April 6, 2008
Alan Greenspan: A response to my critics
On March 17, Alan Greenspan wrote an article for the FT entitled “We will never have a perfect model of risk“, in which he argued: “We will never be able to anticipate all discontinuities in financial markets.” He concluded: “It is important, indeed crucial, that any reforms in, and adjustments to, the structure of markets and regulation [do] not inhibit our most reliable and effective safeguards against cumulative economic failure: market flexibility and open competition.”
The article attracted a number of critical responses in this forum. For example, Paul de Grauwe wrote: “Greenspan’s article is a smokescreen to hide his own responsibility in making the financial crisis possible.” (Read all the responses.)
The article below is Mr Greenspan’s reply to those criticisms, written exclusively for the Economists’ Forum:
I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long term interest rates statistically explains, and is the most likely major cause of, real estate capitalization rates that declined and converged across the globe. By 2006, long term interest rates for all developed and major developing economies declined to single digits, I believe for the first time ever.
Doubtless each individual housing bubble has its own idiosyncratic characteristics and some point to Fed monetary policy complicity in the US bubble. But the US bubble was close to median world experience and the evidence of monetary policy adding to the bubble is statistically very fragile. Paul De Grauwe depends on John Taylor’s counterfactual model simulations to conclude that the low funds rate was the source of the US housing bubble. Taylor (with whom I rarely disagree) and others derive their simulations from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. This suggests important missing variables. Counterfactuals from such flawed structures cannot form the basis for policy.
De Grauwe asserts that “signs of recovery” (I assume he means sustainable recovery) were evident before 2004 and hence the Federal Reserve should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported “conditions remained sluggish in most districts.” Moreover, low rates did not trigger “a massive credit . . . expansion.” Both the monetary base and M2 rose less than 5% in the subsequent year, scarcely tinder for a massive credit expansion. In fact, growth in total credit market debt owed by the U.S. financial sector declined from a 13% gain during 2001 to an 8% gain during 2004. Nonfinancial sector growth was less.
Some argue that adjustable rate mortgage (ARM) originations fueled the bubble. Yet the ARM’s share of total originations is a very weak forecaster of home prices, implying ARMs, although a source of cheap financing, are not a determinant of home prices. If ARMs were not available from 2001 to 2004, home purchases presumably would have been financed with long term debt, which was also very affordable.
De Grauwe is correct; I do believe bank risk managers and loan officers are more knowledgeable than government bank regulators. Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do the bank regulators that examine those counterparties.
Regulators, to be effective, have to be forward looking to anticipate the next financial malfunction. This has not proved to be feasible. Regulators confronting real time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act preemptively. Most regulatory activity focuses on activities that precipitated previous crises and that investors have long since largely abandoned, although new laws may prevent recurrences. New problems, to repeat, are by their nature incapable of being anticipated with any degree of confidence.
Aside from far greater efforts to ferret out fraud (a long time concern of mine), would a material tightening of regulation improve financial performance? I doubt it. The problem is not the lack of regulation, but unrealistic expectations about what regulators are able to anticipate and prevent. How we otherwise explain how the FSA, whose effectiveness is held in such high regard, fumbled Northern Rock? Or in the US, our best examiners have repeatedly failed over the years. These are not aberrations.
Could tightened regulation of subprimes have contained some of the reprehensible, and presumably criminal, acts of lenders? Probably. But the broader crisis would likely have arisen even with increased micro-surveillance.
The core of the subprime problem lies with the misjudgments of the investment community. Subprime did not break from its localized niche status until 2005. As Ben Bernanke recently put it: “The deterioration in underwriting standards …appears to have begun in late 2005.” I assume that judgment reflected the increased delinquency behavior that is now evident for loans initiated in late 2005 and subsequently.
Subprime securitization exploded because subprime mortgage-backed securities (MBS) were seemingly under-priced (high-yielding) at original issuance. Subprime delinquencies and foreclosures (in a rising home price market) were modest at the time, creating the illusion of great profit opportunities. Investors of all stripes pressed securitizers for more MBS. Securitizers, in turn, pressed lenders for mortgage paper with little concern about its quality. As a consequence underwriting standards collapsed, and mortgage originations and securitizations rose to far greater heights than would have occurred without securitization. Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle. It would have required insights that would enable regulators to override the investment judgments of the most experienced analysts of the private sector, the very people on whom regulators rely for their market insights. When investment judgments are distorted by euphoria, even so valuable a financial innovation as securitization will perform poorly.
Counterparties, of course, also confront uncertainty but they appear invariably to know more about their customers than do regulators. They have a much better, but clearly not a flawless record, as the subprime breakdown exposed.
If counterparty surveillance is abandoned or significantly weakened, we are left with regulation by the less informed. Counterparty surveillance needs to be repaired, not abandoned. In the meantime markets are readjusting risk spreads, as a precursor to the new structure that will evolve with time.
I admit to being surprised and appalled at the recent collapse in bank underwriting standards. In response, since last summer, market forces have driven leverage down materially and leverage will doubtless fall further before it stabilizes. Basel II eventually will be altered accordingly.
Investors henceforth will balk at the fees that most hedge funds and private equity funds have been able to obtain during the past surge of euphoria. Future stand-alone SIVs will find financing costs prohibitive. The CDO market will revive, but in a more viable form, perhaps with the relevant counterparties determining the credit ratings of individual tranches through issuance of CDS rather than through credit rating agency evaluation. Securitization, though abused in its subprime applications, is a valued transferor of risk from highly leveraged institutions. It will revive largely in its current form. CDS back office operational risks will not be tolerated.
Indeed, the current low volume of issuance of all such securities suggests much of the fall away of bids has already happened. The restoration of bids and issuance when it occurs will be in a fundamentally changed pricing environment from that which existed prior to last August 9.
I agree with Wolf that social insurance has its price and with his concern of privatizing profits and socializing losses. If we are to have a system in which some financial firms are designated officially as being “too large to liquidate quickly,” we need to recognize that such institutions will gain the advantage of a competitively lower cost of capital. The implicit subsidy of those firms who choose to be “too large” will have to be addressed.
I disagree with Wolf that I have ignored “evidence of malfeasance and gross incompetence.” I have consistently bemoaned criminal fraud and the “excessively lax terms to encourage (subprime) mortgage applications,” for example, last fall in London (HM Treasury Financial Stability Forum).
Wolf argues that central banks “can surely lean against the wind” even if they cannot eliminate bubbles. I know of no instance in which such a policy has been successful. For reasons I have outlined elsewhere, (American Economic Association presentation, January 2004) I doubt that it is possible. If it turns out it is feasible, I would become a strong supporter of “leaning against the wind.”
As far as US monetary policy being (in Wolf’s words) “dangerously asymmetrical,” I point out that over the past half century the US economy has been in recession only one-seventh of the time. Yet the unemployment rate exhibits no trend. Hence the average rate of rise of the unemployment rate has been far greater than its average pace of decline. Monetary policy in response has been more active during recessions than during periods of expansion, but scarcely “dangerous.”
Much of the commentary critical of my FT article is directed less at its substance and more, as Wolf describes it, to “the ideology I display.” Ideology, which regrettably has become a pejorative term, defines that set of ideas that we each believe explains how the world works and therefore how we need to act to achieve our goals. Some of our views of causative forces are rational, some are otherwise. Much of what we confront in reality is uncertain, some of it frighteningly so. Yet people have no choice but to make judgments on the nature of the tenuous ties of causation or they are immobilized.
I do have an ideology. So does each of the members of the Forum. I trust our views are subject to the same standards of evidence that apply to all rational discourse. My view of how the efficiency of global capitalism has evolved over the decades as new evidence has appeared contradicting some earlier judgments and confirming others. I have been surprised by the fierceness of investors in retrenching from risk since August. My view of the range of dispersion of outcomes has been shaken, but not my judgment that free competitive markets are by far the unrivaled way to organize economies. We have tried regulation ranging from heavy to central planning. None meaningfully worked. Do we wish to retest the evidence?
The writer is former chairman of the US Federal Reserve.
