An accident waiting to happen

This is what Alan Greenspan says of the recent market turmoil, according to Reuters.

An unusually high degree of risk-taking across asset classes made recent financial market turmoil all but inevitable, former Federal Reserve Chairman Alan Greenspan said on Sunday.

"The financial crisis that erupted on August 9th was an accident waiting to happen," Greenspan said in a speech on the sidelines of the International Monetary Fund and World Bank meetings. "Credit spreads across all global asset classes had become suppressed to clearly unsustainable levels."

"Something had to give."

But didn't Greenspan himself contribute to the credit bubble during him time as Fed chairman?

Greenspan himself has drawn some criticism for cutting U.S. benchmark interest rates to 1 percent in 2003 and holding them there for a prolonged stretch, which some say helped inflate the U.S. housing bubble. But the former Fed chief said it was low long-term interest rates set in financial markets that pushed down mortgage costs and encouraged home buying.

"Central banks around the world have essentially lost control over the markets beyond maybe three or four or five years out. In other words, there is no evidence that we at the Fed had the capability of affecting mortgage interest rates," he said, noting that even when the U.S. central bank began raising rates in 2004, mortgage rates remained low.

Perhaps Greenspan hadn't read this paper from Marek Jarociński and Frank Smets presented at a St Louis Federal Reserve Bank conference last week. From the conclusion:

There is...evidence that monetary policy has significant effects on residential investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002 to 2004 has contributed to the boom in the housing market in 2004 and 2005.

However, Greenspan almost certainly would have been aware of the analysis from John Taylor presented at the Jackson Hole symposium where the latter concluded that a higher federal funds rate path from 2002 onwards "would have avoided much of the housing boom" and the "reversal of the boom and thereby the resulting market turmoil would not have been as sharp".

Even the low long-term interest rates that Greenspan claimed was beyond the control of central banks was partly attributed by Taylor to monetary policy. He said that "the 2003-2005 period show a large downward shift in the responsiveness of the federal funds rate to inflation" and "this could have led investors to believe that there was a longer run change in policy which would have reduced the response of long term interest rates".

And this is not even taking into consideration the roles of other central banks like the ECB and the BoJ in contributing to easy monetary conditions during much of the period concerned.

For more explicit finger-pointing, see the Economist article "Fast and loose: How the Fed made the subprime bust worse".