In his 12/26 op ed for the Wall Street Journal, former Treasury Secretary John Snow blamed the “current situation” in our housing and credit markets on the “accumulation in recent years of large pools of excess savings around the globe.”  Yet Snow’s theory doesn’t add up, and overlooks the role of Greenspan’s Federal Reserve in fostering the housing bubble.

To be fair to Snow, let us quote him in fuller context:

What brought about the current situation?  The accumulation in recent years of large pools of excess savings around the globe—particularly in Asia and the Middle East—drove interest rates down, making borrowing cheaper.  As a result, the world went on a borrowing and buying binge.  With cheap money in hand, asset values were bid up, especially for housing.  And at the same time interest rates declined, savers began to search for ever higher yields.

Snow also goes on to criticize overly anxious sellers of financial products as well as ratings agencies.  But his fundamental explanation for the housing bubble (and now bust) is that the influx of excess foreign savings bid down interest rates.

As I said above, this theory doesn’t really work.  Yes, an increase in the supply of savings pushes down interest rates, but that’s what it should do; the lower price of capital reflects the abstinence from present consumption on the part of all those foreigners who are living well within their means.  Because they choose to save large fractions of their income, real resources are freed up in the present, to be diverted away from making restaurant meals and television sets, in order to produce things like tractor trailers, drill presses, and factories.

The market rate of interest coordinates the allocation of resources “across time,” so to speak.  When people save more in the present, they expect this will boost their income in the future.  The way this physically occurs is that labor and other resources are diverted away from consumption goods into the production of capital goods, so that future workers are more productive when they work with better tools and equipment.  It is only natural that when people increase their saving, more resources are devoted to durable goods such as housing, which provide services for decades into the future.

So far, it seems that Snow has fingered a perfectly benign market process.  His explanation’s weakness is even more apparent when we ask, “What went wrong?”  After all, it’s not as if foreigners suddenly reduced their excess saving, causing interest rates to spike.

No, I think a much more plausible explanation for the housing boom and now bust is that the Federal Reserve, under the leadership of Alan Greenspan, slashed interest rates repeatedly starting in January 2001, from 6.5% until they reached a low in June 2003 of 1.0%.  (In nominal terms, this was the lowest the target rate had been in the entire data series maintained by the St. Louis Federal Reserve, going back to 1982.)

Unlike the influx of genuine foreign saving, the Fed’s decision to create extra reserves out of thin air—with which to engage in open market operations and drive down the federal funds rate—didn’t free up real resources in order to expand the housing sector.  It makes a big difference to long-run sustainability if a major drop in interest rates is due to (a) actual consumers really saving large fractions of their income versus (b) the Federal Reserve adding numbers to member banks’ deposit tallies.

The Fed story also explains the bust:  When the easy-money policy became too inflationary for comfort, the Fed (under Greenspan and then new Chairman Ben Bernanke at the end) began a steady process of raising interest rates back up, from 1.0% in June 2004 to 5.25% in June 2006.  (See the St. Louis Fed’s graph.)  This eventually fed back into the mortgage market, where the higher rates translated into lower capitalized values for a given house.