It is ludicrous to suggest that the U.S. Government did not have a hand in creating the Housing Bubble. The U.S. Govt. had a direct hand, although it was not the only hand, because:
a. The quasi-governmental organizations of Fannie Mae (FNM), Freddie Mac (FRE) and Veterans Housing Authority were all set up by the U.S. government in order to provide lower cost financing and lower down-payment requirements to buy homes in the USA for politically favored groups: the poor and lower middle-class and veterans. Giving half the American population access to government agency lower cost mortgages, of course drove the price of housing up. And since this government interfering/subsidized financing in the private housing economy was so attractive, including providing mortgages to many at only 5 and 10% downpayments, of course the banks and Wall St. was forced to also write mortgages with very low down payments to stay competitive.
b. I know for a fact, the U.S. government in the early 2000s was even GIFTING DOWN PAYMENTS AND CLOSING COSTS to certain target supposedly poor people, as I knew an El Salvadorean immigrant working as a house cleaner who told me an “community anti-poverty agency” funded by the US Government had GIFTED HER DOWN PAYMENT AND PART OF CLOSING COSTS. By expanding the market of those who could buy homes, to poorer citizens, to those who had not even saved up the down payment and closing costs, as part of Government SOCIAL POLICY, of course it led to more people owning homes who really didn’t have the discipline to pay their mortgage (they’d not saved for the down payment), and who didn’t have ’skin in the game’ since it wasn’t their downpayment of course many WALKED as soon as housing prices went down. They were really playing “heads I win / tails the mortgage lender loses” based on housing prices, with the US Government down payment subsidy targeted to anti-poverty agencies in mainly so-called “minority communities”. By doing this, of course the U.S. government is partly responsible for home prices having been pushed up beyond where the natural free market. And its the lower end of the market and the minority communities that are experiencing the highest rates of foreclosure, as a result of the US Govt. having formerly as part of social policy helped them buy homes. In fact a few years ago the US Govt. was even BRAGGING about highest % of Americans owning homes ever. But it was accomplished by having subsidized un-credit worthy people to buy homes, who really should have stayed renters.
Since the US Government had a direct hand in subsidizing cheap credit via Fannie Mae and Freddie Mac and VHA loans, and so many grants to poor and policeman and teachers to buy homes in certain (mainly poorer) neighborhoods, and so pushed prices up so far above their free-market rate — the US Government should not now be walking away from its long implied guarantee on FNM and FRE govt. agency mortgage bonds, and so help cause Bear Stearns to collapse…etc. The US Govt. said these are Fed. Agency Bonds, and the US Govt. set the credit standards by which FNM and FRE and VHA made loans all these years,k and pushed housing prices up in much of the country, and so it now honor the implied government guarantee non all these and other triple-A rated bonds.
Yes there were unscrupulous mortgage brokers and firms out there that misled some home buyers. But the Fed. Govt. had the power to regulate them all these years, but failed to do so properly, and again it was the US Govt. that created the entire system of low-cost mortgage credit for most Americans starting in the 1930s Depression (such low cost interest rate and long-term 30 year financing to buy homes does not exist in most countries). Its not right for the US Govt. to now walk out on what they created by failing to buy even Govt. Mortgage Agency Bonds at Par. My opinion, from a fellow NYU MBA grad., where Mr. Greenspan did his PhD
Posted by: Andrew | April 7th, 2008 at 12:58 am | Report this commentChristopher Whalen (guest): In my view, the mortal sin of chairman Greenspan was not irresponsible monetary policy, but rather dropping the ball on bank supervision and market structure. I described the ill effects of allowing the liberal academic economists at the Fed’s Board of Governors in Washington to set bank supervision policy in a comment in Friday’s American Banker.
In particular, in the two decades of Greenspan’s tenure, the Fed’s Washington staff, other regulators and the Congress allowed and enabled Wall Street to migrate more and more of the investment world off exchange and into the opaque world of over-the-counter instruments. This change is described by people like Treasury Secretary Hank Paulson as “innovation,” but my old friend Martin Mayer rightly calls it “retrograde.”
In a market comprised primarily of exchange-traded instruments, there is little or no counterparty risk. OTC trades that reference exchange-traded benchmarks are likewise far more stable. By replacing exchange-traded securities with ersatz OTC instruments, Greenspan and the quant economists who dominate the Fed’s Washington staff have created vast systemic risk that need not exist at all and that now threatens our entire financial system.
BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm’s books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the “financial innovation” of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929.
Would that the Congress and the Fed had the courage to confront Paulson and the other banksters who have turned America’s financial markets into an increasingly unstable, derivative house of cards. If all federally commercial banks and funds subject to ERISA were required by law to invest only in SEC registered, exchange-traded instruments, the threat of further systemic risk could be eliminated tomorrow. What a shame that neither Chairman Bernanke nor FRBNY President Timothy Geithner said that last week when they appeared before the Senate Banking Committee.
Mr Whalen is a co-founder of Institutional Risk Analytics, a Los Angeles unit of Lord, Whalen LLC that provides customized financial analysis and valuation tools.
Posted by: rc whalen | April 7th, 2008 at 2:36 am | Report this commentMr Greenspan was not a perfect central banker; merely, by some margin, the best available.
One of the lessons of the crisis is that central bankers do have some power to “lean against the wind”. The Bank of Spain’s refusal to to let the institutions it supervises set up off-balance sheet vehicles unless they provided 8% capital cover has been a key factor in saving the financial system of a country with a very sharp housing bubble. Further, Basel II now permits (this is new) central banks to insist that risk models of large banks reflect any systematic risk the central bank thinks may be lurking in an asset class.
Posted by: David Heigham | April 7th, 2008 at 1:51 pm | Report this commentIn regards to this issue, one element that seems to be over looked and in my opinion has contributed to the mortgage melt down is when our tax laws eliminated the deductibility of mortgage insurance. At first glance this may not seem to have had any effect upon the crisis, however, looking at the chain of events of that decision one may re-consider. Mortgage Insurance has long been considered in the mortgage industry as the “plague”, to be avoided, another set of eyes, mainly getting in the way of getting more people approved for a loan. They are in fact another quality control entity. Once removed, the mortgage industry, loan officer, ceased the opportunity to do 80/20 loans which required one set of eyes to make the approval decision, not two. Therefore, setting up what we currently see happening, tightening up of credit. HELOCs were never intended to be used as a tool to avoid mortgage insurance nor as purchase money. Also, mortgage insurance companies are there to help share and spread the risk. Greed also plays into the equation, which does not fit into any model. There is and has not been any suitability test that lenders are required to perform before making a loan. Simply put, many loans were made that were not suitable for the borrower. There are many more elements that have contributed to the current crises that I am aware of and I am certainly not an economist, but I do believe that the return of mortgage insurance and some sort of suitability testing will help get us back on track for the long run in the mortgage industry. I also believe that Greenspan has directed our country to the best of his ability and is not the responsible party to the current crises. Let’s find ways to fix what is going on rather that trying to blame someone.
Posted by: Tim Hensley | April 7th, 2008 at 2:47 pm | Report this commentEdward Breen: There is an argument that Mr Greenspan bears responsibility for the US housing bubble and collapse due to his policy of “gradualism” in the increase of the FFR by 1/4 point increments begining in 2004. This argument was not posited by Mr De Grauve and it was not defended by Mr Greenspan. The rational basis of the argument is that the broadcast of the Fed’s intention to increase rates in monthly increments until some unstated and unknown condition of interest rate neutrality was eventually reached, encouraged leveraged economic decisons to move forward in order to avoid higher interest rates that were promised to follow. This effect was particularly pronounced in residential housing decsions where borrowers were encouraged to act sooner to buy or refinance, rather then wait until rates certainly would go up. This brought demand for real estate forward and sent false signals to the housing and mortage industries with regard to demand for housing and the value of housing asset collateral. As a consequence the builder community overbuilt and the lending community over leveraged, becoming vulnerable to the inevitable trough in demand that occured as rates continued to rise.
An additional criticism of this “gradualism” policy is that it was begun at an time when there was very low inflation according to the index measures. Mr. Greenspan admits as much in his defense above that he did not leave rates low for too long. He notes that in addtion to low index measures of inflation there was very little growth in the M2. One can fairly ask, whether it was wise to begin raising interest rates gradually at that time, and what was the policy imperative that drove the decision if there was no indication of emerging inflation. Many economists at the time did criticise the decsion as contributing to a “treadmill” effect, where rather than reducing inflation, the gradualism actually created the inflation that is was ostensibly designed to avoid.
In the context of defending policy decisions in the face of uncertainty, Mr. Greenspan should defend his policy of gradualism in FFR increase at a time of no inflation that resulted in a housing bubble and increased inflation before it was ended.
Edward Breen is an attorney and a director of a manufacturing company. He was the president of a real estate development company, Axial Investors Group, during the S&L and real estate collapse of the early 1990s.
Posted by: Edward Breen | April 7th, 2008 at 3:06 pm | Report this commentWith regard to the above submitted post and relevant academic or financial background, Edward Breen was a director of Polyconomics, Inc., an economics consulting enterprise founded by Jude Wanniski, that ceased operations after Mr. Wanniski passed away in 2005. Mr. Breen was also the president of a real estate development company, Axial Investors Group, during the S&L and real estate collapse of the early 1990s’s. Presently Mr. Breen is an attorney and a director of a manufacturing company. He frequently comments on economic policy on the blog site, “Supply Side Forum.com.”
Posted by: Edward Breen | April 7th, 2008 at 4:33 pm | Report this commentMary S Schranz (guest): Financial markets and institutions serve a useful purpose to channel funds from savers to borrowers. Spending by borrowers increases the current level of economic activity. To the extent that funds are used to increase the public and private capital stock, channeling funds from savers to borrowers increases an economy’s productive capacity in the future as well.
