wall st crisis
9 Oct 2008
Greenspan Says It's the Crisis We Had to Have
But the former Chairman of the Fed has not lost faith in market capitalism
If securitised US sub-primes had not emerged as the weak link in the global financial system, some other financial product or market would have. Eventually, the underpricing of risk had to collide with innate human risk aversion: the crisis was a psychological certainty.The asset bubble was destined to follow the course of tulip mania and all the other bubbles of economic history - prolonged euphoria culminating in an abrupt and destabilising outbreak of fear. Even the most sophisticated private sector risk management was unable to neutralise the burst of euphoria and its inevitable consequences.
The clear evidence of underpricing of risk did not prod private sector risk management to tighten the reins. In retrospect, it appears that the most market-savvy managers, although conscious that they were taking extraordinary risks, succumbed to the concern that unless they continued to "get up and dance", as ex-Citigroup CEO Chuck Prince memorably put it, they would irretrievably lose market share. Instead, they gambled that they could keep adding to their risky positions and still sell them out before the deluge. Most were wrong.
But I am also increasingly persuaded that governments and central banks could not have importantly altered the course of the boom either. To do so, they would have had to induce a degree of economic contraction sufficient to nip the budding euphoria. I have seen no evidence, however, that electorates in modern democratic societies would tolerate such severity in macroeconomic policy to combat a prospective problem that might not even materialise. Periodic surges of euphoria and fear are manifestations of deep-seated aspects of human nature, and realistically there is little that governments or central banks have been able to do to divert or defuse them.
Being unable to effectively thwart the waves of speculation, the best strategy is to ensure that our markets at all times have enough flexibility and resilience, unencumbered by protectionism or rigid regulation, to absorb and mitigate the shock of crises.
I do not mean that it is necessarily futile to try to regulate financial risk. There are areas where I believe we need more rather than less official intervention, such as the prosecution of fraud. Fraud undermines a central pillar of competitive markets: voluntary market exchange. Prosecuting it more widely, I believe, would have discouraged the more egregious lending practices of recent years.
Since fraud, especially in the form of blatant misrepresentation, is illegal, no new statutes to my mind are necessary. What we need is far greater enforcement. In my experience, bank regulators, who are expert in accounting, banking law, and risk management, are not equipped for this job. It requires law-enforcement professionals.
Perhaps I should not have been, yet I was appalled and shaken when the financial system failed to protect itself more effectively against a euphoric boom. We at the Federal Reserve had always counted on banks in particular to avoid the most troublesome risks. The elaborate counterparty surveillance procedures of bank loan officers have long been the financial system's first line of defence against breakdowns. Yet there is persuasive evidence that in this crisis, those in charge of counterparty surveillance failed.
I was doubly dispirited by this failure because the world has no one who can do the job better. Financial regulators, in my experience, know far less than private-sector risk managers. Indeed, the open secret about regulation in the free-market world is that regulators take their cues from private-sector practitioners. The Federal Reserve and other supervisory institutions continually seek the advice of the best and brightest risk-management professionals. Basel II, the international consensus on bank regulation first published in 2004, mirrored the risk valuation models of the private markets.
Not surprisingly, Basel II is undergoing significant review as the banking industry revises its own standards; new US regulation governing capital requirements, if it comes, will reflect the private sector's already revised market practices.
Despite the recent failure of risk-management professionals, we need to be wary of the notion that less qualified people can do better. If a physician misdiagnoses, we do not turn to the patient for greater insight.
We prod the physician to come up with a better diagnosis. The system of private-sector risk management needs to be repaired. We have no better alternative.
The markets will continue to adjust on a massive scale. Even so, given the vagaries of human nature, it is doubtful in the extreme that the result will be a crisis-proof financial system. Does government need to do more?
The question is somewhat moot, because modern political reality requires elected officials to respond to virtually every economic aberration with a government program. Given the number of voters whose lives have been directly affected, the pressures on legislators in today's crisis are especially intense. If history is any guide, new regulations will focus mainly on the causes of the current crisis: lax and fraudulent mortgage lending practices, the indiscriminate securitisation of credit products, and over-reliance on risky short term funding for long term assets.
