money and so they can afford to live with the criticism. The rating institutions have a clutch of profitable businesses. They are so indispensable to the financial world that they can shrug off any criticism.

But Mr Greenspan is 82 years old and a mere individual. He is not an institution. He has no business model that enables him to cushion himself against the criticism. Moreover, he had no business model that made him benefit from the so-called ‘irresponsible’ and ‘ill-advised’ decisions as Fed chairman.

Yet his critics have found a causation link between his policies and the sub-prime crisis. His critics hold the view that the sub-prime crisis has its origins in Mr Greenspan’s low-interest-rate policy. Mr Greenspan’s critics have both their data and analyses wrong. He is the ‘fall guy’, the easiest to be attacked.

The critics’ case

Managing short-term interest rates and money supply are the two most important tasks of the US Fed. Therefore, Mr Greenspan’s critics hold the view that he kept short-term interest rates low and expanded money supply when it was most irresponsible to do either.

They assert that his irresponsible policies fuelled a housing boom. They also hold the view that by keeping interest rates low he set off a housing price bubble. What this means is that a reliable and widely used index of housing prices shot up because he kept interest rates low.

The most vicious part of the criticism is that because Mr Greenspan kept interest rates low, lenders chose to lend to vulnerable borrowers at high interest rates so that the lenders could earn higher spreads and bigger profits. America’s vulnerable borrowers are its sub-prime borrowers. What this criticism means is that the proportion of sub-prime loans to all home loans increased when Mr Greenspan followed the irresponsible policy of low short-term interest rates.

Greenspan manages growth

The Fed rate is the most prominent part of the Fed’s monetary policy. It is that rate at which banks and financial institutions manage their short-term liquidity needs. From that perspective, the Fed rate sets the benchmark price of credit for other terms and other borrowers.

The most timely and most influential cut in the Fed rate presided over by Mr Greenspan was on January 3, 2001, when there was significant apprehension that the dotcom bust would break America’s economic spine. The rate was cut from 6.5 per cent to 6 per cent.

Six more cuts were made in 2001 before September 11, 2001; the Fed rate was 3.5 per cent on August 21, 2001. September 11, 2001 triggered four more cuts in 2001; the Fed rate was 1.75 per cent on December 11, 2001. T

hese cuts enabled America to manage a precipitous decline in gross domestic product (GDP). America’s GDP had growth by 3.7 per cent in 2000. GDP growth in 2001 was merely 0.8 per cent in 2001.

Surely, Mr Greenspan did not do anything absurd by cutting the Fed rate when the economy was in serious decline. There were only two more cuts, one in 2002 and the other in 2003. The Fed rate was at its lowest at 1 per cent on June 25, 2003. The two cuts enabled the economy to grow by 1.6 per cent in 2002 and by 2.5 per cent in 2003.

Response to Iraq war

America’s war in Iraq has been funded primarily by the issuance of short-term Treasury bills that mature, say, every quarter. The dependence on short-term borrowings pushed up short-term interest rates.

The average three-month T-bill rate in 2003 was 1.04 per cent. It rose to 1.41 per cent in 2004 and then more than doubled to 3.22 per cent in 2005. It rose further to 4.85 per cent in 2006 and stayed there until September 2007.

Mr Greenspan responded correctly to the inappropriate method of funding the war. He periodically raised the Fed rate. He raised the federal funds rate on 14 occasions after the war began. The Fed rate was a whopping 4.5 per cent when Mr Greenspan handed over charge in 2006 to Mr Ben Bernanke, his successor.

Who inflated the bubble?

What becomes evident is that Mr Greenspan lowered interest rates when America’s GDP growth was in serious decline. Thereafter, he raised them after the war began in 2003. Yet he is criticised for keeping interest rates low. Worse, his critics claim that he triggered a housing bubble by keeping interest rates low.

Data published by America’s Centre for Responsible Lending show that housing prices grew at an annual average rate of 6.25 per cent between January 1998 and January 2001.

Thereafter, it grew by about 7 per cent until January 2004, as a result of the lower interest rates in 2001.

But the index of housing prices grew by an annual average rate of about 10 per cent until January 2006. Surely, Mr Greenspan was the Fed chairman during this period.

Mr Greenspan raised interest rates from 1 per cent to 4.5 per cent. It may be right to argue that his monetary policy could not prick the housing bubble. But it would be cruel to say he inflated a housing bubble by keeping the Fed rate low.

Sub-prime credit

The worst part of Mr Greenspan’s critics’ criticism is that low Fed rates resulted in the enhanced flow of credit to sub-prime borrowers. This is an allegation without any substance. Data published by America’s Centre for Responsible Lending and the US Government Accountability Office show that the flow of sub-prime credit actually fell when Mr Greenspan cut the Fed rate.

The proportion of sub-prime mortgage loans fell from about 10 per cent of all home loans to about 8 per cent in 2003 after Mr Greenspan cut the Fed rate significantly in 2001 through 2003.

The proportion of prime mortgage loans rose during this period. It increased from 80 per cent to 83 per cent. The restoration of healthy GDP growth by Mr Greenspan made this modest rise in the flow of prime credit possible.

The proportion of sub-prime credit shot up from about 8 per cent in 2003 to 20 per cent of all home loans by the end of 2004. High interest rates were crushing the US economy.

The proportion of prime loans fell from 83 per cent to 68 per cent in 2004. The proportion of prime loans fell further to 60 per cent by 2006 when the US shed more jobs.

What becomes evident is that the flow of sub-prime credit enlarged when Mr Greenspan raised the Fed rate. But it would be wrong to say his policies encouraged more sub-prime loans. The worsening economy transformed prime borrowers into sub-prime borrowers. The worsening economy was Iraq’s gift to America.

(The author is a financial analyst. Feedback may be sent to indiagrow@gmail.com and pari@thehindu.co.in)

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