President George W. Bush announces on Oct. 24, 2005, the nomination of Ben Bernanke (on his left) as Chairman of the Federal Reserve, replacing Alan Greenspan (on Bush's right) upon his retirement in January 2006. Greenspan became Chairman in 1987.

Alan Greenspan has responded to his critics who blame the Federal Reserve under his chairmanship for causing the US housing bubble by keeping interest rates too low for too long in the early 2000s, saying the evidence of any link between monetary policy and the bubble was “statistically very fragile”.

Writing in today’s Financial Times, Greenspan says he is “puzzled” why so many commentators seek to explain the US housing bubble in terms of Fed actions when many other economies with different central banks and different monetary policies also saw rapid house price gains.

The former Fed chairman says the most likely cause of this global house price boom was a “dramatic fall in real long term interest rates” around the world, which he believes was caused by abundant global savings.

On March 17th, Greenspan had written in the FT that the current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. He said that it will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

Professor Paul De Grauwe wrote in the FT's Economists' Forum in response: "The point is not that in 2001 the Fed reduced the interest rate too much when it cut it from more than 6% to less than 2% in less than a year. This was probably the right thing to do in a recession. The problem is that it kept the rate there for too long, when the economy showed signs of recovery. This laid the groundwork for a massive credit and liquidity expansion which in turn created an asset bubble in the housing market.

Second, the Fed failed to take up its mandated responsibility to supervise and to regulate the financial institutions. Why did this happen? The root cause is the religious belief of Greenspan in the benevolence of markets and perniciousness of government interventions. At the moment financiers were increasing their exposure to liquidity risk and made fantastic profits doing so, in the knowledge that the Fed was insuring them freely against such a risk, Greenspan stood by and marveled at the creativity of markets. In his wonderful book “The Age of Turbulence” he discusses the new financial instruments and he concludes with a beautiful metaphor: “Why do we wish to inhibit the pollinating bees of Wall Street” (p 372). The problem is that the financiers of Wall Street were mostly pollinating themselves."

Greenspan says in the FT today:"Mr De Grauwe asserts that “signs of recovery” (I assume he means sustainable recovery) were evident before 2004 and hence the Fed should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported that “conditions remained sluggish in most districts”. Moreover, low rates did not trigger “a massive credit ... expansion”. Both the monetary base and the M2 indicator rose less than 5 per cent in the subsequent year, scarcely tinder for a massive credit expansion."

In his article, Greenspan reaffirms his long-held view that central banks cannot effectively “lean against the wind” by setting monetary policy a little tighter than it would otherwise have been during asset price booms.

However, he writes “if it turns out it is feasible” to conduct monetary policy in this way, “I would become a strong supporter of leaning against the wind.”

Greenspan concludes: "I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken but not my judgment that free competitive markets are the unrivalled way to organise economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?"

In an interview with the CBS network's 60 Minutes, last September, Greenspan said he knew about the questionable sub-prime lending tactics that gave loans to homebuyers and investors with low adjustable interest rates that could rise precipitously, but not the severe economic consequences they posed. "While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late," he tells Stahl. "I really didn't get it until very late in 2005 and 2006."

Alan Greenspan: A response to my critics (full version of article on Forum)