The response by US authorities to the crisis on Wall Street raises a broader concern. It is one thing for a central bank to lend to solvent institutions putting up "good" collateral; it is quite another for it to purchase liabilities of an institution that is failing, or to do the equivalent by extending non-recourse loans. Such government bailouts must be extremely rare: if market participants came generally to view a firm as "too big to fail", then, in anticipation of government support in the event of financial trouble, the firm would be able to sell its obligations at interest costs lower than it could were it being judged solely on its own credit merits. Such distortions to the competitive use of financial capital reduce the effectiveness of a financial system in channelling a nation's savings into the most productive uses.
History tells us there is a cost in standards of living from such misuse of capital, if it becomes widespread.
The risk-management systems of banks generally lead them to carry enough capital to meet all contingencies with the exception of disasters on a scale that happen only once or twice per century. The burden of containing the consequences of such events ends up on the doorstep of central banks. The only alternative would be for commercial banks to hold significantly more capital all the time at levels that might be needed only once every 100 years. Bankers strongly resist that approach; apparently they prefer instead to risk bankruptcy once a century.
No one knows for sure, of course, but the evidence is quite persuasive that the current crisis is one of those rare, once in a century or half century events.
Our country has long since abandoned the notion that we should leave crises to be resolved solely by the marketplace. To minimise the impairment of market efficiency from bailouts, the critical need, in my judgment, is to formalise and somewhat revise procedures for federal bailouts. This should ensure that, in the future, government financial assistance to lending institutions does not impact the Federal Reserve's balance sheet and monetary policy.
We need laws that specify and limit the conditions for bailouts - laws that authorise the Treasury to use taxpayer money to counter systemic financial breakdowns transparently and directly rather than circuitously through the central bank. We need a mechanism akin to the Resolution Trust Corporation (RTC), the government company founded in 1989 to deal with the aftermath of the savings and loan crisis.
Most other calls for additional regulation of financial markets are far less compelling to me. It seems superfluous to constrain trading in some of the newer derivatives and other innovative financial products of the past decade. The worst have failed; investors no longer fund them and are not likely to in the future. Others, such as credit default swaps, have over the years proven very useful vehicles for diversifying risks (though in the case of such swaps there are as yet unresolved and worrisome operational risks).
I am similarly skeptical of notions that stepped-up regulation of financial markets could improve their performance - particularly the idea of expanding the mandate of the Federal Reserve to become the market-stability regulator, with broad authority to unearth incipient imbalances and bubbles.
That is mission impossible. Indeed, the international financial community has made numerous efforts in recent years to establish such oversight, but none prevented or ameliorated the crisis that began last summer. Much as we might wish otherwise, policymakers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances. Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated - if people see them coming, then the markets arbitrage them away.
In recent years, critics have pointed to the US current-account imbalance as indicating a major foreign-exchange-rate crisis in waiting. Instead, exchange rates have moved in the direction needed to rebalance supply and demand. But at least so far, there has been no abrupt discontinuity. Another feared crisis in waiting was a financial implosion of a number of hedge funds, leading to a cascade of bank defaults.
Many hedge funds did liquidate following the crisis of August 2007, but, as of June 2008 at least, without important consequences to the financial system overall. The same is true of any crisis or adjustment process-it will never happen exactly the way it is envisaged. That's why I favour requiring that institutions have adequate capital and liquidity buffers to weather unexpected turns.
This is especially the case as government regulation gradually gives way to the self-correcting adjustments of global markets. The shift is probably inevitable because the world economy has become so awesomely complex that no individual or group of individuals can fully understand how it works. That it does work is evident from the high degree of stability apparent in markets almost all the time and the ever-rising standards of living on average from generation to generation across the globe.
The exceptions are the crises that arise from human foibles. I know of no regulatory system or degree of protectionism that can transmute irrational exuberance or debilitating fear into a stable growing economy. Those who imagined that the solution lay in an economy organized and run by an intellectual elite of central planners rather than competitive markets failed time and time again during the past century.
