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Nick -- ever read any George Selgin?

Doing so might help. High productivity requires benign "price level" deflation. No "deflationary spiral".

And what model implies a "deflationary death spiral" when the natural rate is closely tracked, but not hit -- a pseudo-scientific one?

Every look at the massive deflation / bust of 1920-1921? No death spiral. Ironically, no Keynesians or Foster & Catchings cranks in control of the economy, either.

Of course, it's theoretically valid to blame both Greenspan and China -- the empirical evidence suggests Greenspan (see Taylor).

A question from a non-economist:
I understand, at a very high level, the fear the deflation will cause delayed purchases, causing cascading problems.

But how does this take into account the substantial parts of the economy where there has been deflation for decades? Just think about anything based on electronics. Not only have computers gotten better, but their retail prices have declined, even without adjusting for inflation. Isn't this a good thing?

Richard: People expect computer prices to be falling, and so buy fewer computers than they would if they expected the price to stay the same at the current level. But if it's just some goods, it's not a problem: they buy fewer computers, but more of something else, so in aggregate there's enough demand for goods to meet the supply of goods.

If the price of goods is low relative to our money incomes, it's the same as if our money incomes is high relative to the price of goods: it's a good thing, because our real incomes are higher.

But distinguish between high and rising. Distinguish between low and falling. "Deflation" is not low prices; it's falling prices.

If people expect deflation, for goods on average, they may postpone buying all goods, and firms may invest less, for a given nominal interest rate. It's equivalent to a high real (inflation adjusted) interest rate. Aggregate demand is less than aggregate supply, and we enter a recession, so prices fall faster, and people expect prices to fall even faster.

Curses! TypePad seems to have eaten my reply to Greg. Let me see if I can remember what I said.

Greg: If productivity growth is high, the (real) natural rate would tend to be high too, so a moderate amount of deflation would still be compatible with a positive nominal natural rate. So there's less risk of a deflationary spiral and hitting the zero interest floor when productivity growth is high.

But what do you think Greenspan's critics believe? Is it:
1. Setting interest rates below the natural rate causes an asset boom?
2. Setting interest rates low in absolute terms causes an asset boom?

Or is it:
3. Allowing positive inflation causes an asset boom?

If Greenspan had acted in 2003 most of the shoddy derivatives the world has choked on would not have been issued. You people made this man a rockstar and didn't stop him when drugs and STDs rotted his financial brain.

4.Increasing leverage while secretly decreasing asset quality caused a boom.

"Nick Rowe wrote...

Bob: I tend to agree with what you wrote above, except I would express it in terms of China needing to reduce national savings, instead of allowing a flexible exchange rate (though I understand seeing these as two sides of the same coin)."

Yes, I would view it as 2 sides of the same coin.

"The mechanics, though, of how a high Chinese (or world) savings glut caused an asset *bubble* (as opposed to just low real interest rates and therefore high asset prices and high fundamental values) is still not clear to me."

This is my understanding of how the savings glut relates to the housing bubble: The money for the housing bubble was generated through fixed income instruments (debt) rather than equity in the case of the tech bubble. Since yields on traditional AAA investments like Treasuries and GSE debt were driven down by Chinese demand, buyers began to look elsewhere and drove down yields throughout the fixed income market, eventually leading to the popularity of structured credit instruments like ABCP, CDOs etc. that offered higher yields. Around that time you heard a lot about a "search for yield".

This is the type of scenario that played out all across Canada leading up to the ABCP crisis: The CFO of an airline/mining company/etc. meets with their banker to buy some AAA notes, and is dissatisfied with the lousy yields, but is required to hold AAA paper. The banker replies that he has an alternative: some new structured credit products constructed out of CDO squared made out of residential mortgages. The CFO asks "But isn't that risky? How's that triple A?" to which the banker responds "Nope, it's rated AAA just like the treasuries, because it is sliced and diced by financial wizards to reduce the risk, and you still get an extra 50 basis points for free basically".

