What caused the crisis?

Todd Henderson —  13 February 2010

Writing in the Wall Street Journal, Alan Greenspan, who was at the helm of the Fed during the relevant time period, tells us (surprise!) it wasn’t the Fed’s fault. Greenspan notes that short-term interest rates, which the Fed controls, are only loosely correlated with long-term interest rates, which are most relevant to real estate investing (think, 30-year mortgages). Therefore, the Fed (read: Greenspan) can’t be to blame.

So what caused the drop in long-term interest rates? Greenspan blames, well, capitalism. He writes:

[T]he presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition.

In other words, China and others abandoned idiotic political control of markets, and the resulting flood of wealth created needed somewhere to go. It went to invest in US houses. Ergo, the lowering of rates and the rise in values.

This certainly sounds plausible, but why did China invest in my mortgage instead of Google? I’m not an economist, although sometimes I pretend, but it seems like Fed rates, which made T-bills less attractive on the margin, and silly policies about housing, such as forced lending to poor people and guarantees of Fannie and Freddie bonds, made the latter much more attractive. If Chinese investors could only get 2% return on T-bills (guaranteed by the full faith and credit of our government) but could get 8% return on investments in housing (guaranteed by the full faith and credit of our government), then why would they ever choose the former?

So I think it is probably unfair to blame the Fed or Mr. Greenspan for the crisis. It was not loose monetary policy alone that led to the state we are in. A combination of factors led to the boom and the bust. We will probably never know exactly what the relative weight of them was in causing the crisis, but they all have one thing in common — bad government policy. Sure the market acted greedily, selfishly, narrowly, and all the other ways that humans act, but that is to be expected in all states of the world. But for bad government policies, including Mr. Greenspan’s loose money policies, we wouldn’t be where we are today. The real trick is to find ways to harness the good and bad instincts of the market, something that we utterly failed to do given political pressures at home to force people to live a particular vision of the “American dream,” and given the fundamental changes in the global economy. Until we rethink the role of government in our lives, we are as likely to get this wrong as we are right.