The Maestro's mess?

On Sept. 18, the Ben Bernanke-led Federal Reserve Board cut the federal funds rate by a half point, an aggressive move that reflected the approach of his predecessor, Alan Greenspan. For some, this was a relief. But for a growing number of critics, it was an ominous sign-a ham-handed attempt to deal with a housing mess that they say Greenspan left for him.

This is a big change from just a year ago. When Greenspan retired from the Fed early last year, he was hailed as the "Maestro" of the nation's money supply, an economic sage who had kept inflation tame and the economy growing during his 18 years in office (see "End of an era," Feb. 4, 2006). But fallout from the housing crunch is tarnishing that reputation.

While the sinful behavior of borrowers and lenders is at the root of the housing bubble (see "'Subprime' behavior," Sept. 15), critics say the Fed's loose monetary policy earlier this decade poured Miracle-Gro on that root.

Starting in 2001, the Greenspan Fed began a historic lowering of the federal funds rate. Greenspan eventually lowered it to 1 percent by June 2003, the lowest rate since 1958, and he kept it there for a year. Greenspan says he did this to ward off deflation and recession, but critics say it started a credit binge.

Flush with Fed-created money, lenders developed elaborate loans to get subprime buyers into houses that they could not afford. Borrowers could not only put no money down on their adjustable-rate mortgages, they could also pay only the interest on their loans during the first months.

In some of the most reckless of these loans-called "negative amortization" mortgages-borrowers initially would not even have to pay an entire month's interest each month, meaning the loan's principal would grow with each payment. Interest rates and payments would later rise dramatically, but that was a worry for another day.

That day has arrived with a vengeance. Realtytrac reported last week that foreclosure filings in August were up 36 percent over July and 115 percent over a year ago, numbering one for every 510 American households. An earlier Labor Department report, showing a decrease in payroll employment of 4,000 jobs during August, suggests the housing troubles may be spilling over into the larger economy.

Greenspan, whose memoirs hit bookshelves last week, now says he did not realize the danger of "exotic" loans until late in 2005 or early 2006, as he was leaving office. He also blames global economic forces for the housing bubble.

But his critics say the housing bubble was part of a pattern that marked his tenure. A crisis would erupt, such as the bankruptcy of the hedge fund Long Term Capital Management in 1998, and Greenspan would flood the economy with cheap money. That would fix the crisis but would also encourage investors to make risky bets, knowing the Fed would bail them out with more cheap money. It was a pattern, say critics, that led to the dot-com bubble and the housing bubble.

This was the context for the Fed's decision last week. On the one hand, the August jobs report suggested the need for a rate cut, but a rate cut interpreted as a bailout for irresponsible lenders and investors might lead to another destructive bubble.

Bernanke and other Fed officials "are really caught," former Fed official Robert Eisenbeis told the Bloomberg news service before the Fed meeting. "The Fed needs to avoid the perception of bailing out the markets, lenders or borrowers."

But Fed officials then decided on the half-point cut-just what Wall Street demanded and others feared.

"The subprime mess was a bad investment decision from the very beginning and was brought about by having very low interest rates for a very long period of time," Wells Fargo economist Eugenio Aleman told the San Diego Union-Tribune. "And the only way to go forward is to flush it out, take the loss and move forward, not bring it back."