Demand for these products got so strong that Wall Street was calling up mortgage originators and hounding them to produce more loans, even of lower quality, so that they could be packaged and sold. When they ran out of actual loans to package, they created synthetic loans by selling CDS insurance on existing pools of sub-prime debt, and using the cashflow from the premiums to replicate interest payments coming in from actual loans. John Paulson and Andrew Lahde took the other side of many of those bets (bought insurance against subprime defaults) and made massive returns of up to 1000%. Air Transat, Norwegian villages and those grannies at the ABCP hearings ultimately found themselves on the other side of that bet, or holding the underlying garbage.

The whole thing was kicked off by the flood of liquidity / savings glut that everyone was remarking on at the time. This started a search for yield and a drastic decline in lending standards as fixed income buyers (unwittingly) took on huge risk for just a few more basis points provided by opaque instruments.

Philip: you are wandering waaaaay off topic. We are talking interest rates.

Bob: Yep, that mechanism sounds reasonable, but underlying it is a version of 2. low interest rates caused the bubble; or possibly low relative to past experience, rather than low relative to the natural rate. The natural rate itself was low (because of the savings glut). So both Greenspan and his critics were right. The economy was doomed either way (or rather, monetary policy in the narrow sense had no way out.

Your story does, however, rely on the idea that if lenders don't get the interest rates they are used to, they will take on risks, or be fooled into taking risks, they would not otherwise undertake. Normally we think in terms of the opportunities and trade-offs available today, and the fact that the past was different shouldn't affect the choices people take today.


Why would high productivity growth cause the real interest rate to be high?


dave: two channels I can think of: high productivity of investment, and hence high investment demand; high future income relative to current income, and so low savings. High investment demand and low supply of savings causes high real interest rates.

Greenspan keeping rates low after the tech bust and 9/11 was right. It was in 2005 when the economy had recovered that rates were supposed to rise. Then we had Katrina which wiped out a lot of housing stock. Instead of raising rates Greenspan lowered then further. This was his mistake. It only added fuel to the fire. He should have just kept rates steady or biased higher. Why no one talks about Katrina is beyond me.

andy: OK. Your story makes sense. Katrina destroyed some of the capital stock, and so increased the demand for investment, and so raised the natural rate of interest. And so Greenspan's mistake was that he lowered interest rates post-Katrina, when he should have raised them. So presumably you subscribe to version 1. Setting interest rates below the natural rate causes an asset boom. But again, lots of central bankers make mistakes. 49.9% of the time they set interest rates too low, and 49.9% of the time they set them too high. This does not seem to be an outrageously big mistake, looking across countries and across history. Why aren't nearly all economies in a financial crisis most of the time? What made this mistake so special?

3) Foolishly high money creation (aka temporarily low short term interest rates), combined with stupid new construction restrictions in certain few dumba** states, caused a housing bubble.

Essentially everywhere, when demand exceeds supply at the previous price, the price rises. The new price rise induces new supply, amongst other things. But what happens when new supply has a delay of a few years when a bunch of people who were educated in government run schools in California become convinced that "house prices can only go up, it is different this time"?

What happen is that prices rise and rise, new home construction permits finally get approved, but due to the delay there aren't enough new homes. So prices keep rising, and new permit applications keep coming in. After all if replacement costs are x, and retail prices are x+ a juicy premium, who wouldn't build new homes? And keep building them, and keep building them?

Unfortunately, that delay was deadly, and it was really what causes the bubble. Texas had the same indirect access to Chinese capital and Fed money printing, but home prices there didn't skyrocket, even though Texas will (most likely) be gaining 3 (that is a lot) new House seats due to redistricting after the 2010 census, all due to a huge influx of new citizens from other states. With all that massive new housing demand, why didn't Texas also have a housing bubble?

The answer is very simple, and comes right out of econ 101. In Texas, you can build a new house basically as soon as you want to. So in response to new demand, you quickly get new supply, with minimal price rises overall, although some neighborhoods do better than others (location, location, location).

Bubbles happen when people foolishly think that supply won't meet demand. More than anything else, that was the fault of local governments that made getting new home building permits a nightmare, but not impossible.

happy juggler: OK, when the supply of new houses is elastic (like most of Canada) then an increase in demand causes an increase in construction more than an increase in price. And when it's not, like Vancouver (sea on one side, mountains the other), or England (planning restrictions everywhere), price goes up instead.

