Many institutions have been blamed for our current economic woes. But one person, the long-time former chairman of the Federal Reserve, bears primary responsibility.

Conventional wisdom has it that many institutions are to blame for housing’s boom-bust cycle and for the recession it engendered. There is more than enough blame to go around. The banks established lax underwriting standards. The real estate industry helped (illegally as well as legally) to qualify people for mortgages that proved to be unaffordable. The government (the Congress and the White House both) pushed homeownership as a social good and encouraged Fannie Mae and Freddie Mac to invest in low-quality and ultimately toxic home-mortgage securities. Homebuyers bought properties they suspected, if not knew, they could not afford.

The whole exercise stands on its head the aphorism that success has a thousand fathers; failure is an orphan.

The cheap money policy of the Federal Reserve is also on the list. But it is there only as one of many reasons for the credit mania, which was hardly limited to housing, and for the cyclical slump that flowed from it.

In bringing many to task, the conventional wisdom is wide of the mark. The Federal Reserve alone is the father of the mess that the economy now confronts. To be precise, the fault lies with Alan Greenspan, the erstwhile chairman of the board of governors, who because of his maestro status was calling the shots. (For my earlier comments on Alan Greenspan’s management of monetary policy, see “A Bull in Sheep’s Clothing,” in AIER’s Research Reports, September 23, 2002.)

The Federal Reserve, to be sure, had help from other institutions. But when acting legally, these institutions were agents, doing what they were designed to do. The mistakes they made were of their own making, it is true. But they would not—probably could not—have made them without the cheap money the Federal Reserve put in their path.

The cheap money was the only necessary, even if not the sufficient condition, for the bubble—the sine qua non. In that respect, all of the blame for the downturn can be laid at one door: Greenspan’s.

Greenspan has acknowledged mistakes in his tenure as chairman, notably his misplaced confidence in the willingness or ability of financial institutions to design and implement effective risk-management systems with minimal regulatory oversight. However, he has never accepted blame for the housing bubble and for the cheap money that generated and sustained it. To the contrary, he pleads innocent, contending that the housing boom was worldwide. He exculpates himself on those grounds—a sort of “everybody did it” defense, which is tantamount to arguing that “no one is at fault.” Moreover, he continues to maintain—contrary to the greater wisdom of the man in the street—that you cannot recognize a bubble in the making until it has burst.

A look back at Federal Reserve policy that led to the housing bubble points up the Fed’s responsibility for it.

The Federal funds rate—the rate at which System member banks borrow from each other, which the Federal Reserve controls—moved up sharply throughout 1999 and 2000. The move took place against a background of runaway equity prices, high employment of resources, accelerating inflation, and economic-growth measures that were signaling added pressure on capacity and prices (Chart 1). Short-term rates, on commercial paper and other short-term business borrowings, on Treasury bills, and on the initial coupons of variable-rate home mortgages, moved up in tandem.

On the heels of rising U.S. interest rates, the dollar’s external value rose, making it difficult for U.S. producers to compete internationally. Equity prices, which by early 2000 had moved wholly out of line with reality as the NASDAQ scaled 5,000, tumbled. In all, financial conditions tightened significantly and, true to form, the economy slowed.

By early 2001, economic activity went into a mild cyclical downturn, prompting the Federal Reserve to quickly reverse course. By the end of that year, the funds rate had been cut by some two-thirds in aggressive easing steps. It kept moving lower throughout 2002 in deference to the economy’s cyclical weakness and to the uncertainty brought on by the terrorist attack on 9/11.

It was eminently reasonable to open the liquidity spigots as much as possible in the aftermath of 9/11. But it was equally ill-conceived to leave them so open for several years after the uncertainty had passed and the economy had begun to rebound cyclically. Significantly, by the middle of 2004, when real GDP had been clipping along for more than a year at a rate in excess of 4 percent, the funds rate was still near its low of 1 percent.

Reserve provision to member banks remained aggressive all too long. The double-digit growth rate of the monetary base in the immediate aftermath of 9/11 had come down considerably by the time the economy exhibited 4 percent-plus growth rates (Chart 2). So did such broad measures of money as M3. But increases in the economy’s debt outstanding continued apace (Chart 3). And house prices took off, rising for almost three years at a double-digit rate (Chart 4). In just the five years after 9/11, the price of a typical house rose nationally by half.