If material well-being is our goal, I see no alternative to global market capitalism. Its Achilles' heel is the widespread perception that its rewards are not justly distributed. That issue sorely needs to be addressed. But the abandonment of this remarkable global economy, which some critics increasingly advocate, would reverse a paradigm that has elevated hundreds of millions of people from grinding poverty and has enabled a significant segment of the world's population to enjoy a standard of living that was once the exclusive province of elites in the developed world.
This is an edited extract from The Age of Turbulence: Adventures in a New World by Alan Greenspan (Penguin, RRP $35.00).
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With due respect to Mr. Greenspan, I don’t think he actually "Gets it" as they say. This problem did not generate overnight and I suspect he is protecting his own reputation. Sorry to be a cynic.
Greenspan does well not to point the blame on any one culprit as most media pundits do today. No matter what you believe the cause of the crisis was - the fact remains that financial crises, by definition, are characterised by the fact that they were unanticipated.
If his point were just this, I would find his argument to be both insightful and a good basis for a conclusion that freer societies are better equipped to solve social foibles than large government.
Unfortunately, Greenspan uproots the consistency of his argument in three ways.
1. Advocating more oversight of government bail-outs simply because that is what his country has grown accustomed to doing - forgetting his previous statement addressing the threat of moral hazard. I cannot see how a Federal bailout in ANY capacity is consistent with a free market solution.
2. Greenspan had to pat himself on the back for a ‘job well done’ back in 1989 with the S&L crisis. Luckily for him all it took was for some S&L minnows to fall, loose monetary policy and federal credit assurances for large struggling S&L institutions to stave off a recession. As someone so interested in the current financial situation, it amazes me that he doesn’t see the parallels with ‘89 and Bernanke’s initial response to the subprime mess - namely in the Fed’s credit assurance in JP Morgan’s takeover of Bear Sterns.
3. He endorses the arrogant sense of entitlement and importance that financial sector fat cats exude (private sector AND government). It is ludicrous to compare the expertise of a physician to that of a Wall St. risk manager or Treasury secretary. Let me be clear: high finance is NOT a science. And it is NOT an expert field where only a select elite are worthy of domineering our money. Solid financial institutions make us prosperous only because they empower people at the top AND bottom with efficiently allocated capital.
To argue the case for any kind of bail-out or to retain financial experts at the helm as ‘indispensable servants of the public good’ are both severely lacking in thought and a contradiction to the central argument for free markets.
NM: Put a date on this reprint; the impression is a false one, as if Greenspan is now fronting for a calamity in no small part of his own making. Nonetheless, it is good of you to put his words up for review at this time – the reasoning and sentiments are characteristically self-contradictory. Perhaps that was his enigmatic magic-show style, all meant to keep fund managers and stockbrokers in thrall to some mytical free-market yogi?
hershsahai – definition of “crisis” does not imply “unanticipated” as you say it does, at least not in any definition I checked (from as early as July 2007 I read much detailed material anticipating this systemic breakdown-crisis anyway). I understand the germane definitions of “crisis” involve the notions of a turning point, and a crucial time for decision. So your focus on the term is a timely reminder that the ruling powers need to make important decisions right now. NM’s posting of that old Greenspan excerpt are a timely reminder suggesting that most of the ruling powers recognize that need, but are making the wrong decisions.
However, many of these same ruling powers certainly did not anticipate current events, and many others are so corrupt that they did not think it their problem to either anticipate or decide on them anyway. Such corruption, or dishonesty, is apparent in Greenspan’s logic and world view too, where his writing traverses a range of moral corruiption and cultural decadence, from too-clever-dick-by-half sophistry to plain insincere posturing for posterity, and belated schmaltz.
You’re a fraud Greenspan. The sophistry of your writing suits a devotee of Ayn Rand, as you have long been. Hoisting a penant of "capitalism" to defend your untenable position, dragging in as many potential allies as possible by default. Claiming as a victory for neoliberalism and globalisation any progress by hard-working and innovative people in the developing world whereas, in practice, their hard-won achievements came from much sacrifice and in spite of the prolonged misery that was always assured by such projects.