But then, even when supply is elastic, like Spain, you get a construction boom, and subsequent bust (Spain's unemployment has just increased horribly).

And: "Foolishly high money creation (aka temporarily low short term interest rates)". Is this "low" relative to the natural rate, or low in some absolute sense?

Damn that was a fast reply. In answer to your last question, I can only say that in real time that I thought Greenspan was overreacting, although I could understand why. I am not really the Greenspan hater that others are, although I wish he would admit that the absolute low rates he put in, that were temporary, combined with the punch bowl getting taken away, would pretty much by definition cause a dislocation of investments in *something*. Sorry if that wasn't a good enough of an answer, I realize that was mainly the impetus of your initial post to begin with.

As far as Spain, and Ireland, and Estonia (three of my favorite countries over the past decade or so thanks to their reduced statism), and no doubt others that I haven't been paying close enough attention to, you (read: "I") definitely have a bigger problem explaining the price boom. All I can say is that people really did think "it was different this time" due to a permanent increase in national wealth, which in turn was a result of an ending (or dramatic reduction of, anyway) of decades of economically stupid policies, resulting in a permanent new increase in demand fulfillment (on an absolute basis, not necessarily a recurring annual basis). The problem of course is that in the cited countries, new supply could and did come online, so why the price rise despite that? I can only suggest genuine trend extrapolation leading to speculation (by both buyers and builders), thus eventually creating a bubble, leading to overbuilding, which in turn sooner or later had to end, with the bursting of the bubble only a matter of time.

"What made this mistake so special?"

More than one unacknowledged asset bubble. The baseline conception of a healthy stock market probably was wrong, for instance (based on a bubble begun in the 90's).

The problem that Greenspan faced was setting monetary policy in the absence of a badly needed fiscal stimulus. Bush failed to provide fiscal stimulus.

The correct monetary policy would have been to set interest rates at a higher level and let the political consequences force the politicians into fiscal stimulus. Throughout his career, Greenspan, did everything in his power to limit fiscal spending. Greenspan believed that even bad monetary policy was better than fiscal stimulus.

Bush failed to provide a fiscal stimulus? With big tax cuts (badly targeted) and a massive war (also badly targeted)? No that was not the problem. The problem was more subtle than that and the problem with Nick Rowe's hypothetical is that he thinks his model is correct and the level of interest rates is all that matters.
I wonder for instance why he doesn't it wouldn't have better to have hit a deflationary spiral before the level of debt got so big. (I would have been better still to have avoided that level of debt.)

Your post reminded me of the last paragraph of this post on Econbrowser about a year ago:


"Bob: Yep, that mechanism sounds reasonable, but underlying it is a version of 2. low interest rates caused the bubble; or possibly low relative to past experience, rather than low relative to the natural rate. The natural rate itself was low (because of the savings glut). So both Greenspan and his critics were right. The economy was doomed either way (or rather, monetary policy in the narrow sense had no way out."

True. I think your article was bang on. Even at the time when Greenspan was accused of setting rates too low, he would point to the savings glut, so as to say "hey it's not me that's doing this, I'm just reacting in the usual way to low inflation and unemployment risks which dictates that rates go lower, it isn't me that is lowering the natural rate". I think he was right. The only thing I can fault him for is not ringing some alarm bells about the savings glut, and his advocacy of deregulation and non-regulation of risky activities.

"Your story does, however, rely on the idea that if lenders don't get the interest rates they are used to, they will take on risks, or be fooled into taking risks, they would not otherwise undertake. Normally we think in terms of the opportunities and trade-offs available today, and the fact that the past was different shouldn't affect the choices people take today."

