Getting it Right about Greenspan

We were not planning to write about former Fed Chair Alan Greenspan or his book, but regular (and thoughtful) commenter Mike C. convinced us otherwise.  He observed that if we liked Bernanke, we probably had liked Greenspan as well.  Mike went on to cite several of the popular criticisms about Greenspan and we made a brief reply.

It is not our mission at "A Dash" to defend Greenspan.  History will treat him well.  That assessment judgment is a good one, despite the many recent attacks on his record.  No one can serve in such a prominent position for nearly twenty years, making so many decisions, without generating  controversy and dissent.

Why Should We Care?

What convinces us to take up this topic is our ongoing desire to help our readers achieve better investment returns.  One of the biggest traps is underestimating and misunderstanding government.  Some pundits believe that if they can find a few specific errors in the Greenspan record, it shows the weakness of the Fed as an institution.  This empowers the pundit to pretend to be as intelligent and informed as the collective body of people working for the Fed.

If you are a journalist or a blogger building traffic, disparaging the Fed may work well.  If you are making investment decisions, it is better to understand the Fed than to pontificate about what they should be doing.

"Recommending"  ARM’s

Everyone who wants to criticize Greenspan points out that he "advised" homeowners to take adjustable rate mortgages at exactly the wrong time.  Former Dallas Fed President Bob McTeer explains on his blog what really happened:

"…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."

Readers will note that the speech was about a pricing model, not market timing.

Causing the Housing Bubble

In reviewing public policy decisions historians or analysts often use a concept called the counterfactual.  This approach is designed to thwart the kind of thinking that many know more commonly as "Monday morning quarterbacking."  What would have happened if Truman had not approved dropping the atomic bomb?  What if Bush had not invaded Iraq?  We know what did happen, but not what would have happened.

Bob McTeer uses this concept to describe the Fed’s thinking:

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.

McTeer provides a strong defense of the Greenspan decisions, pointing out the need to avoid a low-probability effect ("when disinflation threatened to degenerate into outright deflation") that had serious global consequences.  (Reader note:  His blog is updated only occasionally, but is well worth watching).


After reading McTeer’s defense of Greenspan, you might still disagree with his decisions, but you should have a better understanding of what really happened.

We wonder how many readers just took the standard criticisms as gospel truth, never checking out the facts.  Sometimes the Internet Punditry is not the best source of information.

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  • RB September 28, 2007  

    It’s Greenspan day, hope you get some good comments here

  • Mike C October 2, 2007  

    Good post, and thanks for the link to the McTeer blog. His blog is VERY helpful in understanding Fed operations.
    FWIW, the combination of your post and reading McTeer’s blog has changed my mind. I was formerly in the camp that believed the Fed had made a colossal mistake by taking rates to 1% and leaving them there for the amount of time they did. I now appreciate the point that we don’t know what would have happened had they NOT followed that course of action, and perhaps that alternative scenario would have had a negative outcome.
    In any case, I think debating whether Fed policy/moves they make are “right” or “wrong” is neither productive nor useful. I highly doubt any pundit or blogger has any influence on Fed policy.
    What is more important in my view is to identify likely Fed policy, and use that to generate themes for profitable investing. One could have made alot of money both on the long and short side with the homebuilders during the “housing bubble”, and the aggressive Fed cutting which led to negative real interest rates provided the lift-off for the entire commodity complex and precious metals.
    So what now? Is it one and done, or was the 50bp cut just the first move in a rate cutting cycle. My money is on the latter. What are the investment implications of that? Probably bullish for the market overall, especially stocks that benefit from a falling dollar (large exporting multinationals), and almost certainly bullish for commodities and precious metals.
    As a side note to Fed policy, I think the view that inflation is understated is growing. Here is what David Merkel at Aleph Blog had to say, and I think one has to agree he takes a balanced, measured view of things, and certainly is not an over-the-top extremist
    “One thing that is different about my blog is that I will do different sorts of posts. I’m hard to categorize. This comment makes some very good points, most of which I agree with. I believe inflation is understated in the US, and I think that the idea is growing in the populace, while Ph.D. economists stay in lockstep with the guild, and deny it. My main article on the topic, for those with access to RealMoney, can be found here.”
    I’d like to read the article, but I don’t have a RealMoney subscription.

  • Aaron October 2, 2007  

    Greenspan is clearly a very bright man with lots of insight on the overall economic picture. I do have to question how public he is being with his monetary policy talk and predictions now though. I think he would be better off letting Bernanke have the floor now as it relates to the current state of monetary policy.

  • RB October 2, 2007  

    All you ever wanted to know about Greenie:
    Blinder singles out Greenspan’s single-handedly identifying the productivity acceleration in the nineties and crafting monetary policy around it as his greatest achievement. He identifies his policy (positively) of mopping up after bubbles burst as his legacy.
    For a view of the Greenspan Fed with all its flaws, the book by Laurence Meyer recommended on this blog is strongly recommended. With the benefit of hindsight, Meyer thinks it is possible that they overreacted in cases, such as in 1998 and to the Y2K issue.
    Meyer also admits that we don’t know whether LTCM was as big a disaster as thought (though as a Fed Governor he was completely in the dark about what was done). He also says that deflation is not necessarily a bad thing if it comes from a supply shock as happened during the arrival of the railroads first and automobiles next. What is bad is a deflation occurring after a demand shock such as after a bubble bursting.
    It may perhaps be possible to open up the Greenspan Fed for criticism on the basis that while the Fed is an independent body, it is not “politically tone-deaf”. Therefore and for other controllability reasons, it is biased towards inflation.
    One item of relevance today for those who watch the Fed, might be this line from Meyer’s book regarding when the FOMC might tighten rates:
    “Even the presidential election plays a part — making the beginning of the tightening cycle less likely immediately before or possibly immediately after the election.”