November 3, 2008
On October 23, Alan Greenspan, the nation’s most celebrated Central Banker, affectionately called the “maestro” for his skillful handling of the economy over 18 years as the Nation’s Chief Central Banker, finally faced the music. One must give credit to Mr. Greenspan for showing up more than two years after his retirement as the Chairman of the Federal Reserve Bank. Certainly, not showing up at the Congressional testimony would have been even more damaging to his carefully nurtured image as the nation’s foremost economic seer.
Mr. Greenspan, a Republican and self proclaimed admirer of Ayan Ryan’s somewhat extreme economic views that markets are always correct, has been a fixture in the Washington policy circles since the days of President Nixon. During much of his tenure at the FED, Greenspan enjoyed a “large than life” persona, a celebrity who led a charmed life at the highest echelons of power. The Chairman of the Fed is often called the most powerful man in the country, ahead of the President given the impact of monetary policy on the every day life of each American.
The questions from Congressman Henry Waxman, Chair of the House Banking Committee were direct and rough: “You had the authority to prevent irresponsible lending practices that led to the sub-prime mortgage crisis. You were advised to do so by many others. Do you feel that your ideology pushed you to make decisions that you wish you had not made?” The Congressman reminded the former Fed chairman that he had been one of the nation’s leading defenders of deregulation, reading past statements in which Mr. Greenspan had argued forcefully that government regulators were no better than markets at imposing discipline.
What Congressmen Waxman and others should have asked was: How much did Mr. Greenspan personally benefit from his persistent opposition to regulations of the hedge funds and the derivatives? Why did the former Chairman of the FED, in his role as the regulator in chief of all financial markets, fail to take steps to stop the bubble when he was fully aware that one was growing? Why did he not adequately assess the risks to the financial system of the credit swaps and other derivatives and in banks getting ever larger? Why did Mr. Greenspan not learn from the real world crisis during his tenure – the collapse of the dot.com bubble, and the meltdown of the hedge fund Long Term Capital Management, when excessive leverage from the use of derivatives nearly brought down the financial system? Has he not read economic history to realize that time and again markets are disrupted by excessive greed and deceit leading to much misery? Why did he actively undermine the New Deal regulatory infrastructure put into place seventy years ago to prevent precisely this type of speculative excesses?
Mr. Greenspan, the high priest of unregulated capitalism, chastened by the unprecedented crisis was measured in his responses during his testimony: He said he was shocked that financial markets had failed to respond as anticipated. “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.” Under intense questioning he conceded that he had “found a flaw” in his bedrock believe of “40 years or more” that markets tend to self-regulate. “I made a mistake” a somewhat contrite Greenspan explained. “It has been painful to realize that I had put too much faith in the ability of the markets to self-correct.” “My view is that same as that of many in the academic profession including Nobel prize winning professors.” Finally he confided that while in office he had no clue that a financial catastrophe was in the making. Besides, the best computerized economic models in the country that are used by the FED, also failed to anticipate the financial tsunami.
Shocked and surprised? This is incredulous. Mr. Greenspan with a doctorate in economics is an expert on financial and economic history. He should be fully aware of the long history of manias panics and speculative binges that have from time to time turned the financial markets into gambling casinos. He has lived through and perhaps contributed to some of crises, from the 1987 stock market crash to the LTCM debacle; from the growth to the crash of the dot.com bubble. These are enough to teach several lifetimes worth of lessons.
Mr. Greenspan’s Mea culpa is too little and too late. First his statements do not sound like an apology. He sounds as if he is still passing the buck instead of taking responsibility for his role in leading the nation into an economic debacle. Second, the expression of regret is late. As the economy spun out of control, he remained quiet. In his recently published book for which he received an advance of $3 million, he failed to mention any of this. Finally, he cannot say that he did not have full information of the extent of the rot and the growing bubble.
The basic lessons are few: Do not put blind faith in the markets. Prudent regulations are best for productive capitalism. Look out for greed and excessive speculation. Make sure the ability to leverage is constrained and transparency rules. Keep an eye for any asset bubbles, and defuse these before they become “too big to fail.” As Adam Smith, the father of modern capitalism said, do not trust big business. Power always corrupts. Make sure the regulators identify and crush market power before it is too late.
For more than 18 years as the Chairman of the FED working with several administrations, Mr. Greenspan enjoyed vast powers. During this period, he was a fearless advocate of Laissez-faire capitalism and defender of deregulation. He worked aggressively to block sensible regulations proposed to monitor and manage the derivative market, now considered a $65 trillion cloud casting a long shadow over the economy.