True, I guess this is where the irrational bubble aspects come in, rather than the effects of low real interest rates on asset prices that just set the stage for the bubble. I guess a lot of it comes down to old fashioned greed, fraud and negligence of duties. Fixed income buyers got greedy for a few more basis points and neglected to do their due diligence, rather than accepting that the risk-free rate of return had simply declined. Rating agencies got greedy for fees and started drastically over-rating structured credit instruments. Mortgage originators got greedy and started cutting corners to make bad loans. Like in any bubble, there was plenty of greed and fraud to go around, so the really irrational bubble psychology can't really be blamed on the Chinese (or gulf states, global savers) directly for affecting the underlying fundamentals. The low real interest rates were necessary, but not sufficient to create the bubble.

Robert Bell: that's an interesting find. There are indeed strong similarities between Greenspan's 2003 tightrope and Bernanke's February 2008 tightrope. Perhaps "narrow path" is better than "tightrope". Which raises the question: what made the path so narrow, and made the cliffs so steep on either side?

happy juggler: we are on the same page. I don't have a good answer either, just want to emphasise that blaming the whole thing on the Fed's mistakes doesn't seem so plausible. And it's important to look outside the US, as well, where monetary policy was not set by the FED.

odograph: did Fed policy cause all the asset bubbles? If so, why did it cause them this time, with such bad consequences, when lots of past mistakes by lots of central banks didn't always?

bakho/reason: Yes, Bush's fiscal policy should have offset China's high savings rate. Was the problem not so much a savings glut, but the imbalance between China saving and US dissaving? If so, why would this create problems? Chimerica had a normal level of savings.

My main message is this: there is something very wrong, or at least very puzzling, with the idea that "If only Greenspan had set interest rates a little bit differently, everything would be fine".

reason: so, what did Greenspan do other than set interest rates? Or are you saying that Greenspan is not to blame? And why do low interest rates cause increased debt? No, the answer is not obvious. Low interest rates increase the demand to borrow, but they reduce the supply of lending.

I don't know if it would have been better to have had a deflationary crisis in 2003 rather than 2008. The simple answer would be: 5 more years of good times? I'll take them!

What this analysis misses, is that asset bubbles are generally due to inflation being too low, not too high. Indeed, as the asset bubbles got out of control in the last 5 years, inflation continued to decline towards zero.

If Greenspan recognized the problem, why did he not increase the PCE inflation target, rather than keep it at unsustainably low levels (1.5%)? Why did he do nothing to expand the monetary base (where growth also had approached zero)?

What Greenspan, and most monetarists, believed was that you could keep inflation down, and stimulate the economy by expanding credit instead of currency. The broader aggregates, like M2 and M3, which did grow, reflected an expansion of credit, not currency. Expanding credit without an expanding monetary base is what increases asset prices, and eventually increases systemic risk in over extended credit markets.

Note also, that broad aggregates like M2 were preferred because they correlate better with GDP, but that more narrow measures, like the monetary base or MZM, always correlate better with inflation (with a lag of course).

So yes, Greenspan is to blame, for his aversion to appropriate regulation, his obliviousness to the increasing systemic risks, and his prolifigate Fed policies on the credit side. But the primary problem was and remains that inflation, in terms of the core PCE target, was targeted at too low a level.

To appreciate the consequences of this, and perhaps the motivation for it, one has to appreciate that what economists exclude from core PCE, such as food and energy prices, are primarily any sources of inflation not due to wage increases. What Greenspan, and now Bernanke, seemed to hope to achieve was a way of maximizing economic growth while minimizing the portion of the benefits that had to be shared with wage earners.

I'm not sure why Real Business Cycle theorists, who like to assume that the long run rate of unemployment in the economy must reflect some ideal balance, called the "natural" rate of unemployment, would miss the obvious implication for inflation, that the "natural" inflation rate must also be near the long term rate, which has been nearer to 4%.

Force PCE inflation to hold well below the natural rate for too long, and it should be clear that workers will see a decreasing share of economic gains. For awhile consumers may try to support consumption by borrowing. But ultimately, this becomes unsustainable in the face of rising costs for housing, food and energy (all largely not counted as inflation).

In equities markets, meanwhile, you also see an expansion of debt, and of valuations, as people see higher ROEs and believe them sustainable. In addition, the popularity of the "Fed Model" (ironically), also causes equities to inflate as inflation and interest rates fall. A 5% long bond rate is believed to justify a P/E pf 20 (1/.05) and 4% rate to justify a P/E of 25 (1/.04).