Financial markets and institutions also have the potential to destabilize an economy if poor decisions are made when funds are lent or when excessive speculation occurs. Poor decision-making could be the result of poor management or the result of societal incentives that allow financial institutions to take risks with managers and employees bearing little if any of the costs associated with those risks. Because financial institutions use other people’s money, there is an inherent potential conflict of interest between the institution’s managers and employees and its shareholders, depositors, and others who provide funds to these institutions.
Speculation occurs when monetary policy is too lax. Those with money can either spend it, putting upward pressure on consumer prices, or invest it, be it in stocks, bonds, commodities, derivatives, or real estate. Bubbles can occur in any of these markets when too much money in circulation and interest rates are set too low.
The current crisis in the credit markets is a direct result of misaligned incentives in the financial services industry, government policies that create moral hazard, and loose monetary policy. Addressing each of these issues is necessary to reduce the probability of a similar crisis in the future. To the extent that this requires regulatory reform, the following issues should be considered.
First, long-run economic growth depends on a society’s legal, political, and cultural institutions. Faith in the underlying stability of the financial system promotes economic growth. Hence, regulatory reform should be directed toward promoting stability of the financial system without unnecessarily inhibiting the useful function of channeling funds from savers to borrowers. Included in this reform should be the establishment of an institutional framework to manage future financial crises as another crisis will undoubtedly occur at some point.
Second, all financial products of a similar type should be regulated by the same authority. This will create a level playing field and prevent circumvention of regulations within a country. Different products or different lines of business could be regulated by different agencies if a mechanism for interagency cooperation and coordination is also created.
Third, a global financial crisis requires a global regulatory response. The current crisis spread from its source in the US mortgage market to financial institutions throughout the world due to securitization of mortgages and globalized investing. If a country is unwilling to cede direct regulatory oversight to a global regulator, some type of international body to resolve financial crises and disputes should be established to create as level of a global playing field as possible and to prevent circumvention of regulations by crossing country boundaries.
Fourth, internal firm compensation policies and governmental policies that create moral hazard need to be corrected. Minimum capital requirements are a necessary but not a sufficient condition to promote stability in the financial services sector. A minimum level of capital is needed to provide for unanticipated withdrawals from a financial institution. However, if internal company compensation policies and regulatory bailouts reward excessive risk-taking, excessive risk-taking will occur regardless of the capital requirements.
Direct government regulation of compensation within a firm is unwieldy, politically infeasible, and would likely involve greater social losses than those generated by an unregulated system. But moral hazard must be mitigated. A tax on financial institutions that is tied to the riskiness of the institution’s investments would reduce the incentive to take excessive risk without destroying the incentive to generate productive innovation in the financial services industry.
Fifth, any institution that expects assistance from the government, either via direct taxpayer dollars or via access to central bank funds, must agree to regulatory supervision. This condition also requires that supervisory authorities supervise. Regulators must be aware of the incentives of financial market participants to take advantage of whatever system is in place and to generate noise that obscures their actions. The tax discussed above would provide the funds necessary for supervision and also provide funds that could be used to address the next crisis.
Sixth, use of off-balance sheet accounting techniques to hide risky investments must be curtailed. Potential liabilities must be clearly disclosed or turned into direct liabilities and moved onto the balance sheet. The accounting regulatory bodies bear some of the responsibility for the current crisis by allowing firms to hide liabilities off the balance sheet. The initial tightening in the credit markets was due to direct losses on mortgage-backed securities. The continuation of the crisis long after the initial losses were reported is due to lack of trust between institutions. Proper accountancy that informs rather than obfuscates will restore trust and prevent a temporary crisis from turning into a long-term loss of faith.
Seventh, central bankers must be vigilant in monitoring asset markets as well as consumer and producer prices when setting monetary policy. A low real interest rate environment creates the incentive for speculation. Excessive leverage in the financial system, enabled by margin requirements on short sales and security purchases that are set too low or by other forms of borrowing by financial market participants, also encourages speculation. As Keynes noted many years ago, “Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.” It is the responsibility of regulatory authorities to prevent the speculation that threatens the steady stream of enterprise.
Institutions matter. Investors, regulators, and financial institutions should use the current crisis as an opportunity to create an institutional framework that will serve the global economy well in the future, long after the current generation of managers and regulators are gone.
Mary S. Schranz is an instructor in economics at Madison Area Technical College
Posted by: Mary S Schranz | April 7th, 2008 at 4:35 pm | Report this commentI’m sorry, but these comments from Mr. Greenspan rather sound like, “stuff happens.”
Posted by: richardberlin | April 7th, 2008 at 6:33 pm | Report this commentHow do you evaluate the performance of Fed Reserve Chairmen ?
1. Value of the dollar in relation to other currencies.
2. Increase in the value of the stock market over prior ten years.
3. Net Worth (Strength) of Financial Institutions (Banks + I-Banks).
4. Size of the Federal Budget Deficit (Currently $9.2 Trillion ).
5. Size of the Money Supply.
6. Social Programs (Medicare and Social Security).
While the President and Congress and the American Public all have responsibility for the state of the American economy, Alan Greenspan passed up an opportunity of a lifetime.
He had the ability to influence policy. Greenspan was the FOCUS of world financial markets for many years. Unfortunately, his legacy will be defined as an utter failure to bring about the changes in the domestic economy that could have made the world economy more stable. Greenspan did not provide the charismatic leadership to initiate change.
Paulson and Bernanke have made more radical changes in their short tenure than Greenspan made during his career. Greenspan did his job, moved rates up and down - along with changes in the economic data, according to the Taylor Rule. A computer could’ve done the same.
Let’s hope that some of the reforms going forward will help to repair the damage that has already been done to our society.
Posted by: David Spurr | April 7th, 2008 at 6:45 pm | Report this commentStrong capitalization on the side of Financial Institutions has been always the right answer to reduce moral hazard onto taxpayers from financial crashes. The problem as evidenced by the subprime crisis is still the credit rating attached to to instruments for capitalization requirement purposes. Greenspan blames investors for having dropped underwriting requirementes. In my opinion he is not grasping the whole problem. the US financial regulation model main flaw is its squareminded sight for profit and freedom, no matter if at the end of the day taxpayers have to pay for the abuses.
Posted by: Maria Eugenia Butler | April 7th, 2008 at 7:35 pm | Report this commentTo make a acomparison with other markets, would the FDA be allowed to let the “Drug Rating Agencies” to assess the different drugs that are to be sold on the market?
Taxpayers should claim that the Fed or other Governmental Agency has to make its own credit assessment for capital requirement purposes.
One problem I perceive with the Fed’s monetary policy was that creating a housing bubble in turn decreased the perception of inflation due to use of CPI-U as an index for inflation. 24% of the CPI-U is based on owner’s equivalent rent which doesn’t reflect asset costs during euphoria.
http://www.bls.gov/cpi/cpifact6.htm
“Until the early 1980s, the CPI used what is called the asset price method to measure the change in the costs of owner-occupied housing. The asset price method treats the purchase of an asset, such as a house, as it does the purchase of any consumer good. Because the asset price method can lead to inappropriate results for goods that are purchased largely for investment reasons, the CPI implemented the rental equivalence approach to measuring price change for owner-occupied housing. It was implemented for the CPI-U in January 1983 and for the CPI for Urban Wage Earners and Clerical Workers (CPI-W) in January 1985.”
Determining the costs of shelter by only measuring rents and not considering asset prices acts to reinforce monetary policies which create an oversupply of housing (driving down rents) while in turn driving asset prices higher (due to real inflation, i.e. the oversupply of money against real productivity increases) while masking the inflation from measurements.
Greenspan can’t blame this on inept regulations or misguided investors. It’s purely a poor mechanism used to implement monetary policy as now has been shown and falls squarely on the Fed’s doorstep.
Posted by: Bob McMahon | April 7th, 2008 at 9:10 pm | Report this commentClearly the Fed could have done much more to regulate mortgage issuance to eliminate liars’ loans and other grossly negligant lending.
The Fed could also have better regulated the origination, bundling and sale of collateralized debt obligations to ensure that purchasers reserved capital to cover expected losses of those extraordinarily risky investments. Big risky investments require big, heavy security. In this case, reserves for losses.
The Federal Reserve had options but made a clear choice to do nothing. Its leaders should take responsibility for the effects of that decision.
Posted by: Leo Gallagher | April 7th, 2008 at 10:08 pm | Report this commentSir I commend you for posting this, however I remain unconvinced. Standing by in 2004 as I watched housing prices in LA appreciate 40% in one year, with a 1% short term Fed Rate fueling $0 down 3% ARMs (some of which were negatively amortized) it escapes me how you don’t think this kind of monetary policy fueled this classic bubble of excessive leverage and over speculation.
Posted by: Eddie | April 8th, 2008 at 3:19 am | Report this commentIf all money supply is accomplished via loans. And all loans are given at a percentage interest. Then doesn’t the system thereby require that to be stable the interest charged is also written off at some point?
Over simplified example follows:
If 10 people are loaned $100 each at 10% APR on Jan 1st and all loans are due on Jan. 1st the following year.