His intellectual and moral stature in the nation’s capital and on Wall Street was unique. He was widely respected and admired, even feared. He was considered the nation’s foremost authority over all things relating to the economy. He could have given a siren call for restrain and for regulating the secretive hedge funds. He could have single handedly called for new regulations. He could have directed the Fed to use if vast powers to regulate to penalize some of the worst offenders of speculative excesses and send a clear message.
Clearly he was not an independent observer. His politics has long been known. He is a Republican, but as the chief of nation’s central bank, he was expected to serve as a unbiased public servant. He did not do so. He constantly opposed taxes. He always supported President Bush’s tax cuts when these cuts threatened to greatly explode the annual deficits and add to the national debt. He is also much overrated as a economic forecaster. In 2004, he said, “Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.”
In the case of the LTCM, he successfully engineered a bailout. He was in the room with the big bank CEOs and had information the rest of us did not. He knew how close the system came to a meltdown. Did he not learn any lessons from this experience that the best and brightest can get caught in greed and indulge in irresponsible investments? Did he not learn how fragile and interdependent the system has grown? Was he not aware of the awful power of leverage from derivatives and the comments made by Warren Buffet that these were “(financial) weapons of mass destruction,” and must be monitored and controlled? Why did he used the full weight of his authority to unambiguously stop attempts to regulate the derivative markets? Why did he and his colleagues on the FDIC not seriously warnings from seasoned market participants like Warren Buffet who in 2004 called derivatives, “financial weapons of mass destruction.”
Unfortunately for America, Mr. Greenspan was overrated as an economic guru and as a sage. He is an ideologue and not a moderate. He is opposed to regulations, even good ones, as a core principle of his thinking. Is there a single regulation he has proposed, defended or strengthened? Can he point to any attempt on his part to restrain the excesses in the market (beside the lonely comment on irrational exuberance)? Can he claim in good faith that he and his colleagues did not have all the facts about the bubble in the nation’s housing market?
The real danger from this tragic episode is that Mr. Greenspan and other ideologues are far from convinced that markets are an imperfect device for creating wealth. The blind faith in free markets – the mantra that markets are always efficient and right and never mistaken- are deeply embedded in the psyche of this nation. Common sense and a cursory reading of financial history eloquently make the case for market imperfections and judicious regulations. Yet ideology is powerful. It can dazzle and spell bound the most analytical mind as well as the average citizen. In this environment, Senator McCain’s attempt to raise the bogeyman of socialism makes perfect sense. The dreaded socialism – redistribution of wealth is as un-American as one can go. Any attempt to reform or improve market performance is immediately labeled as an attempt to “regulate” the market, will increase inefficiencies, eliminate liberty and competition, and will be a step towards a complete control of markets – socialism. According to this mindset, either you are for free unregulated markets or against it. There is no middle ground in this debate. Absurd as this view is, it has had considerable influence on the US economic policy and political arena.
The leaders of the unfettered or unregulated capitalism movement have invested too much in buying and selling the snake oil equivalent of the mantra that markets are the best mechanisms for self-discipline. They refuse to learn from economic history and modern economic research that demonstrates that markets are never perfect, have lopsided information and participants often behave irrationally overcome by greed and hubris. Just as in government, power corrupts. Therefore, a system of checks and balances is good for the markets. We need regulators to play cops in the financial streets just as we depend on cops to stop the criminals and protect the good citizens. Just as we need fences for good neighbors, or the sprinkler for the remote possibility of a fire, we need regulations for all the parties to know the limits of what is allowed and what is not, and institutions that play that play the role of lender of the last resort.
Given this dismal conclusion, the cycle of boom and bust will continue in the future, and may even get worse. This loss from the 2008 bust of $8 trillion may look like peanuts when ten years from now we run into the bursting of another bubble that may wipe out $20 trillion or more. We must educate citizens, regulators, and politicians on the basics of capitalism. We should make it mandatory that regulators read financial history to understand the power of human psychology in affecting markets to create as well as to destroy great wealth.
Market failure – economists call cases where markets fail to deliver the most efficient outcome as market failure. This can happen if there is monopoly power in the hand of one large player preventing competition. This can also happen if there are externalities so that the action of the buyer or seller has indirect implications for others. For example, your education has positive implication for your neighbors since educated people are less likely to commit crimes. If this is taken into consideration, the society or community should invest more into education (perhaps subsidize your college education) but it is often not. A bubble will be yet another example of market failure since a bubble outcome – price or output – is far from optimal or efficient. The aftermath is always wasteful and painful. Whenever, possible a bubble must be prevented and controlled. Some have hypothesized that the FED under Greenspan deliberately created the Housing bubble, or failed to prevent its growth, given they had other more important considerations (wanted to prevent a Japan style long recession). From their perspective, the bubble would be the lesser evil. Now we know how foolish this notion is.