But all of this is unsustainable if those rates are unsustainable. It is worth noting that the long term average P/E of the S&P 500 is about 14, consistent with a long term bond rate of about 7.1% (1/14), and a long term real return on bonds of about 3.2% (that is a long term inflation rate of about 3.9%).

Ultimately, the increasing inequity of wealth with workers not getting a fair share of gains becomes unsustainable. If nothing is done to increase wages (raising the PCE inflation rate), the economy will instead bring things back into balance through an economic slowdown (driven by drying up consumer demand), and decreasing wealth (through sharply falling asset prices once it becomes clear that no good investment opportunities remain).

Ultimately, in order to end the threat of deflationary spiral, the Fed, (along with other central banks globally), is likely going to have to raise that long term PCE target. I don't think they have yet come to terms with this.


You're too fixated on the NAIRU explanation for inflation or for target rates. Its a model largely irrelevant to the recent past, and one could say to virtually all debt crises.

Greenspan erred in creating expectations of a "put" on the economy, house prices, credit -- you name it. He did so by arguing that policy should be asymmetric: ultra-aggressive in targeting asset deflation, passive in capping asset inflation. How could Greenspan be held responsible for the market's expectations? One man? This is something economists have trouble with because it can't be modeled. The process of setting expectations is complex and specific to each case. In Argentina the expectation was that convertibility was both sacrosanct and in the country's interest. That drove an unserviceable accumulation of dollar liabilities an export-poor economy. Who created that expectation? Cavallo and Menem. Two men that set up a promise that could not be kept. Greenspan did essentially the same thing by making a promise that a deep recession accompanied by asset deflation could and would be prevented. In the process he used every bit of the massive credibility the Fed had built up since the 1980's. This promise/expectation fed through to all asset pricing, leverage, underwriting guidelines, risk modeling -- you name it, it was underwritten and underpinned by the Fed. Really, anyone attending a backyard barbeque in San Diego in 2006 would have heard the words "Fed" and "will cut interest rates" in a conversation about the local housing market. That's how deeply the promise penetrated into the national psyche.

What does any of the above have to do with NAIRU or the absolute level of policy rates?

What should Greenspan have done? Simply not make the promise, and instead follow a symmetrical policy. That doesn't necessarily mean cap the upside -- it could just mean let the downside of asset deflation unfold. If he had done this in 2003, we would have ended up with a garden variety, albeit deep, post-War recession. Instead, we now face a global recession, and we're going into it with an unheard-of total credit to GDP ratio. If you think the risk that situation presents was worth "5 more years of good times", then frankly we probably have little basis for discussion.

The bottom line for the Greenspan era is that it peddled free-lunch thinking: "we have the tools" to fight asset bubble deflation, he claimed, as if using those "tools" did not come at a steep cost. Bernanke is peddling the same free-lunch nonsense by arguing that he will be able to shrink the Fed's balance sheet without much consequence.

Please, god, save us from economists that serve up free lunches.

was just reading Steve Keen. Musings on money creation, fractional reserve system, classic theories, Heli Ben.


ignorantmike: I had a try reading Steve Keen the other day, not very successfully. I may try again.

Now, We have a couple of nice clear, but very contrasting views from americusdux and David Pearson.

americus says Greenspan's mistake was setting interest rates too high around 2005/6/7? He should have raised the inflation target instead. More inflation would have been better, because it would prevent a crisis.

David says Greenspan's mistake was setting interest rates too low in 2003. Lower inflation would have been better, even if it caused a recession. He says the recession would have been less bad than the one we have now.

Yes, NAIRU (or the natural rate of unemployment, is at the heart of it.

My view is that, *to a first approximation* money is superneutral: real variables are independent of the average rate of inflation. Because people care about real, not nominal, variables, so all behavioural functions (supply and demand functions etc) can be expressed in real terms.

