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.
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.
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.
In the Fed's mirror, a stock market bubble is appearing farther away than it may actually be.
Fortune -- At Thursday's confirmation hearing for Janet Yellen, the nominee to be the next Federal Reserve chairman was asked whether she thought there was a bubble in the stock market.
Yellen gave a pretty clear answer: No.
"Stock prices have risen pretty robustly," Yellen said. "But I think that if you look at traditional valuation MOREStephen Gandel, senior editor - Nov 15, 2013 12:04 PM ET
Some economists are worried that farmland prices are nearing bubble territory. How bad can it be if no one's heard of it?
FORTUNE – Following the collapse of U.S. home prices in 2007, analysts and economists have been eager to spot the next big bubble. There's been talk of a bond bubble. And as U.S. stocks hover near a five-year high, many have wondered if a bubble is in the works. MORENin-Hai Tseng, Writer - May 10, 2013 5:00 AM ET
Is Wall Street's savviest trading firm leaving a LinkedIn fortune on the table?
The LinkedIn (LNKD) buying frenzy Thursday is a windfall for most of the business networking company's longtime shareholders, led by founder Reid Hoffman and his private equity backers.
The 115% surge in LinkedIn shares at midday Thursday sent the value of Hoffman's stake, for instance, soaring from a merely huge $852 million to a surreal $1.8 billion.
But one sizable MOREColin Barr - May 19, 2011 12:53 PM ET
Would you believe the value of LinkedIn has risen 19-fold in just over two years?
You must if you are planning on buying into its initial public offering. LinkedIn is expected to go public this week at a price above $40 a share. That's a far cry from the $2.32 a share the networking-for-professionals outfit valued itself at as recently as the spring of 2009.
That said, the company admits in offering MOREColin Barr - May 17, 2011 1:03 PM ET
Looking for a bubble? Look no further than the U.S. stock market.
So says value investor Jeremy Grantham. He warns in his latest letter to investors that stocks' liquidity-fueled cruise will end in a headlong collision with the rusty garbage scow of economic reality.
The result, he predicts, will be a plunge of 30% or so in the S&P 500, recently at 1340 (see chart, right).
Stocks are so inflated and so certain to MOREColin Barr - May 12, 2011 6:26 AM ET
Just how bubbly is the bond market, anyway?
It looks a little scary out there nowadays. High-yield bonds, for instance, are trading at low yields. The effective yield on the Merrill Lynch High-Yield Master II index -- tracking bonds issued by sub-investment grade companies -- dropped to 6.88% this week.
The last time it was that low was December 2004. It is an odd-looking milestone, considering that the unemployment rate then was 5.4% MOREColin Barr - May 11, 2011 6:25 AM ET
If the party goes on long enough, bubbly debt markets can make even toxic housing assets look tasty.
That explains why the AIG (AIG) bailout, long an albatross for Ben Bernanke & Co., is on the verge of producing an actual cash-on-the-barrel profit for the Fed – while lighting up dollar signs in the eyes of Wall Street.
AIG offered this month to buy back a portfolio of troubled mortgage bonds. Reports MOREColin Barr - Mar 25, 2011 12:54 PM ET
If you thought Goldman Sachs had a crystal ball, boy are you ever wrong.
The Financial Crisis Inquiry Commission today released more interviews and documents backing the 550-page report it released last month on the financial crisis.
Among those documents is a letter Goldman (GS) sent the commission in response to questions the FCIC posed last January and February. The FCIC letter includes a section (see question 22) in which high-profile financial writers MOREColin Barr - Feb 10, 2011 3:53 PM ET
The bull market in bonds isn't dead – it's just taking a nap.
So says Gluskin Sheff economist David Rosenberg. Unlike many investment strategists, he views the recent selloff in Treasury bonds not as a sign of an inflationary fixed-income apocalypse, but as the latest opportunity to buy income-generating bonds cheaper.
What's more, Rosenberg says the current obsession with rising food and energy prices will pass -- and along with it the market support for stocks at what he MOREColin Barr - Feb 7, 2011 12:17 PM ET
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