Alan Greenspan

Redeeming Greenspan: Don't blame the Fed for bubbles

March 27, 2014: 5:00 AM ET

Critics love to call out monetary policy as one of the prime causes of the financial crisis. But the data just don't back that up.

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FORTUNE -- When it comes to financial crisis bogeymen, Alan Greenspan is often thought of as public enemy, let's say, No. 3.

He may not conjure the same ire as too-big-to-fail bank CEOs, but there are few public figures whose reputation was damaged more by the 2008 financial crisis. Critics from the left assailed him for his overconfidence in the self-regulating power of free markets, while hard-money advocates on the right argued that he fueled the real estate bubble by keeping interest rates too low following the bursting of the dotcom bubble in 2001.

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But as economists begin to examine these criticisms, it's becoming increasingly clear that Greenspan can be acquitted of at least the second charge. Sure, there are risks to keeping interests rates too low -- chief among them inflation. But do low interest rates really inflate asset bubbles? According to a paper published Tuesday by the National Bureau of Economic Research, no, they don't.

Researchers studied stock prices from the 1960s up until the financial crisis to determine how they responded to increases in short-term interest rates by the Fed. The result? After short-lived declines in stock prices, values actually rose in the long term.

This makes sense on a conceptual level, if the Federal Reserve is executing its monetary policy decisions as it should. After all, the Federal Reserve should be reacting to economic conditions on the ground rather than acting as the leading cause for why asset prices rise or fall. So, if the Fed raises rates, it's doing so because it has evidence that the economy is growing quickly, that resources are growing increasingly scarce, and that inflation is a concern. All of these factors, all else being equal, would cause stock prices to rise. While news that the Fed is raising rates may cause stocks to temporarily decline in value (because higher interest rates reduce the present value of future income), the overall economic conditions that led the Fed to make the decision to raise rates will continue, in the long run, to drive share prices higher.

The same logic holds when the Fed lowers rates. Cheaper money will cause stock prices to rise, but it can't overcome the many other factors that may be depressing stock values at a given time.

The evidence presented in the NBER paper applies to monetary policy today. Critics of the Fed's stimulative bond-buying efforts often claim that it is stoking asset bubbles in markets as diverse as farm land to tech stocks. But would these assets still look bubble-like to some eyes absent Fed actions? We simply don't know.

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The attitude the Fed is taking so far seems to be, "If there isn't widespread inflation, why assume that monetary policy is the reason certain asset prices look expensive?" Charles Evans, president of the Federal Reserve Bank of Chicago and an FOMC member, has articulated this vision forcefully in recent years. In a 2009 speech, he said:

I agree that the severity of the recent crisis argues against simply waiting and mopping up after the fact if and when the prices of some assets do collapse. But the type of proactive response by a central bank that I envision is not well captured by the expression "leaning against a bubble." I prefer to see policy reacting to apparent exuberance in asset markets and the problematic risk exposure this could create, rather than initiating action out of a strong conviction that these particular assets are overvalued.

In other words, just because we're more aware of the risks that asset bubbles pose, that doesn't make us any more competent in spotting asset bubbles in real time. Furthermore, since monetary policy is a blunt tool that affects the entire economy, it makes little sense to use it as a means to burst bubbles in specific markets. The Fed can use its regulatory powers to help make sure bubbles don't arise, but as much as hard-money folks may want it to be otherwise, it doesn't appear that low interest rates are their cause.

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