That's where I start from, then I think up reasons why superneutrality might not hold exactly, like:
1. Money (currency) does not pay interest, therefore higher inflation means lower real cash balances.
2. Zero lower bound on nominal interest rates.
3. Costs of adjusting nominal prices.

So, americus, you need to explain the mechanism why higher target inflation would prevent crises.

And David, are you saying the Fed should give up targeting CPI inflation? So that if falling asset prices seem to be leading to inflation falling below target, the Fed should just let it happen? OK, if the Fed should not be targeting inflation, what should it target instead?

Nick, you probably knew I would take the bait on this post. Here is my reply.

David: Yes, and it was good to see you take it! To my mind, the key part of David's post (see his link) is his view that the natural rate of interest was high in 2003, due to fast productivity growth, and that this also caused low inflation. By setting the interest rate below the natural rate, Greenspan caused inflation to subsequently rise.

Let me grant you all that, because, at the very least, it's not obviously wrong. But, but, but:
Was his mistake in missing the target? (Because people do miss targets, and this wasn't an especially large miss, judging by subsequent inflation). Or was he aiming at the wrong target? (And what would the right target have been?)

The more you think about it, the bigger the role of China in the crisis becomes. China

- kept global long-term interest rates low through accumulating $2 trillion in reserves, helping trigger the leverage bubble

- kept global consumer inflation low until 2007 by exporting deflation, which kept G7 central bank policy rates low

- triggered the collapse by generating commodity price inflation in 2007 & 2008, forcing central banks to tighten.

Greenspan was screwed

If China accumulated $2 trillion reserves, how much of that was offset by US government accumulated deficits over the same period?

Or did the imbalance itself matter, rather than the net effect?

It was the imbalance and not the net effect.
The US dis-saving (current account deficit) should have pushed up global real interest rates, or USD depreciation should have reduced the CAD.
China, by targeting currency stability against the USD and ignoring investment principles (buying USD Treasuries with an undervalued currency is not a good investment decision) helped prevent the US current account deficit from adjusting.

OK. If China saves, and US dissaves, China runs a current account surplus, and the US a current account deficit, but that is just a larger scale of what happens when some individuals save, and others dissave. Why should that cause a financial crisis?

Possible answer:
In possible world A, both savers and dissavers respond to (real) interest rates and to their levels of debt or assets. If some people originally dissave and others save, eventually the dissavers go so deeply into debt they don't want to dissave as much at the same level of interest, and the savers build up so much assets they don't want to save as much at the same level of interest. So the system equilibrates.

In possible world B, dissavers are the same as in possible world A, but savers are different. Their savings are totally unaffected by the rate of interest, and by their level of assets. They just keep on saving, regardless. So as the dissavers build up debt, they won't continue to dissave, unless the rate of interest falls. So the rate of interest has to fall (or else Chimerica goes into recession because desired savings exceeds desired investment). So the interest rate falls (the Fed cuts it to prevent recession), and the dissavers keep on dissaving, until they build up more debt. And then it repeats, with a further fall in interest rates. B has no long-run equilibrium at a non-negative rate of interest.

So, if this is correct, and the real world is like B, the underlying problem is that China's savings, being government savings, is not responsive to the normal equilibrating forces: the rate of interest; and net assets.

Does that story make sense? If so, it's not really Greenspan's fault. There was nothing he could do, except maybe trigger a crisis sooner, rather than later, by refusing to cut interest rates.


The argument against targeting inflation to the downside is simple: monetary stimulus must be removed or cause inflation. Removal of that stimulus lands you back in the same deflation mire, except with a higher economy-wide leverage ratio.

Some believe that monetary stimulus can be easily removed in the future. This is very much a "business cycle", or "NAIRU" view of the world with the output gap at its center. Stimulate when a gap occurs, remove when its gone, and presto, no inflation or deflation to worry about.

What many economists fail to realize is that debt deflation is a different animal. We have countless examples of inflation ignited in countries undergoing debt crises and deep recessions. How does NAIRU account for that? It doesn't. Monetary stimulus in a debt deflation causes fear that central bank balance sheet growth cannot stop without losing the battle against the primary enemy: unemployment. This is what causes capital flight, along with the related problem of structural fiscal deficits that cause exponential growth in government debt. Again, none of this has nothing to do with NAIRU, so the prescription of waiting for non-deflationary full capacity before removing stimulus is simply not operative. That why Andy Harless' recent post is problematic: it explains that price level targeting is a solution to deflation, but it does not explain how to solve the problem of rising velocity without again causing deflation.

