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The Greenspan Gamble

Wednesday, June 3, 2009

In the wake of the burst tech stock bubble and the shock of the terrorist attacks, the Greenspan Gamble was to purposefully ignite a housing boom. Ex ante, it was a reasonable gamble and it almost worked.

The history of the Federal Reserve has been marked by periods of severe economic and financial problems, after which its policies have come in for sharp attack as deflationary or inflationary blunders. Bernard Shull, in his insightful history of the Fed’s evolution, discusses three of these instances: the “roller coaster” of inflation and deflation from 1919 to 1921; the Great Depression with the collapse of the financial system, including the Fed’s 1937 “tragic mistake” of pushing the economy back into contraction; and the Great Inflation, then stagflation, of the 1970s.

Now with the bubble become bust we have a fourth instance and resulting criticism, such as this statement by Columbia University professor Jeffrey Sachs: “The U.S. crisis was actually made by the Fed . . . one main culprit was none other than Alan Greenspan.” (A typical phase in the reaction to a bust is the search for the guilty, so we should not be surprised at the rhetoric of a “culprit.”)

The ultimate failure of the Greenspan Gamble notwithstanding, the Fed will continue to be extremely useful in helping ameliorate busts and financial panics.

Shull observes that the Fed “has been winning battles since its establishment in 1914, regardless of the merits of its policies.” Its position and power “ratcheted upward . . . in several distinct periods during which its policies were so profoundly disappointing,” as it “transcended its failures.”

A frequently alleged factor in financial market behavior in recent years is said to be the “Greenspan Put”—the belief that the Fed will bail out the market’s mistakes. A more relevant interpretation of events is the “Greenspan Gamble.” In the wake of the burst tech stock bubble, an impending recession from industrial overinvestment, and the shock of the terrorist attacks, the Greenspan Gamble was to purposefully ignite a housing boom to offset industrial weakness and bridge the economy until, with the help of a falling dollar, industrial growth resumed.

Ex ante, it was a reasonable gamble and it almost worked—but the intended housing boom turned into a bubble, nourished by a great credit overextension. Ex post, we now focus on the unintended costs: falling prices for houses, most people’s principal asset, the severe credit contraction, and illiquidity. But remember that in 2007, we were still being treated to pontifications about the “global liquidity glut” which would ensure robust markets for financial assets.

Everybody, no matter how clever and diligent, no matter how many economists and computers are employed, makes mistakes when it comes to predicting, let alone controlling, the future.

What can we conclude from this saga? The ultimate failure of the Greenspan Gamble notwithstanding, the Fed will continue to be extremely useful in helping ameliorate busts and financial panics, just as intended in 1913 and practiced from 2008 to 2009. This extreme usefulness to the government insures its continued influence and authority, which may very possibly include acquiring wider jurisdiction as the “Super Fed.”

But it is in vain to think that as the Fed or as the “Super Fed” it could foresee all future problems or prevent future bubbles and busts. It is even in vain to think it could consistently make correct forecasts of the results of its own actions. Everybody, no matter how clever and diligent, no matter how many economists and computers are employed, makes mistakes when it comes to predicting, let alone controlling, the future.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. Previously he spent 35 years in banking, including 12 years as president and chief executive officer of the Federal Home Loan Bank of Chicago.

Former Federal Reserve Chairman Alan Greenspan is delivering the keynote address at a conference at the American Enterprise Institute on Wednesday, June 3.

FURTHER READING: Pollock recently wrote “Is a ‘Systemic Risk Regulator’ Possible?” and “Why Not Negative Interest Rates?” Also in The American, Pollock wrote “A Theory of Two Big Balance Sheets,” explaining the recent period of bubbles, busts, and bailouts, “Did They Really Believe House Prices Could Not Go Down?,” and “Your Guide to the Housing Crisis.”

Image by Darren Wamboldt/Bergman Group/Flickr user tl8745a. Flickr image found here.

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