Greenspan and the Housing Bubble: Has He Successfully Absolved the Fed?

Judge Richard Posner, whose policy interests extend to economics, jousts with former Federal Reserve chieftain Alan Greenspan about Federal Reserve interest rate policy and its responsibility for the housing bubble and burst. Greenspan is saying that mortgage interest rates were more in thrall to dollars flowing in from China than from the short-term "federal funds" interest rate directly targeted by the Fed in the past decade; Posner thinks not. From his analysis at the Atlantic's web site:

The federal funds rate, being the rate at which banks borrow reserves (cash) from each other, has a strong influence on long-term interest rates. The lower the cost at which a bank acquires capital to lend, the lower will be the rates at which it lends, whether long term or short term, because competition will compress the spread between the bank's cost (its interest expense) and its revenue (such as interest on the loans it makes). At the beginning of 2000, when the federal funds rate was 5.45 percent, the interest rate for the standard 30-year fixed-monthly-payment mortgage rate was 8.21 percent. By the end of 2003, the federal funds rate was below 1 percent (and was negative in real terms, because there was inflation), and the mortgage interest rate had fallen to 5.88 percent. The Fed then gradually raised the federal funds rate, to 5.26 percent in July 2007, and the mortgage interest rate rose also, to 6.7 percent, a smaller but still significant increase; and the bubble burst. Furthermore, given the popularity of adjustable-rate mortgages–which Greenspan encouraged–short-term interest rates had a direct effect on the cost of mortgages during this period. Greenspan's analysis implies that the Federal Reserve lost control of long-term interest rates because of foreign capital and therefore could not have lanced the housing bubble even if it had wanted to, which is hard to square with the fact that the bubble did burst when the mortgage interest rate rose….

A Reason magazine roundtable of economists and market experts, including the late Milton Friedman, asked the unmusical question, Was Greenspan a Bubble Blower?, back in 2006.