In defense of Greenspan on Solow’s criticism
Robert Solow wrote an article about Greenspan, his successes and his mistakes, Alan Greenspan Is Still Trying to Justify His Bad Decisions; What the maestro doesn’t understand.
Even though I agree with what Solow said about Greenspan’s early years, I want to defend Greenspan during the years after the 2001 recession. There was something not even Solow understands to this day. I start with what Robert Solow said here…
“Hindsight leaves no doubt that it would have been a great idea to prick the housing bubble early. But imagine that Greenspan and the Fed had done so. Suppose they had tightened credit, pushed interest rates higher, put an end to the housing boom, and thus—very likely—created a standard recession like so many of the others. They would surely have been pilloried for destroying a nice prosperity in midstream and creating painful unemployment.”
The economy was not going to fall into a recession if interest rates had been raised back in 2003. That view is an error that many economists still have. The economy was no where near the natural level of GDP (effective demand limit) and still had plenty of traction to overcome higher interest rates.
Back up a bit, in 2001, I would say that the Fed rate was too high. The economy was falling into a contraction and the Fed rate was 3.5%. Then as the economy began to recover in 2002, the Fed rate returned to a balanced path back to their previous target. Then the Fed rate started to slide lower in 2003. Inflation had gone down to 1.4%. And even went to 1.3% in 2004. So the Fed lowered the interest rate in response to the inflation rate.
But another thing took place in 2003 that neither the Fed nor Robert Solow saw. The natural level of real GDP in terms of labor and capital utilization shifted in 2003. The Fed didn’t sense this until 2005. Then they reacted by raising the Fed rate fast towards a path of balance. The Fed must have been thinking that they had more spare capacity to work with to get the economy back to full employment of labor and capital. But there wasn’t as much spare capacity as they thought.
I do not blame Greenspan. I cannot even blame Robert Solow for not knowing this. They both do not have a working model for the effective demand limit.
This video explains in more depth the movement of the Fed rate during those years.
It is unfair to criticize Greenspan. The shift of the natural level of real GDP was not seen by anyone. In fact, the more recent shift after the crisis of 2008 is still not seen by anybody. Thus, even Solow continues to make the same mistake in judgement.
I can foresee a moment when the Fed realizes the natural level of real GDP is closer than they think and has to tighten policy quickly, like Greenspan did back in 2005. Will Robert Solow criticize Ben Bernanke in the future for holding the Fed rate down too low? If he doesn’t criticize now, he shouldn’t in the future. Like Solow said, “Hindsight leaves no doubt that it would have been a great idea to prick the housing bubble early.”
Solow is criticizing from hindsight. I understand what Greenspan was thinking and what he was reacting to. I do not blame him. The invisible shift of the natural level of real GDP took him and others by surprise.
The problem now is that the more recent shift will surprise even the likes of Solow.
I would argue that Greenspan knew precisely what he was doing and it was purely for political reasons. I remember how the year 2000 developed, with Greenspan constantly ratcheting the Fed interest rate higher claiming that the economy was – oh – so hot. A year later we find out that the economy was cooling during the entire year. Funny how 2000 was an election year and the candidate leading the race initially was from the incumbent party not favored by Greenspan.
Compare that to 2003 and 2004 and the picture starts to come into much sharper focus. The party Greenspan favored and on whose behalf he had testified about radically lowering tax rates just two years before suddenly finds that the economy is missing some cylinders and they just started a war. The economy is going to be sliding into a recession in 2004 with a stumble-bum President at the helm in what is shaping up to be a close race despite the incumbency. The mess in Iraq had spooked business, just like Dubya’s old man’s adventure in Iraq had done in 1991. Does anyone rational believe Greenspan is gonna do anything but lower interest rates in that environment? As it turned out, Dubya needed every ounce of juice to be able to squeak by in “winning” the 2004 election, which is all that mattered to the Maestro.
PrahaPartizan,
I say in the video that the Fed rate was high around 2000, maybe to bring down the bubble. If the reason was political, then you are right.
I also say that in 2003 to 2004 the Fed rate was low because inflation was too low and many economists were worried about falling into another recession. Even Solow says in his article that a recession was likely with a higher Fed rate. And even the eventual crisis was not seen back in 2004.
Now if part of the reason to keep the Fed rate low was political, then you are right again.
Yet, there were economic reasons too.
Greenspan was one of a handful of people, along with Gramm, Summers, and Ruben who caused the housing meltdown by pushing through the Commodity Futures Modernization Act of 2000. The derivative tsunami that ensued is what caused the multi trillion dollar meltdown.
Focusing on monetary policy regarding the housing bubble is like worrying about your hair color while your pants are on fire. Complete misdirection.
By the way, it’s still with us, and Wall Street and the congressional chorus are still singing falsehoods. Face it: the financial sector is a zero sum game, with the vast majority losing and the few winning huge. It used to be called theft.
angry:
Too simplistic a viewpoint. The Commodity Futures act and the repeal of an already weakened Glass Steagal (section 20) might have been a doorway for the resulting economy; but, there were other things in motion. Allowing people to withdraw home equity from their homes without penalty put $billions at the door of Wall Street. Add this to the $billions of overseas investments arriving from overseas looking for safe haven just about the time the FED hit 1% and Greenspan saying “not yet” for increasing the Fed Rate and you had the perfect storm. Without the need for investment with a surplus of domestic and foreign currency, nothing would have happened.
I agree Greenspan, Rubin, Weil, Gramm Levitt and Summers (with Geithner in the wings) have much to be at fault for; but, it was more than just a passage of the enabler act which brought this to bear.
Run75441,
YOu bring up a good point… the overseas money flooding in during 2003 to 2006.
The US had never seen such a huge inflow of financial flows from abroad. This added to a low Fed rate at the time. I failed to mention that in the post.