Saturday, April 4, 2009

A Phony Debate

Did Greenspan's cause the current financial crisis by keeping the federal funds rate target too low for too long (2001-2003)? John Taylor has published a book recently taking Greenspan to task for precisely this. Is this a reasonable charge?

The Federal Reserve is one of many central banks around the world. The US is one of many short term borrowing markets around the world. There was a time, no doubt, when whatever happened in the US was the only thing that mattered to world economic variables. Not true anymore. The Fed can tinker around the edges, but the overall course of interest rates has nothing to do with the Federal Reserve. The decade of the 1970s serves as a permanent historical marker to the inability of the Federal Reserve to determine the course of interest rates, when market forces are pushing rates in a different direction. The idea that a central bank, any central bank, can make a minor adjustment to its balance sheet and thereby determine interest rates is silly.

Interest rates, even short ones, are determined by market forces. It isn't the Fed that pushed the overnight federal funds rate to zero last year. Funds traded at zero long before the Fed made its announced target rate change. In fact, the Fed has been behind the curve of the actual funds rate since the summer of 2007. They have lowered their target rate for federal funds repeatedly simply in an effort to catch up with the plunge in the actual market-determined federal funds rate. Something similar will happen on the way back up (which has already begun).

The Fed did not cause the financial crisis. That's a silly argument. There is a strong possibility that no one caused the current financial crisis! Yes! It is often the case that markets overshoot -- booms and busts do occur without their being some specific villain hiding behind the curtains pulling the strings. Why look for a villain? Looking for a villain leads to the wrong prescription for curing the crisis. Finding a villain and punishing him (or regulating him out of existence) is the wrong policy.

The right policy is to let the chips fall where they may. That way, market participants learn and future crises might not be so severe. The current policy teaches no lessons to market participants other than that bad behavior might be rewarded by misguided government policy (think TARP, Stimulus package, Mortgage relief, Fed guarantees, etc., etc.)

Markets go up and down, markets have booms and busts. They always have; they always will. That is why we are a wealthy and economically healthy society. Abolishing booms and busts may abolish the wealthy and healthy society as well.