An extremely important debate is being carried out in the WSJ. First, Anna Schwartz (co-author of Milton Friedman's most important book) criticized Bernanke for fighting the wrong war (link to WSJ editorial in this post). Then John Taylor criticized Greenspan for having caused the credit bubble (link to WSj editorial in that post). Now Greenspan offers his defense as a direct rebuttal to John Taylor: the problem was not holding short term rates too low for too long, but the unusually low long term rates due to the savings glut of mercantilist economies like China. These low long term rates then fed a worldwide housing bubble. Greenspan acknowledges the critical importance of this issue on policy:
"How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.
"If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue."
Greenspan then shoots his cannon across the bow of the Obama administration and the mantra of 'deregulation' having caused the bubble: "[T]he appropriate policy response is not to bridle financial intermediation with heavy regulation. ... The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities."
We cannot rewind history, but we can conduct a thought experiment to test Greenspan's argument: absent his reflation of US credit, plus his coterminous relaxing of requirements (such as bank reserve levels), would the exponential growth of credit have exploded in 2004-8? Specifically to Greenspan's defense, since he focuses on the housing bubble, would housing have exploded?
Methinks Greenspan protests too much. Before the Greenspan reflation, global housing was rising but not exponentially. Fannie & Freddie had already been pushing subprime mortgages and relaxed lending requirements, but the bubble had not emerged. Globalization and the savings glut had begun in the early '90s, and may have contributed to the dot-com bubble; but even that one was sparked by Greenspan pumping liquidity in 1997 after the Asian Flu, in 1998 after the failure of Long Term Capital Management, and in 1999 to avoid the spurious Y2K problem. Does he really want to argue that the well-recognized Greenspan Put (to bail out investors of their excesses) did not enbolden an environment of "euphoria" and excessive risk-taking?
As a coda to his argument, the policy solutions he proposes, of higher capital requirements for banks and prosecution of fraud, are entirely consistent with Taylor's contention that excessive easing caused the bubble. If Greenspan really thought the mercantilist Asian economies caused the problem, he should propose counters to that. But he welcomes globalization and believes it caused prosperity in the US. Hence his defense contains its own rebuttal.
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