Money supply = 10 x $100 = $1000
% of Money supply encumbered = 100%
Interest rate on entire money supply = 10%
Money due Jan 1 following year = $1100
Money supply shortage = $1100-$1000 = $100
Write offs Jan 1 following year will be $100
Property redistribution from borrower to lender will occur if something of actual value was used to guarantee the loan that was in default.
Come Jan 1st regardless of the productivity or any other factor of the 10 people 10% of the population at minimum will default, and property backing these loans will transfer hands.
For the system to be stable this has to occur. One can prolong the defaulting of the loans only if the money supply is consistently expanded. Yet the amount that will one day have to go into default will only grow larger using this policy.
The real moral hazard of this system is the very basic fundamentals of the system. Where the system itself requires that lenders win and some borrowers lose.
I know this is a very simple example but if someone could please explain an error in the logic I would much appreciate it.
Posted by: Money and production are they related? | April 8th, 2008 at 6:57 am | Report this commentI agree, regulation cannot nor can be expected to prevent crises. In addition, regulators neither are able nor should they be expected to foresee financial crises. Regulators should attempt to prevent a systematic collapse of the financial system as a whole. I believe therefore that the single and most important element for regulation to control is leverage. Institutions and by extension their shareholders should not be prevented by regulation or by any other means to risk their own assets in the pursuit of economic profits. It is the inherent risk to the taxpayer that the collective actions of these companies and their peers pose to the stability of the financial system primarily through leverage that the regulators should look to control.
Posted by: PV | April 8th, 2008 at 8:59 am | Report this commentThe problem with relying on real interest rates is that they still reflect Fed policy as well as the method used to measure inflation. What is of more importance is the mythical “natural” rate of interest (mythical due to the existence of central banks).
The natural rate of interest, of course, is the rate that balances supply and demand of savings and borrowing in a market free of central banks. Ultimately, it is a price, just like any other. Mr. Greenspan and many other self-proclaimed free market proponents have decried as harmful price controls in centrally-controlled economies, yet they still believe that it is not only possible, but beneficial, to manipulate the price of money.
Granted, Mr. Greenspan’s argument that interest rates were significantly affected by an increase in global savings at first glance appears to hold some weight. The mere fact, however, that we are unable to know what interest rates would have been without central bank intervention prevents us from knowing the true affects of this increase.
A bit of data cherry-picking, intentional or not, is also occurring. Looking at other definitions of money supply over a time period matching the Fed’s loose monetary policy, we see a slightly different picture. The decreases in the Fed Funds rate post-tech boom started in January 2001. From this point to January 2007, arguably when the subprime crisis was starting to come to the attention of the general public, MZM increased 51%, or a little over 7% annualized. M3 from January 2002 to January 2006 (no official stats exist for January 2007) grew by 40%, or 7% annualized. True, these numbers are not at hyperinflationary levels, but if we use the money supply as an indicator of true inflation, they are well above the comfort zone.
Finally, constraining ourselves to the past seven years deprives us of the bigger picture. Loose monetary policy was alive and well at the Fed in the mid to late 90’s, and the technology bust that occurred may well have been the first warning sign of things to come. While the Fed was able to temporarily inflate itself out of trouble, we now may be facing the consequences of this “put off until tomorrow what you could more easily do today” policy.
How would things have played out if we had let the market due its job? Unfortunately, as a wise owl once said about counting the number of licks it takes to reach the center of a tootsie roll pop, we may never know
Justin D. Rietz
Posted by: Justin Rietz | April 8th, 2008 at 10:20 am | Report this commentWillem Buiter: Mr Greenspan’s apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince.
The Greenspan Fed (August 1987 – January 2006) did contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
The Greenspan Fed brought us the Greenspan put (now the Greenspan-Bernanke put). This is the aggressive response of the official monetary policy rate to a sharp decline in asset prices (especially stock prices), even though the asset price declines (a) are unlikely to cause future economic activity to decline by more than was required to meet the Fed’s triple mandate and (b) do not convey new information about future economic activity or inflation that would warrant interest rate cuts of this magnitude.
To me, this indicates that the Fed has been co-opted by Wall Street - the Fed has internalised the objectives, concerns, world view and fears of the financial community to an excessive degree. This socialisation into a partial and often highly distorted perception of reality is unhealthy and dangerous.
The Greenspan Fed failed to appreciate the downside of rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for the undoubted virtues of securitisation.
The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
The Greenspan Fed, by enabling the rescue of Long-term capital management in 1998, acted as a moral hazard incubator. Both before and after LTCM, the Greenspan Fed failed to press for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail. This demonstrates either bad judgement or regulatory capture. The moral hazard-fraught rescue of Bear Stearns is the lineal descendant of the LTCM bailout.
During his years as Chairman of the Federal Reserve Board, Alan Greenspan’s statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator.
Mr Greenspan consistently saw but half the picture when it came to what makes competitive market capitalism work. He recognised the central roles of greed, self-interest and competition. He failed to appreciate the complementary roles of non-strategic/opportunistic forms of altruism, honesty, trustworthiness, solidarity and cooperation.
He emphasized self-regulation, spontaneous order and the disciplining effect of reputation. He did not understand the weakness of reputational concerns as a (self-)enforcement mechanism ensuring good behaviour, when credible commitment is, at best, limited in a world with short horizons and easy exits.
He failed to appreciate the essential role external/third-party (i.e. state) enforcement of laws, rules and regulations, and the indispensability of collective action when faced with the threat of the breakdown of trust and confidence.
By overselling, at home and all over the world, the virtues of American-style transactions-based financial capitalism and light-touch regulation, Mr. Greenspan has done more to harm the cause of decentralised, competitive market-based financial systems based on private ownership, than even Charles Ponzi.
Alan Greenspan’s period as Chairman of the Board of Governors of the Federal Reserve System represents to me the nadir of central banking in advanced economic-financial systems during modern times. While monetary policy was only mildly incompetent, the regulatory failures were horrendous. The US and the world economy will pay the price for Mr Greenspan’s misjudgements and errors for years, perhaps decades, to come.
Posted by: Willem Buiter | April 8th, 2008 at 11:45 am | Report this commentRobert McDowell Guest contributor
I have no criticisms of Greenspan’s views. But, I do criticise banks for oignoring economics analysis and for ignoring central banks’ and regulators’ advice whenever this involves economics. Bank’s inhouse economists have been purposefully left out of credit and market risk analysis. Greenspan’s advice, like many others, boils down to regretting that short term credit was allowed, even encouraged, and not just by low real bank rates, to speculate in longer term assets and to accept classic liquidity mismatches.
The inter-bank credit market (wholesale finance) has been taken for granted. We can learn from farmers who do not assume there will always be a rainy season. Bankers and non-bank investors in banking assets assumed banks will always be the last to suffer liquidity proiblems.In fact, liquidity risk, which is part of classic banking awareness, has until last year been understood or considered by very few bankers; most, if tested a year ago, would not be able to define it. We may blame New Keynesian thinking for the notion that credit and economic cycles can be banished by stabilisation policy. This dream ignores that long run confidence in stability generates one-way markets i.e. asset bubbles. We need cycles to maintain 2-way markets (uncertainty) and should welcome them.
Too much is being blamed on sub-prime securitised assets. The economic losses (after defaulted debt recoveries) will by themselves not be severe over the medium term - probably less than $200bn in the US including interest and this will roughly vindicate the ratings agencies through-the-cycle risk ratings. The short term knock-on in the financial food chain of leveraged funds and marked-to-market values is much greater. But, the greatest impact will be in the enforced changes in world trade and in general recession events. But, sub-prime is not the main cause of US-led recession, even if property and other asset price bubbles do play a large part - a normal regular cause of cycle downturns.
In part,sub-prime is an outcome too of public policy to extend home ownership to many of the poorest quarter of the population who otherwise would lack financial assets and the related dearth of new social housing.That public finance should bail out those who are over-extended and unbalanced relative to long run trends is proportionate in the circumstances. One important result is to restore belief in the role of government retaning a size commiserate with counter-cyclical responsibilities (about 25% net share of GDP, or 45% budget ratio to GDP).
One glaring omission in the public debate about the Fed’s and other regulators’ responsibilities is failure to discuss BIS’s Basel II new laws and rules relating to a liquidity shock crisis and recession etc.? There should be little doubt that Basel II when fully established is the best that can be currently conceived to clarify and mitigate the current crisis and similar crises.
It is shocking how Basel II has been ignored in the debate.The only explanation must be that Basel II is not yet fully on US banks’ agendas (only Europe’s) or an erroneous assumption that it concerns credit and solvency risks, but not also systemic and general economy risks?
Basel II contains plenty of sound advice about liquidity risk and credit cycles alongside the advice emanating for years in central banks ’stability reports’ about credit bubbles, unfortunately conjoined only rarely with clear instructions to banks to refrain from unbalanced lending, it is valid to suggest that where countries have adopted a multi-strand or tripartite regulatory & supervisory system, banks’ sensitivity to whatever central banks tell them has been lost in analysis. Bankers became cynical about macro-economics just as they ignored central banks’ stability reports. We may blame Monetarist and New Keynesian precepts alongside short term bonus-driven greed and leveraged credit churning like a Lloyds underwriting snake of old, some fraud and so on.