We have run this extract from the new revised edition of the Age of Turbulence. This version includes a new chapter on the current credit crisis. Link here
Thanks Rod McGuinness
Managing Editor newmatilda.com
Thanks Rod, I wasn’t aware that he updated it. I suppose it suffices as a review of sorts that I found no substantial, pointed relevance or illumination beyond the earlier period of that book’s first release and publicity, up to that time when Bear Stearns started diving.
Good call to post the extract though. I think he should get much more serious scrutiny instead of the gushing adulation that has come from the funny-money marketeers.
http://www.youtube.com/watch?v=MNJ-kUtTigU
mil-observer. To respond to your comments about the definition of a financial crisis, instead of entering into an ontological debate, allow me to canvas the following thought experiment.
If investors correctly anticipated everything, like for example:
1. that house prices would plummet in 2007
2. that risk premiums understated the actual risk of mortgage backed securities
Just to name two out of many, many more things that could’ve/should’ve been anticipated… then today, this current mess would not exist as we know it. Full-stop. If investors had correctly anticipated everything - then, sure as the sun will rise to the east, they would be sure that sub-prime mortgages and CDO’s were a bad idea long before it would ever become a problem on their balance sheets. This is not an outrageous statement. This is the humbling reality that our limits to perfect knowledge are the only way our expectations can ever be disappointed. So if we could perfectly anticipate the future, our expectations will never be disappointed and there can never be financial crises. I maintain therefore that a financial crisis, by definition, is characterised by the fact that it was unanticipated.
This is both obvious and intuitive, and I wish that more journalists would write about our limitations to knowledge and how to improve our understanding of what we don’t know in going forward. Instead of debates about how we can ‘stop greed’ or ‘protect investors from themselves’, I wish we would hear debates about how to best involve the entire community in a knowledge sharing framework. This is our best option going forward to face the unknown. A free society with free movement of knowledge in a free market will prove far more effective going forward than putting these decisions in the hands of arrogant and pompous Wall St. and Govt pseudo-experts.
With all due respect Mr Greenspan and hias apologists make me sick!
To excuse their fear and greed with the bleating cry that it’s too hard to predict the future is, to continue the patient analogy with:
If you keep plying someone with alcohol and drugs, then throw them off the top of a 20 story building, then say "I thought they would bounce", makes it all OK.
The Utube ref from Rockjaw from 2006 says it all.
Patting themselves all on the back, the Merry Xmas (we won’t mention Hanukka). Geez, "If you don’t throw the money at these guys they might exit from Wall St." What a great loss that would be!
Oh the irony, the poetic justice… Become a merchant banker, or at least marry one. Please I’ll laugh myself into convulsions.
To say in medicine you can treat someone "scientifically", but in economics it’s not possible. Well derrr!
These guys are supposed to be math geniuses. Most of them can’t count past their 11 digits.
Yes, granted their 11th digit might be very tiny, they still seem to get 10’s of millions bonuses, or were they dudded too?
In medicine, there should be no hesitation in asking the patient ,exactly what is wrong and what is going on. After all noone else has a greater stake in the treatment.
Also, there should never be such a thing as an emergency; there are only complications that one is trained to deal with.
Just as in our physical health, our financial health must be looked after by ourselves. We are the captains of our own team, doctors may be star players or coaches, but we ultimately must determine what actions are to be taken.
Your Health,
Oli
Hi hershsahai,
You seem to think that we can only say that the tree crashes down in the jungle if investors saw it happen. Well I for one do not share your faith in such people, because I saw that most of them were like blind mice, or lemmings with a view only on each other’s butts during their deluded chase.
“Unanticipated” by whom? Even as a more general definition, you would imply that if “investors” do not anticipate something then it is itself “unanticipated”. That might be worse than saying saying that consequences of drug addiction are “unforeseen” because the junkie said: “Oh, I don’t depend on this stuff, I still hold down my job, I can take it or leave it”! Or the logical consequences of gambling are “uncertain” because the pokie addict insisted: “I’m just having a flutter – it’s quite normal, even healthy”!