Nick Rowe said: "Why aren't nearly all economies in a financial crisis most of the time? What made this mistake so special?"

TOO MUCH DEBT!!!!! (and negative real earnings growth for most people because of outsourcing, illegal immigration, legal immigration i.e the labor market is oversupplied)

People need to look beyond the fed setting interest rates. Raise jobs and raise wages to raise interest rates and lower financial asset returns. Presto, if interest rates are say 8% for speculators and financial asset returns are 7%, the speculation/investment banking model GOES AWAY!!!!!

Blame both china and greenspan. The communist gov't wanted to employ as many people there as possible to stay in power so they need low wages and lots of jobs. greenspan needs cheap labor to keep wages and jobs low in the USA to keep price inflation low to keep interest rates low to attempt to produce MORE AND MORE DEBT ON THE LOWER AND MIDDLE CLASS IN THE USA FOR HIS BANKING BUDDIES SO THEY BECOME RICHER! That is one unholy alliance.

Nick Rowe said: "Let us allow that Greenspan, in hindsight, should have paid more attention to asset prices."


"In 2003, Alan Greenspan argued that the Fed needed to set low interest rates to prevent falling into a liquidity trap and deflationary spiral."


"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."

If I remembering correctly, geekspeak has said that for asset bubbles to form LOW AND STABLE interest rates are needed (he claims long-term). It is simple. If someone at GS can borrow at 1% to 4% and make 7% to 20% a year, they are like why not. Paulson will be proud and give me a BIG, BIG BONUS!!!!! I will keep doing this until it does not work and thank you to the fed!

Nick Rowe said: "[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.]"

I disagree!!! Because of cheap labor free trade agreements suppressing wages, there was no interest rate (and therefore a corresponding debt level) that would BOTH prevent price deflation AND prevent an asset bubble(s). In this case, the BIGGEST bubble was CONSUMER DEBT!!! Of course, geekspeak likes it this way because he likes asset bubbles and was trying to trick people into working more now and working more later (no retirement at all) to pay off all that debt to his banking buddies!!!

"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."

Since when has geekspeak ever worried about asset prices. Didn't he claim that asset bubbles CANNOT be identified until AFTER they burst???

About housing, asset prices, and geekspeak; see this link for this quote:


"At the time, Mr. Greenspan expected his policy to boost housing because the rest of the economy was relatively unresponsive to lower interest rates. Based on DECADES OF HIS OWN RESEARCH, he believed a buoyant housing market would spur consumers to borrow against home values and spend more. This would not produce a housing bubble, he predicted, because it was difficult to speculate in homes and the memory of the 2000 tech-stock bust remained fresh.

Mr. Greenspan now admits he was wrong about the improbability of a housing bubble. Yet he has long maintained that bubbles are an unavoidable feature of a dynamic economy. He pulls out a 1999 speech and shows, underlined in green marker, passages in which he warned of recurring but unpredictable patterns of overconfidence followed by investor panic. He does not share some foreign central bankers' belief that their job is to defend against excessive asset-price inflation: No sensible policy, he maintains, could have prevented the housing bubble."

In my opinion, what is the difference between a buoyant housing market and an "asset bubble" housing market??? HOW ABOUT GEEKSPEAK?!?!?

Will it be at least 50 to 100 years before consumers get SUCKERED LIKE THAT AGAIN!?!?!

HOW MANY TIMES HAS GEEKSPEAK BEEN WRONG?!?!? In my opinion, he is 95% political hack and 5% economist!!!!!


Nick Rowe said: "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."

