In 2003, Alan Greenspan argued that the Fed needed to set low interest rates to prevent falling into a liquidity trap and deflationary spiral. (H/T commenter Declan). In 2008, Greenspan's critics argue that those same low interest rates caused an asset bubble, which burst, causing the economy to fall into a liquidity trap and deflationary spiral. Is it possible that Greenspan and his critics were both right? Was the US economy doomed either way?
Greenspan's critics could be arguing one of two positions: first, they could be saying that setting interest rates too low relative to the natural rate caused the asset bubble; or they could be saying that setting interest rates too low in absolute terms caused the asset bubble. Let's take each in turn.
1. Suppose Greenspan, like a good neo-Wicksellian, says: if the Fed sets interest rates above some "natural" rate, inflation will continue to fall; and if the Fed sets interest rates below the natural rate, inflation will continue to rise. His critics agree, but add that setting interest rates below that same natural rate will also cause an asset bubble.
[Don't get hung up and sidetracked on the "natural rate" concept. All that matters, in this context, is that there is some rate which could both keep inflation stable and prevent an asset bubble.]
In this case, the right monetary policy is simple, at least in principle. The Fed should set the interest rate equal to the natural rate, following that narrow path between an immediate deflationary spiral on one side, and increasing inflation, an asset boom, bust, and subsequent deflationary spiral on the other side. The path may be narrow, but it exists.
But it's a lot harder to follow that narrow path in practice. The Fed does not actually see the path in real time, and can only observe whether it has wandered to one side or the other by watching inflation and asset prices. We can only hope that the Fed sees its mistakes quickly enough, and responds quickly enough, that it gets back on the path before falling over the cliffs on either side.
If this is what Greenspan's critics believe, then they must believe that Greenspan wandered too far from the path ever to get back onto it. Trying to avoid falling over the cliff on one side, Greenspan wandered too far from the path on the other side.
I simply do not find the above view credible. Let us allow that Greenspan, in hindsight, should have paid more attention to asset prices. Even allow that it would have been better if the Fed had explicitly targeted a weighted average of consumer and asset price inflation. The rise of inflation above target was small, certainly by any historical standard. Mistakes happen, will happen in the future, and lots of central bankers in other times and other places have been far less competent than Alan Greenspan. If the above view were correct, most countries, most of the time, would be in a financial crisis. They aren't.
2. Suppose Greenspan's critics argue that it is setting interest rates too low in some absolute sense that causes an asset bubble, rather than setting them too low relative to the natural rate.
In this case, the correct path for monetary policy might not just be narrow; it might not exist at all. If the Fed sets interest rates anywhere above a natural rate of (say) 3%, the result will be an immediate deflationary spiral. But if the Fed sets interest rates anywhere below (say) 4%, the result will be an asset bubble, burst, and subsequent deflationary spiral. The economy is doomed either way, and the only choice is between facing doom now or later.
I find this second interpretation of Greenspan's critics far more credible. Perhaps most of the time, in most countries, the natural rate is high enough that setting the interest rate at or close to the natural rate will not cause an asset bubble, so financial crises are rare. But some unfortunate rare circumstance (a world savings glut seeking US Treasuries?) caused the natural rate to be very low in the US around 2003-5, so it was impossible to set an interest rate low enough to prevent inflation falling, and yet high enough to prevent an asset bubble.
But then you can't blame Greenspan for failing to follow the safe path if the safe path did not exist!
If an interest rate low enough to keep inflation stable were not high enough to prevent an asset bubble, there was nothing Greenspan could do. If he had set an interest rate high enough to prevent a bubble the result would have been a deflationary spiral in any case. Perhaps a more expansionary fiscal policy could have raised the natural rate enough to prevent an asset bubble? Hmmm. Was US fiscal policy especially contractionary? Hardly.
Or are those who say they are blaming Greenspan, really blaming China?