I warned fellow workers of this as early as April last year. At the time they were offered first bite of company shares, and some asked my opinion. Horrified I gave it: “This crash is bigger than the Depression”. Yes, I used the present tense, because the preconditions were already in place, and many more astute people than myself had spelt out the impending disaster. My fellow workers treated my response with concern and respect, but whenever I offered such advice to more middle class types I invariably elicited contempt and ridicule. Even around ten days ago one such spoilt child of a monetarist parasite expressed his confidence in the system, with condescending reassurance that the big bosses “have a pretty good idea what they’re doing”.
And my anecdote points to a more profound problem: almost any real dissent has simply been impossible under the regime set up by Greenspan and Co. Whether in networks purporting to “educate” or just “communicate”, our culture is so corrupt, and our ruling elites so irresponsible, stupid and arrogant, that they are still not listening. They still refuse to even acknowledge the consequences of their misguided beliefs and ill-considered decisions; much less consider sensible proposals for solution.
Therefore, what you claim to be “obvious and intuitive” merely distracts us from the fact that investors, speculators and their willing accomplices in government all kept the Big Lies going to ensure that this great crash was a great shocking surprise – to themselves. They have only modified their Big Lie a little by claiming that their shortcomings are in fact "responsibility", "inevitability", and motivated by concern for their constituents.
My friends and I have not only anticipated this great crash; it is as though we have been watching it in slow motion, all the while being ridiculed, abused or just ignored by people who believe they deserve to get rich at others’ expense, and by not working for their living.
I like the photo though.
Do you think somebody will eventually buy him that drink?
I should have added that many have foretold of this crash much earlier, even since just after Sir Alan Greenspan’s network introduced the derivatives scam post-87. I only referred to my own such "anticipation" - as a worker/lay punter - for added emphasis on my point about this crash’s deeper roots of intellectual, moral and societal bankruptcy.
Please correct me if I am wrong but…
The US$62-trillion in outstanding credit default swaps (CDS) that have been written in the last 10 years will have to be honoured by the taxpayers of western countries. Tough. That’s the price of ‘guaranteeing all deposits.’
I figure that you do not need a crystal ball to see what this will do asset prices – look at Japan.
Well Bob, Sir Greenspan’s total derivatives bubble (of which CDS form a key part) is much, much larger. Some people have gone on estimating to 600 trillion but then stopped counting, realizing that normal accountancy is impossible, and that it is actually an incalculable galaxy of funny money, but well into the quadrillion figure. Think Weimar Republic, not a mere Banana one. I guess that’s what you meant by reference to asset prices? I am thinking of ALL prices!
Hi mil-observer,
It’s interesting that you take such issue with this point particularly. In my previous post I made criticisms of Greenspan that probably needed more elaboration than my point about financial crises being characterised by unanticipated consequences. In fact, that simple point is the basis of all my criticisms of Greenspan’s piece.
Let me use your example of a tree falling to explain this point again, I wish I’d used it in the first place actually. If there are people (they don’t have to be investors, you know) who don’t want to be killed and know with certainty that a tree will fall nearby, then they would choose not to stand under the tree.
I guess we could complicate this argument with drug addict-like behaviour and say that some people would do it anyway because they make irrational decisions. That’s fine, but why should the behaviour of these people speak for the actions of the majority of society? Would you stand under a tree that was certain to fall?
But I guess that’s not the issue here. I mean you seem to have anticipated the whole financial mess anyway, right? And it still happened…amazing. You must be quite pleased with yourself having made predictions far better than any economist, financial analyst or hedge fund manager had ever come close to making. It’s interesting that you call derivative markets a scam. I mean, if you were a derivatives trader, you’d be the richest man on the planet. Tell me, which market is going to crash next? Which index fund should I short-sell next? What about commodities, where’s oil going to be in two months? Ah forget it, you know what I might set up my own hedge fund and base all of my investment decisions on the wonderful insights you have on how financial markets work. At least one of us will get rich off your genius.