In some markets, notably on the West and East coasts and in “sun spots” such as Florida and the Southwest, it had doubled and then some. The price of a typical house also had risen rapidly throughout the latter half of the 1990s. But after 9/11, home mortgage rates, keyed off a funds rate brought down to 1 percent and held at or near that level year after year, acted as fuel thrown on an already lit fire. Greenspan shed many a crocodile tear over the risk of deflation even as that fire raged.

It was not the job of bankers to husband reserves pumped out by the Federal Reserve when there were willing borrowers at prevailing interest rates. Instead, it was to extend the credit that banks are in a position to extend, if need be, to successively less creditworthy borrowers.

A bank management that simply would have added to its holdings of Treasury bills, which were yielding virtually nothing, or of Treasury bonds with yields that were also relatively low, would not have retained the confidence of its shareholders for long. At one point in June 2003, the yield on 10-year Treasuries dipped to just over 3 percent—strikingly, only about one quarter of a percentage point above today’s level even though the economy is infinitely weaker today. Charles Prince, who was head of Citigroup during the housing bubble, put the bankers’ role this way in a 2007 interview: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”

The housing stock, to be sure, is not fixed. But it is huge relative to the flow of new units built in a few years’ time. Even in boom years for homebuilding, the housing supply is inelastic. It is no accident that the price of housing surged in a background of historically low mortgage rates and, joined to them, ever relaxed underwriting standards. The demand side was almost totally in charge. The mantra, which Greenspan shared, to judge by his frequent public statements to the effect, was that the price of housing had never fallen nationally (only in locally troubled markets). The corollary was that, even in a regime of relaxed underwriting standards, lenders and buyers alike had ample protection.

Greenspan also sang the praises of the variable-rate mortgage. One of his strongest statements of its virtues came in February 2004, ironically on the eve of consideration by the Federal Reserve of a change in course that would begin to lift interest rates, however gingerly, by the summer. He told the Credit Union National Association that the variable-rate mortgage was a way of saving households “tens of thousands of dollars” because it did not include the cost to borrowers of the prepayment risk embodied in fixed-rate mortgages. Such endorsement gave the green light to homebuyers and to predatory lenders in minority and other relatively poor communities, particularly in the Middle West which had remained largely untouched by the housing bubble.

The prospective buyer, looking at a house with an inflated $300,000 price tag at a time when the initial rate on a variable-rate mortgage was 3 percent (that was not uncommon) might well have viewed it as just as affordable as a $200,000 house at a 6 percent rate. The monthly principal and interest payment, most of the cost of carrying the house, is virtually the same. Many, who in normal times, when mortgage rates were closer to 6 percent, would have been looking to buy a $200,000 house, in fact, viewed the inflated $300,000 price tag exactly that way. They were unmindful as much as they should have been that eventually rates would have to return to reasonably normal levels.

Because of the mistaken premise of ever-rising house prices, paying an absurdly high price for a house was not viewed as risky by the buyer. Nor was financing an overvalued asset viewed that way by the lender. Both drew added confidence from the ubiquity of home equity lines of credit, which could be called on in a pinch. These too were a manifestation of the cheap money policy that shaped home finance.

Underwriting was based not on creditworthiness, but on the lowest “affordable” cost of carry, which was set by teaser rates on variable-rate mortgages for the first several years of a mortgage’s life. These rates, in turn, were keyed off the de minimis short-term rates engineered by the Federal Reserve. With short-term rates as low as they were, the long-term fixed-rate mortgage instrument was naturally pushed aside. Greenspan was surely right in viewing fixed-rate mortgages as expensive for the homebuyer, but just as surely wrong in not emphasizing the risks of variable-rate mortgages entered into at a time of unsustainably low interest rates.

The cost of carry turned out to be affordable only for a while. For many borrowers, the longer-run cost of carry proved to be unaffordable not because mortgages rates came to be reset to more normal levels but because of the bloated price tag.

