In my battles with Greenspan defenders, things often come down to examination of what the Federal Reserve did with the money supply (however defined) after the dot-com crash. The idea is that interest rates per se are irrelevant, since the (typical) way the Fed moves interest rates is by shrinking or enlarging the total amount of bank reserves through open market operations.

The reason we are supposed to focus on money, not nominal interest rates, is that the market interest rate could be changing for "fundamental" reasons. For example, if the free market interest rate should be rising, then the mere fact that the Fed raises its target rate too doesn't prove that the Fed is "tightening." Indeed, if the Fed's hikes lag behind the increase in what the free-market interest rate would be (however we define it), then arguably the situation would represent one of "easier money."

This is a very important point, and failure to heed it led certain Keynesians astray when they thought the German central bank in the Weimar Republic was engaged in tight money because nominal interest rates were so much higher than normal. (!!) This despite the wheelbarrows of cash.

Notwithstanding all of the above, I think there is a similar danger in throwing nominal interest rates out the window. For example, I have a gut feeling that interest rates are too low right now, simply because...I can't believe free market interest rates would ever be virtually zero--let alone negative for brief periods!--in a modern economy not threatened by roving marauders. (Even if Geithner et al. are marauders, they are not roving. They are here for at least another three years, so suck it up.)

When it comes to the housing boom, suppose (for whatever reason) that interest rates in the early 2000s responded very strongly to modest injections of money from the Fed. In other words, nobody has ever shown me that, say, a 1% increase in the growth of some monetary aggregate could only cause a proportionally small distortion in market interest rates. And because interest rates are prices that mean something about intertemporal tradeoffs, that can in theory really screw up the whole economy.

To reiterate a basic point that even many free market economists overlook: INTEREST AND MONEY ARE NOT THE SAME THING. The problem with government intervention in the banking system is not merely that "it will eventually lead to price inflation." No, when the government distorts the interest rate, it messes up the intertemporal coordination of the economy. People's long-term plans don't mesh as well as they would in the absence of a central bank.

With the above as background, I was very pleased to read this post by David Beckworth (HT2 Arnold Kling). He quotes from various academic papers and blog posts showing plausible ways that low nominal interest rates could have fueled the housing boom. Here's a good excerpt, and note that the first paragraph is from Beckworth, while the remainder is his quoting in turn of Barry Ritholtz:

Both papers above empirically show the low federal funds rates were very important to the excessive leverage and big bets made by financial institutions during this time. Barry Ritholtz provides a nice summary of this channel in a recent post:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers....

And then the list goes on to describe the events we all know.

Let me add one point here: Tyler Cowen (I think?) had a post a while back ridiculing or at least seriously questioning this line of argument. He said something like (and this is a paraphrase), "Suppose the government started paying people to store bananas on their roofs. After a while, if a bunch of roofs started caving in, would that be a sign of irrational homeowners or bad government policies? Surely the people who believe in the free market should be troubled that homeowners would respond so stupidly to a government incentive that they had the option of refusing."

With that skepticism in mind, I imagine someone could dismiss the excerpt I've placed above by saying, "Well gee whiz, suppose that the Fed didn't exist, and that the analogous free market interest rate fell to 1% from 2003 - 2004. Are you saying that the dumb investment banks would have blown up a few years later because of their insatiable need for higher yields?"

But hang on: If I'm right that it was Greenspan (and other central bankers) who pushed down nominal interest rates well below what they should have been, in an attempt to have a "soft landing" after the dot-com crash, then it's not true that the free market interest rate would have been anywhere near those low levels. Things like investors' preferences regarding risk and yield help determine what the structure of free market interest rates would be.

In that respect, I think Cowen's banana analogy (if I have correctly represented it above, which I may not have) would be similar to someone saying, "What's the big deal with setting Manhattan rents at $400 a month? Suppose there were a new invention that made building apartments easier, and the supply curve shifted way out so that the market price was $400. Do the free marketeers think this would all of a sudden cause a massive shortage of apartments? Of course not. So why do they get their undies in a bunch when I suggest that the government set a price cap at $400?"