Six other missing debating points to be noted in passing:
1. banks have not disclosed losses borne directly by their customers in retail investment funds
2. most ABS issues were ultimately sold to Far & Near East investors who have not yet disclosed book losses
3. packaging bank assets for sale was not really complicated (even if too complicated for some)
4. ABS’s have been central to the pattern of world trade, which now has to change fast and dramatically. Acquisition of financial assets were not demanded as Greenspan suggests merely because of their apparant profitability, but because they paid for trade deficits
5. securitisations were structured (not just rated) as failsafe and extolled by BIS and other regulators as being the way of the future for how banks would tier globally (financiers - originators - distributors)
6. financial markets are not incorporated within GDP economic models, and therefore no one has published an economic model that accounts for the prese4nt crisis.
The public debate is intuitive about the role of regulators, assuming that they actually or potentially police the general quality of the markets. This is a wake-up call to the regulators whose focus has been on individual malfeasance, not the economic conditions.The central banks issue sectoral cross-market data, but rarely back this with instructions to all banks.All commentators under-estimate how much can be known about the markets - a point that Greenspan emphasised. All also under-estimate the future role of Basel II. Basel II goes further than where public debate on the crisis has got to so far, by making it a matter of law that banks should have the equivalent of in-house regulators (independent risk units) caring about a comprehensive range of risks and doing so comprehensively. But Basel II has not yet solidified in the analytical aspects of Pillar II where it concerns economic shocks and liquidity risk.
Pillar I of Basel II concerns solvency of assets in bank & trading books. This is specified in detail and banks have therefore worked on this assiduously. Pillar II is what really counts. the external (economics) context of all risks and especially liquidity risk (liabilities) and systemic risk (banks’ actions faced with credit and economic cycles), and generally risk diversification i.e. the balance of risks across all borrowers and depositors and the impact on banks’ capital of real world shocks.
The regulators were waiting to do peer reviews to learn from how banks variously solved Pillar II before figuring out how they should then regulate the banks in precisely those matters causing the present global crisis!
Pillar II was not specified in detail by regulators and was left to the banks to work out for themselves. This caused nervousness and anxiety among banks. None of them have the self-confidence to complete Pillar II fully The insurance companies have to do the same work in Solvency II, but are better equipped actuarily to understand the issues, and have more regulatory time to do so. None of the major banks have completed Pillar II in time for the credit crunch or to meet the regulatory deadline in Europe. Almost all are a year or more behind schedule.
It was not until the crisis hit that senior bankers’ minds began to be focused adequately on Pillar II - a process of concentration on what even now is only fitfully and chaotically forming. The FSA, among all regulators, has been the benchmark reference par excellence for the banks on Pillar I, while the central banks provided material for Pillar II (now supplanted in my view globally by the FT - an interesting phenomenon created by features writers like Crook, Wolf & Forum, Munchau, Kay and others - the FT has never been so fascinating as over the past year).
But, as some commentators (e.g. papers by Wynne Godley et al) have pointed out, there are no known complete models (GDP economics + finance sector balances + assets values) that can accommodate and forecast the present crisis! The lack of complete models is evidenced here in Wolfe’s forum. Some IT and accounting firms offer packages called stress test models, but all are simplistic (viewed by experienced applied economists who know about banking).
The banks have been afraid to allow economists to become involved for fear of economists running the banks. This has been said to me repeatedly by senior bankers and confirmed by regulators. In my view banks have to learn how to econmomically benchmark themselves to their sectors and the sectors to the economy. Any other modeling approaches totally fail. It is not a question of more or less regulation. It is a question of whether banks will seek to comprehensively analyse their business in the wider economic context - something they have been at great pains to avoid.
Basel II insists on comprehensive self-awareness about solvency risks, plus, above all, awareness of the wider economic context. Instead, the banks have devoted over 90% of their risk management work on Pillar I (Solvency) and postponed or avoided Pillar II (Liquidity and Economics modeling). If the credit crunch had arrived 2 years later, or the banks had begun their Pillar II work 2 years earlier, and regulators could have provided detailed advice in the form of complete models (accounting + economic) then there would be much less chaos than we can see now.
Banks have theoretically known that crunches and cycles are inevitable, but hoped and assumed that these would be staved off for some years yet. There were plenty of warnings, including about the inevitable loss of confidence in new derivative instruments that would test credit markets severely, as well as about credit and mortgage bubbles.It is not the job of regulators or governments to inform anyone when a credit cycle is likely to end or a recession will hit. Banks are supposed to do this work themselves.But few did. Even when Merrils and Citi and some others published doom-laden forecasts, these were largely ignored even internally within the forecast issuing banks.
While we can assume that in the medium term future mistakes of recent years such as ignoring systemic risk and economic modeling will not be repeated, how banks (and others) respond and adjust up and down the feeding chain will be so chaotic that it will take the whole of recession plus recovery period (5-6 years) to gain clarity. By that time the realised economic losses directly related to sub-prime delinquency and defaults will be the least of the total losses compared to the losses via all the leverage dependencies, even before losses generated by recessions (first Anglo-Saxon cycle, then 6-8 quarters later Euroland and RoW).
The solution concerns adjustment to shock and recovery financing, which are inevitably Government driven and essentially replacing devallued ABS (mainly MBS) paper with government paper (at a premium). My own preference is to propose adapting non-marketable government bonds for this role ($4trillions in US Federal Debt alone), but this is unlikely to be an opinion attended to.
Robert McDowell
Posted by: Robert McDowell, Edinburgh | April 8th, 2008 at 12:24 pm | Report this commentMichael Hudson: I would like to make two points that others have not made. One concerns his logic, the other concerns the empirical data the Fed (mis)-used.
First, Mr Greenspan uses a false logic when he argues that private bankers know the financial marketplace better than regulators, because they’re there on the spot. No doubt this is true. But Mr. Greenspan argues as if it follows that they should regulate themselves, as if they did NOT know there was a bubble.
Here’s the problem. By spring of 2006, bankers knew there was a bubble. The public knew it. In May, I published a cover story in Harpers on the topic. In June, I addressed a bank annual meeting and met with a number of bank presidents. They said that they knew that the loans they were making had no foreseeable way of being repaid. But if they didn’t make the loans, they explained, other bankers would do so. And making a bad loan was cost-free. They would turn around and sell it to a packager as quickly as possible, to get it off their own books.
There was no regulator for these packagers. And under Mr. Paulson’s recent proposals, the Securities and Exchange Commission will be folded up, its regulatory powers taken away – and given to a Fed that does not believe in applying whatever regulatory powers it has (as Mr Crook pointed out so clearly in yesterday’s FT).
My second point is more serious. It concerns the Fed’s statistics on real estate, specifically on land valuation. If a real estate bubble develops, this is where historical time series get out of whack first. The Fed uses good Census Dept. valuations for overall real estate. But then it uses a methodology that treats land as a “residual,” after pretending that buildings increase in value by their “replacement cost,” calculated by applying a construction-cost index.
For corporately owned real estate, this showed that all the land in the United States had a NEGATIVE value of $4bn in 1994. In fact, the land statistics were so embarrassing to the Fed under Mr Greenspan’s tenure there that they stopped breaking them out separately. (One could calculate them by subtracting the building statistics from the total real estate.)
Six months ago the Fed avoided this embarrassment by incorporating corporate farms and finance into the “corporate” sector, so that the balance is now positive. The statistics show that corporate-held land is about 60 per cent of overall property value. But residential land is only 30 per cent - about $7 trillion instead of $14 trillion.
Bankers and economists take the Fed’s data and adjust it for more realistic views. But Mr. Greenspan used this data to encourage homeowners to borrow against their homes to finance their consumption. He called this “equity withdrawal” and even “wealth extraction.” But it wasn’t the kind of wealth that Adam Smith wrote about in The Wealth of Nations. It was simply asset-price inflation. Everyone knew there was a bubble except, it seems, the maestro. He kept saying the economy was getting richer.
Until his last few speeches at the Fed, that is. The last few sounded pessimistic for the first time, with a flavor of “after me, the deluge.”
What makes this discussion so important is that the financial sector paid a reported $400m dollars in 2007-08 to shape Secretary Treasury Hank Paulson’s working group on (de)regulatory reform. The financial system is now at a turning point. Bankers have shown that they can’t regulate themselves when they’re making so much money by feeding the bubble.
Michael Hudson is distinguished professor of economics at University of Missouri (Kansas City),and chief economic adviser to Dennis Kucinich
Posted by: Michael Hudson | April 8th, 2008 at 2:14 pm | Report this commentDear Panel:
This telling comment by Mr Greenspan: “Much of the commentary critical of my FT article is directed less at its substance and more, as Wolf describes it, to the ideology I display. Ideology, which regrettably has become a pejorative term, defines that set of ideas that we each believe explains how the world works and therefore how we need to act to achieve our goals. Some of our views of causative forces are rational, some are otherwise. Much of what we confront in reality is uncertain, some of it frighteningly so. Yet people have no choice but to make judgments on the nature of the tenuous ties of causation or they are immobilized.”
leaves unanswered the question: Is there a region of regulation definable as “lax” which enables fraud and then accelerates fraud?
