Alan Greenspan, dietified or demonized?

My high-school AP Economics instructor had a shrine to Alan Greenspan in her classroom. No really, a shrine. Complete with a golden picture frame and candles. At the time it seemed a bit stalker-ish, but as I have learned more about the role of the Federal Reserve in our economy I have realized that such a shrine was not wholly unwarranted. At his retirement in 2006, many dubbed Greenspan the greatest Federal Reserve Chairman in history, but the subsequent recession has given them pause for thought. Specifically, “Was the Fed responsible for the housing bubble?”

While the invisible hand directs economic forces both micro and macro, fiscal and monetary policy can have a huge impact on the growth of an economy as a whole. Growth, as measured by real GDP, must be kept within sustainable limits. If the economy grows too quickly inflation can choke out any real gains in GDP and destroy capital investment. On the other hand deflation can bring even an explosive period of growth to its knees. Just ask the Japanese. The Federal Reserve’s control over interest rates has a direct impact on capital investment and therefore the rate of inflation, making it the most powerful monetary force in the country.

Few people understood the Feds role better than Alan Greenspan at the end of his tenure as Chairman of the Fed. For almost two decades he consistently pumped liquidity back into the market during times of economic crisis in a policy that would come to be know as the “Greenspan Put”. When consumer spending showed signs of slowing the Fed would respond by dropping the interest rate to re-stimulate the economy. This may have worked for the 1987 stock market crash, the Gulf War, the 1997 Asian crisis, Y2K, the burst of the internet bubble, and the 9/11 terror attack, but what about the current economic crisis? It is generally accepted that the housing market crash was at the heart of the 2008 economic meltdown, but what part did the Fed play in creating, or discouraging, the housing bubble.

Greenspan did take some credit for the housing bubble, claiming that it was “fundamentally engendered by the decline in real long-term interest rates.” But as noted, the Fed does not have direct control over long-term interest rates. Long-term rates are determined by the market’s confidence that interest rates will eventually come back down. By consistently lowering interest rates the Fed may indeed have created an atmosphere of confidence in the economy, but this hardly makes Greenspan responsible for the bubble. If anything this places the blame squarely on the shoulders of the financial institutions that took advantage of this confidence and sacrificed long-term stability for trade short-term gains.

If Greenspan had any significant impact on the 2008 crisis it would have been in the form of ideology rather than policy. A perennial advocate of free-market forces over government regulation, on Oct 28 2008 he testified before congress that his long held ideology was “significantly flawed” and did not sufficiently protect shareholders and investments from unscrupulous individuals. The evidences left by his 19-year tenure is an unquestionable testament to the power of the free market, but even a deity of high-school economics teachers cannot predict the behavior of the increasingly complex markets that make up our national and global economies.