Ridiculous!!!!!!! In my opinion, is it possible that geekspeak is the LEAST COMPETENT EVER because of his PROBABLE, worthless philosophy of wage and job suppression to produce MORE AND MORE DEBT ON THE LOWER AND MIDDLE CLASS to make himself, the fed, his banking buddies, and the spoiled and the rich in the USA more powerful and richer?????

andy & Nick Rowe, if I am remebering correctly, Hurricane Katrina was in August or September 2005. According to this link:


The fed did NOT lower rates. They raised them all year in 2005.

Did I miss something????

The housing bubble was well underway before the fed funds rate dropped below what the Taylor Rule said it should be.

Compare Taylor Rule graph and housing bubble graph. Alan Greenspan just poured gas on an already burning fire.

James: But what if CPI inflation were falling and house price inflation were rising?
If the house price bubble started before the Fed cut interest rates below the Taylor rule, that suggests (if one accepts the Taylor rule as a good source of advice) that the Fed's policy did not cause the housing bubble.

An alternative explanation of the initial rise in house prices is this: if an increase in world savings were causing a long-term decline in the natural rate of interest, one would expect real asset prices to rise. Equilibrium price of house = annual rent/real rate of interest.

Too Much Fed,

Was it really necessary to post 9 (!) frothing-at-the-mouth messages in a row? That's just rude

"I disagree!!! Because of cheap labor free trade agreements suppressing wages, there was no interest rate (and therefore a corresponding debt level) that would BOTH prevent price deflation AND prevent an asset bubble(s)."

Well then you agree with Nick's second point, don't you? Seems like you barely bothered reading the original article.

Nick Rowe said...
"An alternative explanation of the initial rise in house prices is this: if an increase in world savings were causing a long-term decline in the natural rate of interest, one would expect real asset prices to rise. Equilibrium price of house = annual rent/real rate of interest."

First let me point out that your "Equilibrium price of house = annual rent/real rate of interest" equation should probably be "Equilibrium price of house = (annual rent - expenses) / real rate of interest". For investment residential real estate, expenses generally make up 45% of the gross rent, although expenses are lower for homeowners because they don't have to worry about vacancies and management overhead.

Your equation seems to support your argument that low absolute interest rates can cause a bubble. As absolute real interest rates get closer to zero, small interest rate changes can cause the equilibrium home prices to swing wildly, both up and down, because the denominator varies more. (BTW, if we get caught in a deflationary spiral, real interest rates could jump substantially since nominal rates can't go below zero.)

However, the real long-term interest rate changed much more in the 1980s than during this past decade. Why no super bubble then?

Yikes! Bad link. The real long-term interest rate.

James: I agree with you. I left out expenses to (over)simplify. (BTW, the "real" interest rate should be defined as "nominal rate minus expected inflation of rents net of expenses, as you probably know).

I have used that same argument myself, in the past, about low real interest rates making the fundamental price swing wildly in response to small changes, and so making it harder for people to distinguish bubbles from fundamentals, and so making bubbles more likely. I can see the arithmetic, and the argument seems plausible. But I have never totally convinced myself that the argument is right. Do you know of anyone who has more formally laid out that argument?

Re the 1980's: good question. Dunno. Maybe that shows that low interest rates weren't the, or the only, cause of the bubble. Maybe the rating agencies giving AAA ratings to risky securitised mortgages played a bigger role?

bob, my apologies if 9 messages in a row was rude.

I read the article quickly (it was late) and may not have read it in order (a paragraph here and there).

"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."

"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."

I don't believe the economy is doomed! I see talk about interest rates (manipulating debt levels), price inflation, and asset prices. I see NO MENTION OF WAGES / WAGE GROWTH. I see no mention of wage growth vs. productivity growth. I see no mention of wages/income vs. debt levels. I see no mention of wages vs. interest payments. I see no mention of currency vs. debt based on that currency levels (the money supply mix).

If free trade led to HIGHER WAGES would greenspan (or anyone else at the fed) support it? I DOUBT IT!

What if the best thing to do is raise wages, make them positive in real terms, raise interest rates, and lower debt levels? Would greenspan (or anyone else at the fed) even consider this, much less support it? I DOUBT IT! As a matter of fact, is it possible that greenspan has supported just the opposite for his own personal and his banking buddies' gain???

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