Even before the full display (if in fact that has occurred) of these “unwelcome market outcomes” I (and others) would answer, “yes”.
Bill Sutphin
Seymour Tn
I am employed as a network security officer for a bank. I graduated in 1976 from the University of Central FL (Orlando FL) with a BS in Computer Science. Perhaps the panel will explore my question.
Posted by: Bill Sutphin | April 8th, 2008 at 2:33 pm | Report this comment[…] Greenspan’s apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to […]
Posted by: FT.com | Willem Buiter’s Maverecon | The Greenspan Fed: a tragedy of errors | April 8th, 2008 at 3:08 pm | Report this commentI agree with the analysis of Mr W. Buiter.
Posted by: François Withofs | April 8th, 2008 at 3:10 pm | Report this commentFor a European it is very strange when it comes to regulation in the financial services industry Mr Greenspan and his supporters always immediately refer to central planning-regime which in their opinion has proved not workable.
Competitive markets can well function on the basiis of common rules as it is applies in the EU.
To put it very simple, in order to control the traffic one needs some basic rules and a policeman
to enforce these rules.That does not mean that we are living in a totalitarian state.
Xi Fang (Guest contributor): The central questions in this discussion are: first, what should be the objective of financial regulators; and second, what should and could they do to get closer to their objective?
Few would seriously dispute the usefulness of financial innovations, ranging from limited liability corporations to asset backed securities. However, given the very nature of innovation (to borrow from Taleb and Rumsfield) – full of unknown unknowns – financial failures, and periodically crisis, are inevitable. It’s neither feasible nor desirable to prevent financial failures altogether. Ironically, the artificially low volatility enabled by regulators’ effort in preventing crisis would sow the seeds of more devastating ones, as the current one could attest.
Therefore the objective of financial regulators should be to strike a sensible (or reasonable, or appropriate, or whatever phrase accepting the role of unknown unknowns and limitations of human rationality) balance between encouraging innovation and maintaining stability. Sensible decisions beg for human judgement and should not be judged ex post based on realised outcome only. Moreover, a wide range of decisions could be regarded as “sensible” at the same time, especially when the uncertainties are huge.
Once we have accepted that preventing financial crisis altogether should not be the objective and that perfectly reasonable and knowledgeable persons could have significantly different views on the best course of actions when facing uncertainties, we could see why many current criticisms on the imprudence of the Fed and Greenspan are unreasonable.
However, that does not mean the Fed and Greenspan, and the current financial regulations at large, are flawless and blameless. Something essential is largely missing in the rationality-paradigm-dominated current financial regulations – the recognition of the role of psychology in the financial system.
Every crisis is different, but nearly every crisis is also the same – the greed drives prices of assets ranging from tulip and houses to financial securities to unreasonable and unsustainable levels, and the fear drives all to rush for the exit at the same time. Although there have been a large (and some, if not all, reasonable people would treat as large enough) body of evidence ranging from the history of financial crisis to behaviour finance suggesting that the market could be driven by emotions to extreme states for substantial periods and that micro-level deviations from rational economic behaviour could lead to macro-level emerging properties in the complex systems like the financial markets unexplainable by the rationality paradigm which treats irrational (or more accurately, real human) behaviours simply as random (and mostly normal-distributed) and harmless deviations. Although market “failures” like information asymmetry, moral hazard, adverse selection, externalities have been buzz words in the current financial regulations, rarely has any serious thought been given to what if real human beings cannot process the information in the way predicted by the model.
Findings from behaviour finance like the importance of default options have already been used to design better policies to address other economic and financial issues such as organ donation and pension contributions, and it surely could help design a better regulatory system for the financial markets. I appreciate this subject is far less mature than the well-established rationality paradigm, but it’s time for us to at least start experimenting. Every crisis brings new opportunities; let’s hope this one would be no different.
Xi Fang is a consultant at Europe Economics
Posted by: Xi Fang | April 8th, 2008 at 3:35 pm | Report this commentfrom Robert McDowell (banking risk economist)
Posted by: Robert McDowell, Edinburgh | April 8th, 2008 at 7:14 pm | Report this commentIf there had been no $1-2tn sub-prime mortgages sold and securitised, we would still have asset bubbles in property and other credit markets. We would still have a recession arriving. Central banks and regulators would have repeated their warnings and banks would be facing higher write-downs and falling equity values. The pain might have been spread over a few more quarters and be less of a systemic shock. But,the central banks and regulators would be less in the line of fire than G7 finance ministers (governments and economists) for not acting sooner to tackle the glaring bubble of the world’s trade and payments imbalances, especially that of the US (and a dozen other high deficit economies travelling steerage in the same boat). The US created a credit-led boom that generated export-led growth for China, Japan, India and much of the rest of the world. To pay for this generosity required generating and packaging massive amounts of financial assets for sale to trade surplus countries. Sub-prime paper was underwritten and highly rated. The market collapse of this asset class and the wholesale banking liquidity crisis were not readily or precisely foreseeable, but the crisis of economic circumstances that caused these were most definitely and eminently foreseeable, by economists e.g. at the Levy Economics Institute, New York, and at CERF at The Judge Institute, Cambridge, to name but two. Politicians are not financial whizzkids or economics greybeards, but they did knowingly take high risks with credit boom growth and by running persistently high trade deficits. All knew that this was not sustainable long term, but then what is? If we can crawl out of the present hole in less than 5 years, maybe most of us will be able to laugh and feel charitable, seeing the bright side of debt economics?
Greenspan states that “The core of the subprime problem lies with the misjudgments of the investment community.” There was no misjudgement. The investment community knew they could gear their portfolios to unacceptable levels, and with a Greenspan Put in hand, they did just that. However, the true guilty party in this whole debacle is the American public, for giving the Fed a dual mandate on growth and inflation.
Posted by: Mark Williamson | April 8th, 2008 at 9:02 pm | Report this comment“The dramatic fall in real long term interest rates statistically explains, and is the most likely major cause of, real estate capitalization rates that declined and converged across the globe.”
Posted by: PRalli | April 8th, 2008 at 10:29 pm | Report this commentBut we can ask whether it made sense for the Federal Reserve so to raise short term rates that the yield curve first flattened then inverted. An inverted yield curve traditionally makes life hard for mortgage banks… but securitization allows them to duck out of this problem and earn fees instead. This in turn, according to theory, makes the Central Bank less able to fine tune the economy, because credit is rationed by the ability to securitize (which seems to be a binary off or on) rather than the slope of the curve (which is more continuously variable). I can’t help feeling that there was a certain wisdom in the Glass-Steagall idea that banks should ‘pay’ for their implied safety net by agreeing to stay out of the securities business. Maybe that also means that banking companies should also not be allowed to globalize!
The Federal Reserve can hardly be blamed for the vertical and horizontal integration of the finance industry, but maybe it should have realised that its own levers of control were becoming discontinuous instead of gradual and fine tuneable. A sign of this discontinuity is the scary volatility of the Dollar/Euro exchange rate which sits uncomfortably with the apparent convergence of interest rates.
Lakshman Achuthan and Anirvan Banerji: A spirited debate is under way about how the US economy got into its current state, marked by a housing downturn, credit crisis and recessionary job losses. Searching for its antecedents, observers have concluded that the housing and credit bubbles guaranteed recession. But because this debate will influence policy for the next economic cycle, the right lessons must be learned from this series of unfortunate events. The debate so far has overlooked an essential point – that this recession was actually avoidable as recently as several weeks ago. How could that be?
The Fed has rightly been lauded for its actions this year, but its initial delay is widely downplayed. Yet, because of well-known lags with which monetary policy affects the economy, they needed to be especially quick to act in the face of recession. Instead, as in the lead-up to the 2001 recession, inflation concerns based on backward-looking indicators needlessly inhibited its actions for far too long. This implies a fundamentally flawed approach because on average, inflation has peaked four months after the start of postwar recessions.
Yet, ECRI’s forward-looking Future Inflation Gauge, a measure of underlying inflation pressures whose track record has been highlighted by independent analysts , was already in a cyclical downswing last summer. The Fed had a green light to slash rates that it failed to heed.
As the New Year began, The Economist noted, “One of the most reliable gauges is (ECRI’s) weekly leading index… This index correctly forecast the past two recessions and is now showing its weakest performance since the 2001 recession.” But it also cited our view that “prompt policy stimulus could still avert a formal downturn.”
Shortly thereafter, Fed chairman Ben Bernanke not only began aggressive monetary stimulus, but also endorsed quick fiscal stimulus, emphasizing that “it would not be window dressing.” Apparently realizing that the economy was on the cusp of recession, he may have understood that only timely fiscal stimulus could save the day. Given the history of fiscal stimulus arriving too late to head off recession, how was that even possible? Because, for the first time, premature pessimism had created a unique opportunity for a self-correcting recession prophecy.
