I Am Naive...
The Malthusian Trap

Paul Krugman on Alan Greenspan

He writes:

Greenspan and the Bubble - New York Times: Most of what Alan Greenspan said at last week's conference in his honor made very good sense. But his words of wisdom come too late. He's like a man who suggests leaving the barn door ajar, and then - after the horse is gone - delivers a lecture on the importance of keeping your animals properly locked up.

Regular readers know that I have never forgiven the Federal Reserve chairman for his role in creating today's budget deficit. In 2001 Mr. Greenspan, a stern fiscal taskmaster during the Clinton years, gave decisive support to the Bush administration's irresponsible tax cuts, urging Congress to reduce the federal government's revenue so that it wouldn't pay off its debt too quickly. Since then, federal debt has soared. But as far as I can tell, Mr. Greenspan has never admitted that he gave Congress bad advice. He has, however, gone back to lecturing us about the evils of deficits.

Now, it seems, he's playing a similar game with regard to the housing bubble. At the conference, Mr. Greenspan didn't say in plain English that house prices are way out of line. But he never says things in plain English. What he did say, after emphasizing the recent economic importance of rising house prices, was that "this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent." And he warned that "history has not dealt kindly with the aftermath of protracted periods of low-risk premiums." I believe that translates as "Beware the bursting bubble."...

If Mr. Greenspan had said two years ago what he's saying now, people might have borrowed less and bought more wisely. But he didn't, and now it's too late. There are signs that the housing market either has peaked already or soon will. And it will be up to Mr. Greenspan's successor to manage the bubble's aftermath.

How bad will that aftermath be? The U.S. economy is currently suffering from twin imbalances.... One way or another, the economy will eventually eliminate both imbalances. But if the process doesn't go smoothly - if, in particular, the housing bubble bursts before the trade deficit shrinks - we're going to have an economic slowdown, and possibly a recession...

Krugman's line, "[Greenspan's] like a man who suggests leaving the barn door ajar, and then -- after the horse is gone -- delivers a lecture on the importance of keeping your animals properly locked up," is a very good one.

Let me endorse Krugman's discontent with Greenspan's enabling of the Bush 2001 tax cut. He should have spoken out much more strongly against any possibility of returning to deficits. He should have explicitly warned the Bush administration the Republican congressional leaders that the Federal Reserve cannot in the long run maintain effective price stability if the federal budget is in chaos. I can't endorse Paul 100%, however, because at the time I did not think the tax cut was a huge deal. It had not yet penetrated my mind that the Bush policy was one of huge permanent tax cuts, huge increases in domestic spending aimed at favored groups (drug company lobbyists, farm states, places with Republican House members), and huge increases in military spending to wage wars of choice that would weaken America's strategic position. I thought Greenspan's failure to mightily oppose the tax cut was a mistake, but not a big one--especially if it was Greenspan's judgment that he needed to create a good working relationship with the Bush administration.

My mistake. Paul was right.

I'm less sure--even now--that I want to endorse Paul's criticism of Greenspan on the bubble. There are, broadly speaking, three things that Greenspan could have done when confronted with the dot-com bubble and with the current... um... housing-and-bond-market "conundrum." Alan Greenspan thought that the stock market was overvalued in late 1996--that there was then a bubble. From today's standpoint it looks as though he was wrong: invest in high-tech companies in late 1996 and hold them until today, and your returns have been quite healthy. My view is that Alan Greenspan doesn't think that he is very good at judging whether assets are overvalued or not. That means that he needs to be very cautious, and to say much less than he thinks, because if he is wrong he will do significant damage.

It's an old Bill Brainard point. If you don't have a great deal of confidence in your judgment, you should discount your own point of view. You should only do a small part of what you would do if you were certain that your view of the situation was the correct one. I think--I don't know--that this is what has led Alan Greenspan to hesitate.

That being said, in retrospect it would, I think, have been better had the Federal Reserve been more willing to publicly worry about overvaluations and to impose additional capital requirements on firms fueling purchases of stocks and houses. But should the Federal Reserve have gone further and actually raised interest rates in the absence of inflation to try to cool off asset prices? I don't think so. Raising interest rates reduces employment.

As John Maynard Keynes almost said, in a world of scarcity it is better to give speculators more rope than to deliberately raise unemployment.