Greenspan: How the credit crisis happened

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NEW YORK (CNNMoney.com) -- Former Federal Reserve Chairman Alan Greenspan in a commentary published Wednesday argues that Fed policy under his leadership was not the cause of the housing bubble that precipitated the current crisis in financial credit markets, as some have charged.

Instead he argues in the Wall Street Journal that the credit markets melted down in August because "risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction." And he says that if it hadn't been problems with rising defaults of subprime mortgages and declining home prices, some other problem in some other market would have triggered the crisis.

"The crisis was thus an accident waiting to happen," he writes.

He says that the current crisis in financial credit markets won't end until the glut of homes on the market is liquidated and declines in home prices play themselves out, and that the central bank can have only a limited effect on credit market problems with its policy and other actions.

He writes that he does not believe the Fed leaving the fed funds rate at 1 percent for almost a year starting in June 2003 was a major cause of what he now concedes was a bubble in U.S. housing prices that built up during the subsequent years, although he concedes it may have played a role.

"I do not doubt that a low U.S. federal funds rate in response to the dot.com crash, and especially the 1 percent rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in U.S. home prices," he wrote. "In my judgment, however, the impact on demand for homes financed with ARMs was not major.

"Demand in those days was driven by the expectation of rising prices - the dynamic that fuels most asset-price bubbles," he added. "If low adjustable-rate financing had not been available, most of the demand would have been financed with fixed rate, long-term mortgages. In fact, home prices continued to rise for two years subsequent to the peak of ARM originations."

While he was chairman of the central bank through January 2006, Greenspan always denied there was a bubble in the nationwide U.S. real estate market, saying only that a certain number of metropolitan real estate markets could see declines in home values because of a localized run-up in prices. That view of any real estate bubble as a merely a local phenomenon is a condition he termed as "froth" in congressional testimony in 2005, as well as in subsequent comments.

But his commentary Wednesday now portrays the run-up in home prices as not just a national but also a global event.

"Sharply rising home prices erupted into major housing bubbles worldwide, Japan and Germany (for differing reasons) being the only principal exceptions," he wrote. "The Economist's surveys document the remarkable convergence of more than 20 individual nations' house price rises during the past decade. U.S. price gains, at their peak, were no more than average."

And he argues that there was little that the Fed could have done to stop the housing bubble from taking place.

"After more than a half-century observing numerous price bubbles evolve and deflate, I have reluctantly concluded that bubbles cannot be safely defused by monetary policy or other policy initiatives before the speculative fever breaks on its own," he wrote.

The low interest rates were justified by the deflationary risks in the early part of the decade after the dot.com stock bubble burst, he writes.

"We will never know whether the temporary 1 percent federal funds rate fended off a deflationary crisis, potentially much more daunting than the current one," he wrote. "But I did fret that maintaining rates too low for too long was problematic."

He said the lack of growth of the monetary base or money supply during the period of low rates assured him the central bank was pursuing the correct policy.

As to the current crisis, he predicts "very large losses will, no doubt, be taken as a consequence." But he also believes markets will work out the the problems themselves.

"After a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business," he concludes.