Prominent pundits have been predicting a US recession since 2005, when Hurricane Katrina hit an economy under assault from Fed rate hikes and oil price spikes, a combination that had triggered many a past recession. With the advent of the home price downturn, the gloomy chorus grew.
By early 2007, respected Wall Street analysts were predicting up to 100 basis points of rate cuts by year-end. By early June, faced with accelerating economic growth, they abruptly switched their call to zero rate cuts. The economy’s unexpected resilience actually triggered the credit crisis by invalidating expectations of modest resets to subprime adjustable rate mortgages.
US growth plunged following the credit crisis, but the economy grew stubbornly through year-end. In fact, in 2007 US real GDP rose by 2.5 per cent, compared with 2.3 per cent in the eurozone. Still, persistent pessimism made the dollar swoon further, cementing an export-driven boost to manufacturing.
The drumbeat of downbeat commentary induced business managers to aggressively reduce inventories, cutting the inventory/sales ratio to a record low. This created a unique opportunity for policy stimulus to avert recession.
Typically, business managers, surprised by recession, face a Wile E. Coyote moment when the floor falls away and demand plummets. Stuck with soaring inventories, they slash production and jobs, thereby reducing income and spending, which in turn feeds back into lower sales, triggering further production cutbacks, perpetuating the vicious cycle that is the hallmark of recession.
In every recession, the manufacturing sector accounts for the majority of job losses, largely due to such inventory cycle dynamics. But this time, with inventories cut to the bone, this key recession driver was absent. In fact, a sudden step-up in demand would have set manufacturers scrambling to ramp up production and hiring. A quick burst of stimulus would have been unusually potent – even if only a fraction had been spent – and quickly reversed the recessionary vicious cycle.
Policymakers seemed to get the urgency. In January, Treasury secretary Hank Paulson declared that “time is of the essence”, House Speaker Nancy Pelosi spoke of “timely, targeted and temporary” stimulus, and the Administration and Congress enacted a tax rebate package with exemplary speed – but designed it to reach consumers several months later! It was as if the medics had arrived and taken a quick decision to administer CPR – in a few months.
It was certainly possible to devise innovative ways to get money to consumers in short order. Perhaps what doomed the effort is the received wisdom that fiscal policy is never timely.
A recession means many months of job losses that boost foreclosures, worsening the credit crisis. But if stimulus had reached consumers in weeks instead of months, it would have forestalled a recession, helping to stabilize the housing market. Such a soft landing would have bought some breathing room in which to resolve the credit crisis until the lagged effect of monetary policy kicked in.
Given the magnitude of the housing and credit bubbles, there was no way to avoid paying the piper once they had popped. But in this instance, resolving those excesses did not require a recession.
Arguably, in a market economy, recessions are cathartic. But this recession is causing unnecessary collateral damage to millions of innocent bystanders while making it politically expedient to throw far more money at the problem than was needed to avert recession in the first place. Therefore, this is a needlessly expensive recession of choice.
Alan Greenspan recently emphasized the non-linear shifts that occur at business cycle turning points, noting that “you don’t gradually fall into recession, you jump”. That is precisely why the timing of policy is so critical in the vicinity of turning points, and why state-of-the-art leading indicator systems, not standard econometric models, are needed to signal the approach of such tipping points.
In February, ECRI’s leading index for the nonfinancial services sector, which accounts for five out of eight U.S. jobs, locked onto a recessionary trajectory. In effect, the 3am call on the economy had gone unanswered.
Lakshman Achuthan and Anirvan Banerji are the co-founders of the Economic Cycle Research Institute in New York, and the co-authors of Beating the Business Cycle: How to Predict and Profit from Turning Points in the Economy, published by Currency Doubleday
Posted by: Lakshman Achuthan and Anirvan Banerji | April 10th, 2008 at 2:06 pm | Report this commentFrom my point of you- US Federal Reserve have limited monetary policy leverage tool’s.. Chairman coud rise or drop interest rate. Also can give advise to goverment about possible fiscal measure.. Noutoriosly well known US goverment current account deficit and budget defficit, who sooner or later can rise some trouble in internal and external market..Current subprime market turmoil is quite logical.. So called real estate bubble burth, when mortage lending sector reach some saturation level, according to market capacity and real purchase power.. In this case- customer’s who have poor income or bad credit history..
Posted by: Andis | April 10th, 2008 at 2:41 pm | Report this commentThe long term decline in interest rates only explains the rise in demand for home ownership. It does not explain why there is a sudden critical level of inability to make repayments. The reason is that the mortgage market (and credit market generally) is excessively based on sales by staff who are paid largely on commission and inadequately supervised, and are therefore prepared to give credit to borrowers who are insufficiently ’solid’ i.e the sub-prime sector, in order to make a quick buck.
Posted by: Michael Turner | April 10th, 2008 at 3:10 pm | Report this commentAnother of the possible causes of the current problems is the influence of economic modelling by computer. There seems to be the view that such models form a legitimate and effective means of checking assumptions and predicting outcomes in the economy.
There are several flaws in this, the most obvious being that the model is the result of assumptions by its creators and is therefore not independant from the assumptions it is used for checking.
Another flaw is more serious still. This is the impossibility of creating an accurate economic model in the first place that can be used for control purposes. Even if a suitably complex and well-adjusted model could be devised (and the many problems of data collection solved), for confidence its results would need to be checked against reality for some suitably long period (presumably several economic cycles . . .) over which time the object being modelled would change and the model would have to change too.
Posted by: Anthony New | April 10th, 2008 at 3:26 pm | Report this commentEven if these problems could be overcome, and an ‘accurate’, believable, and reliable model somehow produced, as soon as an economic model is used for control purposes it becomes a new part of the economy which will have its own impact. No such model can be both complete and accurate unless it includes its own existance and the beliefs (or otherwise) displayed by economically active people and organisations in its own predictions.
Inductive reasoning by experts in the field (=guesswork) provides a workable alternative, but as we have seen the experts also fail to predict
outcomes, especially when those experts (whether bankers or regulators) have strong reasons to prefer some kinds of outcome to other kinds.
In terms of engineering modelling (where complex oscillatory systems are well understood) the problem of economic stability can be re-stated as the search for ‘velocity feedback’ that damps the excessive perturbations that would otherwise take place.
There are several aspects to this:-
Firstly, using regulatory means to stifle the positive-feedback mechanisms that allow the growth of bubbles such as the recent asset-price bubble. Examples are assymetric remuneration packages, risk decoupling due to off-balance sheet securitisiation. This needs strong intervention to be effective
Secondly, the reduction of delay in the negative feedback mechanisms that already exist. As is well known in engineering, sufficient delay turns a putative negative feedback mechanism into an osscillation-provoking positive one. This again would require a quick regulatory response if not necessarily a heavy-handed one.
Thirdly, The creation of new negative-feedback machanisms, or the promotion and securing of existing ones. Again, attention to remuneration packages and risk management are needed. But I would suggest also some appropriate closed forum be created similar to the ones that exist in the aerospace world, where problems can be discussed openly and without blame or atribution. But this would again need to concentrate on looking ahead and would need an operating link to the economic levers. Arranging this and managing the conflicting interests of the governments, academics, bankers, and industrial spokesmen needed would be a challenge.
Looking at these from a system viewpoint, it is clear that in order to change an unstable economic system into a stable one a strong hands-on approach is essential. To think anything else is purely wishful thinking.
Manish Patel: It’s astonishing that someone of Greenspan’s experience continues to focus on quasi theoretical issues and quasi market conditions.
Three factors have led to the current situation: a) Securitisations (ABCPs) were supported by financial institutions (liquidity facilties), at extremely low risk charges. This enabled leverage which would not ordinarily have been available through regular lending on the banking book; b) subsequently, the appetite to lend grew; c) monetary expansion - I’ve included this to ensure that the economists don’t miss out.
The consequent liquidity crisis, interbank or otherwise is simply a function of inadequate short term funding for numerous vehicles that have long-term liabilities.
The credit crunch therefore, is inevitable, the collapse even more accute. Price inflation and deflation can be created through such structuring, by mixing great practices with bad ones - that is, we mark to market/model exposures, revalue our collateral and keep on leveraging based upon incorrect risk factors (/pricing). Someone woke up, pulled the pin out of the sytem, the banks looked at the real risk (of the liquidity facilities), and guess what, they didn’t like what they saw.
Manish Patel is managing director of MPCapital, a quantitative hedge fund, based in Mayfair, London
Posted by: Manish Patel - MPCapital | April 10th, 2008 at 5:54 pm | Report this commentThe quality of the debate is certainly improving - let me lower the standard. The abandonment of the unfashionable criteria that shaped my previous existence is partly the cause of the crisis. I feel, however, we must look to the Basle rules on the allocation of bank capital, particularly against real estate lending, and the definition of capital. Lending in the real estate field exploded worldwide and provided commercial banks among others with the opportunity for aggressive lending particularly in the area of domestic real estate. The surge in property values over 25 years has created social problems and now, per evolution, the current crisis. Let’s get back to basics. The BIS needs to rethink its control measures. The banks will squeal but we shall all sleep easier despite the arguments which will be proferred in support of free markets blah, blah, blah!! Bankruptcy and poverty are not the hallmarks of freedom.
