Remember the Fable of the Banana Subsidy?  Government subsidizes bananas.  People buy a ton of bananas and store them on their roofs.  The bananas weigh so much that their roofs collapse.  Then people say, “It’s the government’s fault!” – which is true in a sense, but also misleading.

I see the same ambiguity in a Forbes interview with fellow GMU prof Todd Zywicki.  Greenspan says that the Fed isn’t to blame for a housing bubble:

As Fed chairman, [Greenspan] had only lowered short-term interest rates, he argued in the Wall Street Journal,
not the long-term rates on which mortgage prices are based. “No one, to
my knowledge,” Greenspan huffed, “employs overnight interest
rates–such as the Fed Funds rate–to determine the capitalization rate
of real estate.”

So far, Greenspan sounds like he’s just echoing the arguments of critics of Austrian Business Cycle Theory – such as myself.  But here’s Zywicki’s reply to Greenspan:

“What Greenspan overlooks,” Zywicki says, “are adjustable-rate
mortgages. ARMs are really sensitive to shorter-term interest rates.”

at the data going back to nineteen-eighties,” Zywicki continues. “When
the spread between regular mortgages and ARMs is less than about 150
basis points, people tend to take out regular mortgages. But when that
spread widens, they switch to ARMs.

“What Greenspan did was artificially drive down the prices of ARMs,
widening the spread. Low interest rates on ARMs enabled ordinary
Americans to get bigger mortgages than they would otherwise have
believed they could afford. That pushed up home prices. And that created the updraft that brought in speculators.”

If you pay attention, you’ll notice that Todd’s making a Banana Subsidy argument.  The government cut interest rates, and then… banks started offering loans to people who wouldn’t be able to pay them back – and borrowers accepted. 

Maybe Todd’s story is right.  If he is, the Fed made a terrible mistake.  Unfortunately, for Todd’s story to work, we also have to admit that business and consumers are so clueless that they’re habitually on the edge of disaster.

My preferred story, in contrast, is just that once in a century, we get a once-in-a-century economic disaster.  These disasters are hard for anyone to foresee, no matter how smart he is.   The trick is just to keep the rarity of such disasters in perspective, stay calm, and let things get back to normal.