WASHINGTON — In a detailed review of the causes of the financial crisis, former Federal Reserve Chairman Alan Greenspan acknowledged a range of regulatory failures but strongly disputed the widely held view that the Fed left interest rates too low for too long.
"We had been lulled into a sense of complacency by the modestly negative economic aftermaths of the stock market crash of 1987 and the dotcom boom," Greenspan said in a paper, "The Crisis," that he will present at a Brookings Institution conference Friday. "Given history, we believed that any declines in home prices would be gradual. Destabilizing debt problems were not perceived to arise under those conditions."
Greenspan's reputation has been tarnished by the crisis. Widely hailed when he left office in January 2006 as one of the greatest central bankers ever, he is now blamed by many for advocating deregulation and low interest rates during the 1990s and 2000s.
Current Fed Chairman Ben Bernanke has said failed supervision was a key ingredient in the crisis. In response he has beefed up the Fed's oversight of the nation's biggest banks and become more aggressive about enforcing consumer protection rules. But like Greenspan, he has argued against the idea that low rates fueled the boom.
In Greenspan's 48-page review of the causes and consequences of the crisis, the text of which was released by Brookings, he acknowledged that the regulatory system failed, that Fed officials didn't take seriously enough the risks building in the subprime mortgage market last decade, that regulators more broadly didn't demand that banks hold enough capital and that he didn't do enough to rein in "megabanks" that posed a risk to the financial system.
He offered a full-throated defense of the interest rate policies he championed. Low rates did play a role in spurring a housing bubble last decade, Greenspan said. But it wasn't the short-term rates he controlled, he said. It was longer-term rates, which were driven lower by a flood of savings released by emerging markets into the global financial system.
The Fed pushed its benchmark interest rate--the federal funds rate--to 1% in 2003, to fend off a dangerous bout of deflation. Greenspan says rates on 30-year fixed rate mortgages drove the housing boom, not the overnight lending rates the Fed controls. Because of the flood of foreign capital, he said, longer-term rates became less closely linked to the federal funds rate during the boom, something he described at the time as a "conundrum."
"Could the breakdown that so devastated global financial markets have been prevented?" Greenspan asked. "Given the inappropriately low level of financial intermediary capital (i.e. excessive leverage) and two decades of virtual unrelenting prosperity, low inflation and low long-term interest rates, I very much doubt it."
The best solution today, he says, is to demand that banks hold more capital. He dismisses the idea that a new "systemic risk" regulator, as Congress is now considering, might prevent the next crisis.
"The current sad state of economic forecasting should give governments pause on the issue," he says.
Greenspan offered a detailed defense in a dispute he has had with old friend John Taylor, the Stanford University professor and former Bush Administration official who has blamed the Fed's low rates for the financial crisis. Taylor is the author of a rule on monetary policy that ties interest rate changes to changes in inflation and economic slack. He argues the Fed veered from the rule and caused the housing bubble.
Greenspan shot back that the "Taylor Rule" applies to broad inflation but not asset bubbles. He also pointed to a recent study by the Federal Reserve, which showed other central banks that moved in line with the Taylor Rule last decade still experienced housing bubbles.