Adjusted for inflation, prime interest rates were negative from 2002 to 2005

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Adjusted for inflation, prime interest rates were negative from 2002 to 2005

Friday, March 13th, 2009 | Economics |

Lots of people, me included, think that the main cause of the real estate bubble and credit bubble were the interest rates set by the Federal Reserve under former Chairman Alan Greenspan. Those interest rates were kept too low for too long. It turns out that the interest rates were so low that once you factored in inflation the interest rates were negative. The Federal Reserve under Greenspan was paying banks to borrow money.

Greenspan recently surfaced to defend his record and distance his decisions from the current mortgage mess and collapse. For his trouble he’s getting attacked further, just as he deserves.

Greenspan lays out his case that the Fed’s easy money policies can’t possibly be to blame for “the U.S. housing bubble that is at the core of today’s financial mess.” It is long-term interest rates that determine “the prices of long-lived assets,” such as housing, he writes. And those rates, which stayed low as a result of a “global savings glut,” are out of the Fed’s control.

Control, yes. Influence, no.

“Why not try raising short rates if long rates are too low?” asks Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago. “The recession was over in 2001. Why did he take so long to start to raise the funds rate?”

Greenspan is selective in arguing his case. By any measure, the overnight fed funds rate was too low earlier in the decade. The real funds rate, which is the nominal rate adjusted for inflation, was negative for three years, from October 2002 to October 2005, a longer stretch than in the mid-1970s. And we know how well that turned out.

Now we have additional evidence of the effect of negative real rates. When financial institutions are being paid to borrow, borrow they will.

The history of the mortgage crisis is not going to be kind to Alan Greenspan.

Tags: greenspan, inflation, mortgages, the fed