The blame game*

The blame game has started. I refer to recent charges that former Federal Reserve Board Chairman Alan Greenspan caused the current financial market turmoil by pushing interest rates too low, touting variable-rate mortgages, and bailing out Long Term Capital Management.

I don't think so. Policymakers use cost-benefit analysis in making decision. They choose between likely alternatives A and B by comparing the expected benefits of each to the expected cost of each. Choosing A doesn't mean there were no benefits of B or no costs of A. It just means A's expected benefit/cost ratio was higher than B's.

Critics may later "discover" the chosen alternative A had costs or downsides. Well, of course it does; the point is they were deemed to be smaller relative to benefits than the B alternative. B's costs, however, remain invisible and are ignored because B wasn't chosen. Even so, alternatives are still relevant to evaluating outcomes.

Mr. Greenspan's Alternative A was to allow short-term interest rates to decline to very low levels when disinflation threatened to degenerate into outright deflation. Alternative B was to ignore that risk and take our chances. He was too good a student of Austrian economics to assume no costs to such low rates, and he often warned of the dangers of the dramatic lowering of risk spreads that accompanied low rates.

The chairman didn't give deflation a high probability of occurring, but he did expect the consequences of any such occurrence to be severe enough to justify preventative action. One might argue that the low rates required to sustain aggregate demand in 2003 were themselves evidence of the seriousness of the threat.

A more important point in his defense, however, is that disinflation and falling interest rates were a worldwide phenomenon. To attribute them to Alan Greenspan is parochial in the extreme. As the threat of deflation diminished, the Federal Open Market Committee (FOMC) raised its target Fed funds rate in 17 consecutive quarter-point steps over a two-year period. During that period of rising short-term rates, long-term rates remained flat or declined worldwide, not just here. That "conundrum," as the chairman famously called it, eventually was attributed to the extremely high saving rates of newly emerging economies worldwide.

As indicated above, the flattening of yield curves was accompanied by a dramatic decline in risk spreads worldwide, against which the chairman cautioned frequently. A memorable milestone of that period was the Mexican sale of peso bonds for less than 9 percent when not long before they couldn't get that rate even in dollar-denominated bonds.

When rising short rates failed to pull up long rates, the chairman, at least internally, focused on the impact on the 10-year bond yield. Dissection of its 10 implicit one-year tranches revealed that rates rose on the first few tranches, but actually fell in the out-years. Again, the conundrum of rising short rates and falling long-term rates and risk spreads was worldwide. As powerful as the Maestro was, it's still a stretch to blame him for single-handedly inverting the world's yield curve.

Now, what about the chairman luring unsuspecting consumers into adjustable rate mortgages they couldn't afford? The origin of this charge is his speech on Feb. 23, 2004, to the Credit Union National Association. In a technical discussion of "Mitigating Homeowner Payment Shocks," the chairman noted fixed-rate mortgages had the advantage of allowing homeowners to prepay debt when interest rates fall but don't require higher payments when rates rise.

His research indicated, however, that this advantage was probably overpriced by the market. "Homeowners pay a lot of money for the right to refinance and for the insurance against increasing mortgage payments. Calculations by market analysts of the 'option adjusted spread' on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners' annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward."

Somehow, I doubt the chairman's geek speak sent Joe Six-pack running off to apply for an ARM he couldn't afford. Affordability, let's remember, is primarily a matter of income. At the Economic Club of New York a week later, the chairman, asked about his earlier remarks on ARMS, emphasized that their focus and applicability was limited to a very small segment of households.

Finally, the Fed was not a party to any bail out of Long Term Capital Management, unless inviting its creditors to use the New York Fed's board room constitutes a bail out. LTCM's major creditors bailed themselves out in mid-September 1998 by adding good money after bad, leaving the original investors only a few cents on the dollar. I doubt they felt bailed out by anybody.

In addition to the charge of a specific Fed bailout, the Greenspan Fed is also accused of easing monetary policy to help LTCM even though its three quarter-point easing moves from Sep. 29 to Nov. 17, 1998, came after the resolution of LTCM by its creditors in mid-September and was motivated by the market impact of the Russian debt default and devaluation on top of the ongoing Asian crisis.

Insurance against Asian contagion seemed reasonable at the time and still does to me. Ironically, when pre-emptive policies work as intended, it makes them seem unnecessary in retrospect. But we should always remember that the way things turn out is not the only way they could have turned out.

*Appeared in the Washington Times on September 16, 2007.