The long-held view of former Fed Chairman Allan Greenspan regarding the Fed's inability to deflate an asset bubble has always been open to debate, and no more so than since the bursting of this latest one. The problem is that the economic system's procyclical tendencies where not directly under the control of the Fed, mainly because the Central Bank exerts its greatest influence on the shorter end of the yield curve.

“There has never been an instance, of which I’m aware, that leaning against the wind was successfully done,” Greenspan, 83, said in a Feb. 27 telephone interview.

Procyclicality has to do with the ability of financial institutions to lower the cost and expand the amount of credit available as the economy is overheating, the exact opposite of what a Central Bank would like to see happen. In this last instance, the explosive growth of securitization had the effect of lowering long-term interest rates as asset prices were bubbling, a situation which was, according to Mr. Greenspan, out of the Fed's control.

One reason the Fed lacked the ability to control the situation was because regulators did not have the authority to require banks to take increased reserves (in percentage terms) against the loans they were writing beyond what the normal requirements were. Forcing banks to hold a higher percentage of capital in reserve would have naturally had the effect of making less cash available. For example, the Basel II requirement is only an 8% reserve against loans and there are no provisions in the agreement to raise the percentage as the portfolio of loans increases.

“It has always bothered me that our capital requirements are so low,” Greenspan said. “We do not have an adequate cushion.”

But it wasn't only the large commercial banks which were providing the capital this decade. Mark Gertler, a New York University economics professor who has collaborated on research with Fed Chairman Ben Bernanke, points out that leaving investment banks essentially unregulated even as they held mortgages and issued short-term liabilities like commercial banks was a big part of the problem. Once the ability to roll-over short-term debt ended as housing prices started to decline, the game was essentially over.

“The first-order cause of this crisis was the regulatory system was way out of whack,” Gertler said. “It’s not the case that you can get at this alone with interest-rate policy; it really requires smart regulatory policy.”

If you really want to trace the cause of the crisis, one needs to look at the massive current account imbalances which built up this decade as huge exporters such as OPEC and the Chinese sold their goods to voracious U.S. consumers. A current account surplus is a form of national savings, because it represents that the population of the surplus country isn't consuming anywhere near what consumers in the current account deficit nation are.

This savings glut was a key for the asset bubble in the U.S. and elsewhere as China parked their enormous holdings of foreign reserves, which were and are held mostly in dollars, back into the U.S. in the form of Treasury purchases. Their holdings in U.S. debt helped to keep long-term interest rates low and flooded the market with cash, exactly at the time that demand for credit was soaring.

In essence, the supply-demand equation was skewed. The price of money (interest rates) declined and the availability (supply) of it went up as demand increased. This is procyclicality in action.

The situation we have now in the recession is the exact opposite; counter cyclicality. The supply of credit has decreased and the cost of credit (at least until the Fed really got into the situation) increased as demand waned.