Short versus long term interest rates and the Greenspan legacy

Comments on “Greenspan Sees ‘Seeds of a Bottoming’ in U.S. Housing (Update3)”, a news report by Vivien Lou Chen and Dawn Kopecki, 12/05/2009, http://www.bloomberg.com/apps/news?pid=20601087&sid=af__GYb21Pz4&refer=home

That report talked about Greenspan’s comments on US housing and equity markets. Greenspan said that that the decline in the U.S. housing market may be bottoming and it’s “very easy to see” financial markets continuing to improve.

It was mentioned in the report that Greenspan said in congressional testimony in October 2008 that “a flaw” in his free-market ideology contributed to the “once-in-a-century” credit crisis. There was also some discussion about the role of the US monetary policies under Greenspan in the formation of the housing market bubbles at the end of the report. The following three paragraphs are excerpt from that report for reference.

Former Fed Vice Chairman Alan Blinder, Stanford University professor John Taylor and other economists say Greenspan’s approach of keeping rates low for an extended period helped to foster the housing bubble.
“I’ve always argued going back many decades that you do not capitalize a piece of real estate with overnight interest rates,” the former chairman said today in response to an audience question. The housing market is instead fuelled by a decline in long- term interest rates, which started a full year before the Fed began cutting the federal funds rate, Greenspan said.
“I think there is a recalibration of financial history that I find very puzzling,” he said. Referring to his critics, he said, “I can say that I respectfully disagree. They’re wrong.”

Obviously, Greenspan talked the potentials that short and long term interest rates could have on housing prices, especially given the fact that the US mortgage rates may be more like fixed rates over longer terms, unlike the case in Australia. However, it was unclear what relationships there generally are between the two. Further, it was unclear how monetary policies affect the long term rates, if the main focus of the monetary policies is on the short term rates.

One may be reasonably think that international capital flow especially in terms of trading of US longer term Treasury bonds should have an impact on the long term rates in the US, at least for the short term. This shows the differences in monetary policies between a closed and an open (capital market) economy.

In an open economy, the role of the monetary authority in determining interest rates may be weakened. One can also assume that foreign purchases of US Treasury long term bonds over the past many years might have contributed to the decline or low long term interest rates in the US. What Greenspan referred could be the effects of that.

Even assuming that the above is all correct one could still expect that the US Fed should have had some influences on the long term interest rates in the US, especially over a fairly lengthy period, given the size of the US economy and its monetary bases relative to international capital flows. Therefore, Greenspan as the Fed Chairman for many years should have had considerable responsibility over the growing of the US housing bubbles.

In retrospect, it would have been better if the Fed had taken some measures to slow the credit flows to the housing market, assuming it had the ability or tools to do it. Further, the Fed should have realised the potential dangerous consequences of the rotten practice of some of the sub-prime mortgage lenders or agent had. It should have done some regulations or asked for power to regulate them. They didn’t, obviously.

It was true that international imbalance in savings and investment/consumption may have been a factor for lowering the US long term interest rates prior to the financial crisis. The Fed and Greenspan as its Chairman at that time must have played a role if not the major role in the making of the US housing bubbles.

Indeed, low long term interest rates in the US also lowered the international long term rates, in turn the long term rates in many countries, because of the role of the US dollar as the main international reserves and the size of the US market. That could, in turn, have led to the making of housing and other market bubbles in many places in the world.

The US has had very large impact on the international interest rates. So have its monetary policies had. Naturally, it was important for the US authority to manage its monetary policies prudently, not just for itself, but also for the international community at large.

Over the longer term, the international community and the US authority should more closely coordinate their policies. Further, any future development in terms of international financial institutions and governance must learn from the past experiences and lessons.