06 Nov 2008

"Did the Fed Cause the Housing Bubble?" Henderson & Hummel vs. Murphy: This Time, It’s Personal

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OK I have been putting this off for a few days, hoping to get time to “do it right.” Well, that’s not going to happen; I’m sitting in a hotel room at 6:00 local time, I got out of bed about 16 hours ago, I still have two official work projects to do, plus I have to go find a restaurant so I can purchase comped sushi. (Condolences may be sent to my personal email account.) My point is, this is going to be good enough for Free Advice work, but will not be the final nail in the coffin.

As you probably know, more and more mainstream economists and financial analysts are coming around to the idea that Alan Greenspan really screwed up by keeping interest rates so low, for so long. Ironically, two guys who think the Fed should be abolished–Jeff Hummel and David Henderson (H&H)–wrote a piece for IBD back in March, exonerating Greenspan. Soon afterward, I wrote a critique for Mises.org, where I blew them up, if I do say so myself.

H&H are back, recycling their arguments and adding just a few extensions in a new Cato publication. What’s interesting is that in this new piece, they don’t merely exonerate Greenspan from the housing bubble; they actually say “Alan Greenspan stands out as the most competent–and arguably the only competent–helmsman of United States monetary policy since the creation of the Federal Reserve System.”

Now if things had just remained at that, no big deal. As I said, the major IBD arguments are still in the Cato paper, and I thought I had disposed of them in my earlier Mises piece. But then in an email to me and a few others, Hummel made it sound as if my critique was pointless. So that’s what is motivating the current blog post, and of course Hummel has given me permission to quote from his email.

(Incidentally, before I forget, here is Jeff Tucker and also Stefan Karlsson responding to the H&H Cato paper.)

So this is Jeff Hummel, in an email to Jeff Tucker, me, and some others:

[Jeff Tucker,] I applaud your willingness to look at the monetary measures, unlike so
many of our critics. But I believe you have misinterpreted the evidence
>> in
>> several of your graphs. Far more important, even if you have correctly
>> interpreted them, none of them address any of our main arguments, which
>> can summarize:
>> 1. Fluctuations in interest rates under Greenspan, including the Federal
>> funds rate, were MAINLY the result of changes in the demand and supply
>> savings (imagine that!) rather than monetary policy. (Robert Murphy
>> replying as if we were making an argument about real vs. nominal
>> rates, which was clearly not true in our original FORBES [IBD? –Bob] article nor in
>> the present one, if he reads them properly.)

OK, this isn’t really a big deal, but since this whole post is a narcissistic defense of my honor, let’s go back to the tape… In their original IBD piece, they wrote:

Why do people judge the Federal Reserve, whether under Alan Greenspan or Ben Bernanke, to be a major cause of the subprime bust? They note how low interest rates were from 2002 through 2004 and make the classic mistake of using interest rates to judge monetary policy. If interest rates are low, they reason, monetary policy must have been excessively expansionary.

Years ago, Milton Friedman pointed out one problem with this reasoning by emphasizing the distinction between nominal and real rates. Nominal rates can be low because expected inflation is low, an indicator of tight monetary policy.

So I guess it’s true, they are quoting Friedman as bringing up the distinction between real and nominal. But in context, it sure as heck looks like they are saying, “Once you adjust for inflation, the ‘low’ interest rates in the early 2000s weren’t really that low. Duh, I can’t believe how stupid Greenspan’s critics are that they don’t even adjust for the reduction in inflation rates.” And so in response, I completely blew them up with the following chart:

Everyone get that? When you adjust the actual fed funds rate for the (ex post) actual rate of yr/yr price inflation, then rates under Greenspan during the middle of the housing boom were the lowest they had been since 1979. In light of that chart, I am not surprised that Hummel now tries to claim that they never brought up the distinction between real vs. nominal.

Back to the email:

>> 2. All the broader monetary aggregates (M2, M3, MZM), being mostly
>> deregulated under Greenspan, are now controlled by the market rather
>> the Fed.

That’s fine, I don’t mention any of the broader aggregates. (Jeff T. did, so maybe Hummel is responding here to Jeff T.’s blog post.)