For their part, lenders had uncommonly little interest in the valuation of the assets they were underwriting. They could, they thought, count on an ever-rising price of housing to make the assets money-good. Nor were they concerned all that much about the creditworthiness of the borrowers. They could, they thought, count on the consumer credit agencies, which, as it turns out, essentially were run by computers. They also knew that the loans would not stay on their books for long but would be packaged in securities whose valuations were also computer-driven.

Buyers of mortgage-backed securities as well as buyers of long-term corporate debt also seemed unwilling to acknowledge the risk inherent in a regime of easy money. As short-term rates remained at basement levels, institutional investors became unhappy with the returns available to them on super-safe Treasury securities, long as well as short. So they began to “reach for yield.” They could not look to the weak stock market either for handsome returns.

In that background, they began to move their portfolios away from those traditional assets to buy lesser quality corporate names and mortgage-backed securities, which, like the underlying mortgage contracts themselves, were based on the false premise of ever-rising house prices. Moreover, they reached for ever-higher yields by buying those tranches of the securities that embodied the mortgages extended to less and less creditworthy homebuyers.

The mistakes they made as investors were compounded by leverage. But who—because credit was ample and cheap—gave the green light to the leveraging?

With institutional investors reaching for yield, spreads “came in,” that is, with the added demand, yields on mortgage-backed securities and on corporates came down relative to yields on Treasuries. The conclusion that market participants drew was that the “price of risk” had fallen, a perspective Greenspan seemed to share.

The price of risk had not fallen at all. All that was at work was an effort by investors to seek out higher returns than those that could be obtained on relatively riskless securities with their rock-bottom yields. The reaching for yield should not have been interpreted as implying a fall in the price of risk, but a rise. The added demand for risky assets never would have materialized had returns on Treasuries not been so paltry. In hindsight, the price of risk was high indeed, to judge by the ever-growing financial troubles of those institutional investors who had reached for yield. And it does not take hindsight to see that.

It does not take hindsight to view an untoward growth of money and credit, lax underwriting standards, and falling spreads over Treasuries as sources of financial risk. By their very nature, they are.

The “everybody did it” defense does not wash either. A prolonged period of cheap money in the United States made it difficult for foreign central banks to head off undue appreciation of their currencies and its consequences for their own economies. Conscious of that risk, they, too, kept their interest rates too low for too long. In a global economy, led by the colossus United States, they were hardly independent central banks. Despite their defensive efforts, the U.S. dollar fell throughout the years of easy money, and even well thereafter when U.S. interest rates finally began to back up.

The instinct of the Federal Reserve was to ignore the stock-market bubble of the 1990s and, almost immediately on the heel of that, the housing bubble of the 2000s on the theory that the Fed was not in a position to recognize bubbles for what they were until they burst. The thinking was that the after¬effects could be dealt with easily by easing actions.

Greenspan’s confidence in the efficacy of easy money may well have come out of the success with such a strategy time after time during his tenure as chairman. It had worked after the dramatic fall in equity values in 1987, and had worked after the failure of Long-Term Capital Management and the financial turmoil in Asian markets about a decade later. It had also worked, as previously noted, after the bursting of the stock-market bubble in 2000 and the onset of the recession that followed. That confidence shines through particularly in a 2004 speech Greenspan made at the meetings of the American Economic Association. In it, he asserts that “much of the ability of the U.S. economy to absorb these sequences of shocks resulted from notably improved structural flexibility. But highly aggressive monetary ease was doubtless also a significant contributor to stability (emphasis mine).” These experiences emboldened the Federal Reserve for yet one more go at it. And they emboldened financial market participants as well.

The lessons are clear. One is that today’s generous liquidity provision, however needed to head off a 1930s economy, cannot be left in place long past its time. Neither can the fiscal stimulus put in place earlier this year. Another is that it is foolish to immortalize mere mortals before their time, even if they are tenured chairmen of the Federal Reserve. Yet another is that there must be some semblance of equilibrium between the price of housing and affordability, and not just at provisionally low interest rates but at those that are apt to prevail in normal times.

A policy designed to keep propping up the price of housing will succeed in doing that only if at the same time it brings back the kind of inflation that devastated the American economy in the 1970s. The sooner the price of housing falls enough to bring it back into line with prevailing incomes, the sooner the American economy can climb back out of the huge hole Greenspan dug for it.

Keming Liang, AIER research associate, contributed to this report.