RALEIGH – If you’re not following the debate between John Taylor and Alan Greenspan about monetary expansion and interest rates, you’re not paying attention to the central controversy of the present moment. Here, let me get you started.
Stanford University economist John Taylor, originator of the famous “Taylor Rule” for guiding the policy decisions of central banks, argued in a recent Wall Street Journal op-ed that the Federal Reserve had pushed too hard on the monetary spigot earlier in the decade, particularly in the period between 2003 and 2005.
By keeping interest rates artificially low, monetary authorities touched off a classic boom-and-bust cycle by facilitating permissive lending practices, fueling the creation of new and poorly understood financial instruments, and inducing capital into irrational and unsustainable investments. Eventually, as always, the irrationality of these investments became evident and inflated asset prices began to fall back down to Earth. “Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust,” Taylor concluded.
In response to Taylor’s argument, former Fed head Alan Greenspan argued in yesterday’s Journal that monetary policy couldn’t have been the culprit, that the real cause of low interest rates and the resulting boom-and-bust cycle was the massive accumulation of financial assets in China and other emerging-market countries that had become part of the worldwide financial economy in recent decades. This “led to an excess of global intended savings relative to intended capital investment,” Greenspan wrote. The resulting decline in long-term interest rates between 2000 and 2005 “statistically explains, and is the most likely cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble,” he continued.
Greenspan excuses the Fed as the main instigator of the problem, not surprisingly, but his argument isn’t merely self-serving. It rests on his assertion of a growing disconnect between open-market operations in the United States – the Fed buys or sells government bonds to set short-term U.S. interest rates – and trends in mortgage rates and other long-term rates. From 1971 to 2002, the federal funds rate and the mortgage rate were highly correlated, Greenspan reported. But since then, the correlation disappeared. He thinks the Fed’s interest-rate policies are being swamped by international capital flows.
Taylor doesn’t discount the importance of international capital flows in influencing mortgage borrowing and long-term interest rates. Still, monetary policy retains its salience. Indeed, in his original article Taylor was criticizing not just the Fed but also central banks in Europe and Asia. “Researchers at the Organization for Economic Cooperation and Development have provided corroborating evidence from other countries,” Taylor wrote. “The greater the degree of monetary excess in a country, the larger was the housing boom.” The mistake wasn’t just confined to New York and Washington. It was virtually worldwide. The economic consequences are also widespread, and in parts of Europe predate and exceed America’s downturn.
Neither man is dismissing the significance of other public policy factors, such as government mandates and subsidies encouraging Fannie Mae, Freddie Mac, and private lenders to give loans to marginal borrowers in the interest of promoting home ownership. (I think that the federal government’s adoption of absurd “market-to-market” accounting rules was also a grave error with disastrous economic consequences.) But while they disagree about the cause of historically low interest rates, the two economists recognize that those interest rates were at the center of the subsequent boom-and-bust cycle.
That is, John Taylor and Alan Greenspan are grown-ups. They aren’t launching into tirades about unrelated economic policies, dastardly capitalists, or extraneous politicians. I happen to think Taylor has the better of the debate so far. But that’s not my point today. It is simply this: there’s a difference between airing honest, informed disagreements about important public policy questions on the one hand, and on the other engaging in Saul Alinsky-style smear tactics and machinations to advance a radical agenda under cover of “crisis management.”
Hood is president of the John Locke Foundation