>> 3. The apparent rapid growth in the monetary base under Greenspan (and
>> the only monetary measure still closely tied to the base) was ENTIRELY
>> result of increases in currency in circulation, most of which went
>> 4. Thus, total reserves are the best gauge of Federal Reserve policy,
>> they remained almost constant over Greenspan’s nearly twenty-year reign,
>> meaning he approximately froze the monetary base, however

OK, something is really fishy here. Greenspan floods the world with paper dollars, and then the coincident growth in other monetary measures (M2, MZM, etc.) is blamed on “the market.” Jeff Tucker said this is like giving a bunch of food and water to rabbits and then blaming the population growth on nature. But I confess I have not looked into this matter enough to do more than announce my suspicions; Stefan’s post claims to blow them up on this point, but again I can’t independently verify his claim. Moving on:

>> And don’t throw Murphy’s posts at me. I admire the fact that he shares
>> your willingness to look at monetary measures. But in the post you link
>> to, he likewise fails to adjust the monetary base for currency going
>> abroad. This makes his comparison with the 1970s utterly misleading.
>> all, it shows base growth peaking over 1970s rates THROUGHOUT the 1980s
>> and 1990s. So are you and Murphy now going to proclaim that price
>> inflation was actually worse under Greenspan than previously?

Here is the graph Hummel is talking about:

So to repeat, my point was that if we put aside the interest rate itself (since, after all, Greenspan could’ve been passively responding to an influx of real savings), and just look at growth in the base (which the Fed absolutely controls), then even so the growth during the middle of the housing boom was at a higher yr/yr rate than during the entire 1970s. My point was, how the heck can H&H claim Greenspan exercised tight control over the money supply, if he allowed it to grow faster than it grew during the entire 1970s?

Now Hummel is right, at first the chart above is surprising. You are expecting to see huge rates of base growth during the 1970s (massive price inflation) and then much lower rates throughout the 1980s and 1990s. Part of what happened is that the Reagan tax cuts caused an influx of investment in US assets, so that the demand for dollars increased. In contrast, during the 1970s the US was in the midst of wage and price controls, all kinds of central planning in oil markets, etc. So it was a terrible place to invest, and increases in the supply of dollars pushed up consumer prices rather than asset prices.

I think a similar thing happened after the Bush tax cuts. If Greenspan truly had maintained tight money, I think there would have been a moderate but short recession, and then you would have seen a strengthening dollar with very low price inflation (perhaps even deflation). Instead, the dollar fell pretty quickly and you had moderate price inflation, despite growth in productivity (though I don’t know how much faith to put in such macro measures). It is the same Austrian business cycle story of the 1920s and the crash of 1929.

Speaking of which, check this out: Look at when the high rates of base growth collapsed: first in January 1987, and then again in 1993, and then again in the end of 1999. The US stock market crashed after the first and third of these episodes. (I can’t think of anything off the top of my head that goes with the 1993 collapse in the base.) Is it really so crazy to say that a central bank, injecting a volatile stream of billions upon billions into the credit system, is going to really screw things up? Is Hummel saying that the high rates of base growth during the 1970s didn’t cause inflation then?

This is something that has been bothering me for a while. If home prices go up at double-digit rates, that’s not called “inflation,” whereas if milk and egg prices had been rising, people would have said, “Whoa Alan, chill out with the counterfeiting!” Yes, you want to avoid a purely mechanistic explanation; it’s not really correct to think of all the little dollar bills “supporting” asset vs. goods prices. But still, we sure did get pretty high rates of price inflation during the last year, and I think it was related to the unwinding of the asset bubble engineered by Greenspan.

Finally, I’ll leave you with this nice chart, which plots yr/yr increases in the Case/Schiller Home Price Index against the federal funds rate. Now it’s true, the housing boom started in about 1997, but then again, if memory serves that is exactly when Clinton passed significant tax changes that definitely would have boosted house prices. In any event, the chart is certainly consistent with the idea that the low Fed rates pumped up the bubble, and then the bubble tapered off and burst as the rates were raised back up.

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