Posted by: John Davidson - retired banker | April 10th, 2008 at 6:27 pm | Report this commentI am always amazed at how many use hindsight for a I-told-you-so analysis. Could Greenspan have anticipated how housing bubble might end? Let’s take a look at the factors. We have cheap money and borrowers with weak credit. Not necessarily low income but weak credit, which implies that their loan repayment history is not perfect. Now, you take cheap money and give these people a huge loan in anticipation they will make payments on time. Given their credit history with smaller loans and payments, likelihood of “making good” on a huge loan is about zero. Since banks award the loans and trade CDOs, they are directly responsible for the bubble. Greenspan is responsible for monitoring health of the banks and he did a poor job with that since he did not see that banks are loading up on all-risk loans with little chance of repayment. This is where he personally should have blown the whistle and required from banks to either change the lending policies OR increase interest rates to discourage from such reckless lending. Tricking borrowers into predatory loan terms is an entirely different matter which also contributed to this mess.
Instead of regulation, banks must learn to manage risk. People who cannot pay their smaller bills on time are not customers for making big payments on time. That is such a no-brainer that it escapes me how Greenspan and all the geniuses on Wall Street missed it.
For disclosure, I will say that I did make a few dollars on credit bubble collapse, as I should because I recognized the conditions on time and traded accordingly.
Posted by: Sam | April 10th, 2008 at 8:54 pm | Report this commentYou have to admire Dr. Greenspan for coming out swinging to defend the decisions he made and those he didn’t. Nonetheless, a case can be made that someone in his position and world-status did indeed fuel all-out gambling by those searching for enhanced performance. Because he frequently applauded the concept of risk diversification through derivatives, provided almost free money for an extended period and described a strategy for cleaning up bubbles after they break, he created an endorphin-charged atmosphere, at least, in the minds of many. Unlike his individual defense, others defending their overseer roles when beset by participants in major sporting events who are using steroids for enhanced performance, an analogous example, have relied more on studies, commissions and laboratory testing to cover their tracks. Dr. Greenspan’s spirited personal defense is invigorating in its contrast. Logic, plausibility and coherence certainly are on ample display in his comments. Yet, in the final analysis; like astrologers, we pick the stars that fit the patterns we want. Dr. Greenspan is no exception.
Posted by: Arnold Holtzman | April 10th, 2008 at 9:27 pm | Report this commentAs a long time real estate investor, Mr. Greenspan’s writings make me wonder on which planet he now resides.
Historically low interest rates, coupled with reckless, baseless and at times fraudulent lending practices, are the main reason why the United States has the real estate train wreck we are now enduring. The unintended consequence of the Fed’s lowering of interest to soften the effects of the dot com implosion eventually was a huge factor responsible for creating havoc in the real estate market.
I do not care about monetary policy, long term liquidity or the number of Kugerrands a Wall Street mogul can stuff in the pockets of his $5,000 silk suit.
Here in the real world the only figures that are of any meaning to the average home buyer are how much down and how much per month. The former being determined by the “lending money to anyone who can fog a mirror” mentality and the latter being related to the interest rates.
With the lax attitude in the lending market, if you can buy 1 house and make 100K, buy three and make 300K. After all, real estate always goes up. Don’t worry, you’ll get the best rate. Just lie about all three houses being your prime residence. Who’s going to know?
The historically low and in my view irresponsible interest rates, coupled with the stated subprime income ARM’s which magically morphed into “securities” and were traded like baseball cards whipped up the whole process into a feeding frenzy.
In my view there are a series of culprits, starting with the 1% prime rate. Whose big idea was that? That would be Mr. G. By the way, Big Al also made the statement that ARM’s were a good thing. They are, under certain circumstances, but they obviously aren’t under most.
It plain that the real estate run up would not have been possible without low interest. Of course it was exacerbated by the greed that gripped the financial world along with the denial of reality concerning the actual value of the mortgages that are now defaulting.
Sorry Mr. Greenspan. I personally at one time revered you and took a measure of comfort that you were at the financial helm. Sadly, you will become the most reviled person of the beginning of the 21st century, as this mess will have your face on it. It all started with you and while a lot of us saw the bubble developing, we had and still have trouble believing that you couldn’t see it.
Mr. Greenspan you had to have seen it coming, but you did nothing to stop it.
Posted by: Michael H. Mosieur | April 10th, 2008 at 9:34 pm | Report this commentMr. Greenspan is correct in stating that the role of regulators primarily involves “shutting the barn door after the horse has bolted”. Almost certainly any regulator who correctly anticipated a bubble (or other issue) and successfully took corrective measures to deflate it, would be criticised for unnecessarily interfering with the free market, as there would be no tangible evidence of there have having been a problem in the first place.
There are appear to be at least four defining lessons from the current financial crisis, only one of which indirectly implicates Mr. Greenspan as bearing partial responsibility:
First, that diversification only works if one is truly diversified, i.e. a portfolio of AAA subprime CDOs provides a diversification score of 1.0, as all of the subprime CDOs are exposed to the same systemic risk, namely, price declines in the U.S. housing market;
Second, that the Tier 1 capital (or functional equivalent) held by certain investment banks and other financial institutions (e.g. Bear Stearns and Carlyle Capital Corp.) has proven to be inadequate to provide liquidity during periods of extreme market volatility AND that the types of securities held as Tier 1 capital has been defined too broadly (e.g. bonds issued by Fannie Mae and Freddie Mac that do not have an explicit U.S. Government guarantee.);
Third, that most financial institutions, including investment banks, SIVs and hedge funds have relied too heavily on short-term debt to finance long-term assets, to take advantage of the arbitrage on the yield curve (while it existed) and on short-term vs. long-term credit spreads, thereby further compounding their financial risk;
Fourth, that the rating agency default models will only provide accurate ratings if the model assumptions are consistent with the characteristics of the underlying securities, i.e. the underwriting standards for sub-prime mortgages were much lower than for conforming mortgages and therefore the default assumptions for sub-prime mortgages should have been significantly higher.
I believe that Mr. Greenspan is fundamentally correct that monetary policy (i.e. the level of the Federal Funds Rate) had a relatively limited impact in creating the sub-prime bubble, although it is undeniable that it had some accelerating effect, as Mr. Greenspan himself accepts. The larger issue, and this is where Mr. Greenspan indirectly bears partial responsibility for the current situation, is that largely unregulated financial institutions have taken critical roles in the working of the financial economy of the United States. The proliferation of securitization vehicles whose fundamental economic and financial assumptions went untested by regulators and who had no formal equity capitalization requirements, is analogous to that of a power grid supplied by nuclear power stations - when they run smoothly, one barely notices their presence, except to enjoy the cheap power, however, when they melt down, everyone within range is showered with highly toxic radioactive waste. As I understand the argument put forward by Mr. Greenspan against regulating such entities, because they exclusively sell their packaged securities to sophisticated market participants, caveat emptor should prevail, as the market has a superior ability to assess risk and price risk than a regulator. From my perspective, there are two flaws in this argument, first, the lack of transparency inherent in an unregulated private securitization vehicle actively disadvantages investors in enabling an accurate assessment of the risks, as has clearly happened in the current situation, and second, those sophisticated market participants are themselves critical components of the U.S. financial economy and therefore their insolvency or failure comes at a cost to the economy and/or the taxpayer at large.
This is perhaps best illustrated by comparison with another sector of the energy industry, namely utility and non-utility power generators. Although non-utility power generators are not regulated by state electric regulators, ALL power generators within a state are subject to the same federal and state environmental regulations. It is inconceivable that a non-utility generator should be exempt from air emissions regulations, even if it only sells power to sophisticated market participants. Why? Due to the significant societal impacts of allowing a power plant to emit any amount of SOx, NOx, Mercury, Arsenic, etc. The issue of whether a power plant is owned by a regulated utility or an unregulated non-utility generator is irrelevant for environmental regulation, as they both perform the same task and produce similar pollutants. In my opinion, this applies equally to the situation with Fannie Mae and Freddie Mac versus mortgage securitization vehicles. One group is regulated, the other is not, but they both perform the same task and produce similar securities.
If applied correctly, regulation can enhance the transparency and efficiency of markets. It can also act as a buffer, to prevent the worst excesses of markets from damaging the economy at large. Mr. Greenspan’s words as Chairman of the Federal Reserve carried a significant weight against regulation of the hedge fund and securitization universe and I believe that this is the area where we need to examine his legacy, not his monetary policy decisions, which I suspect no mere mortal could have done better.
Posted by: Mark Miles, New York | April 10th, 2008 at 11:36 pm | Report this commentGreenspan is correct. The Fed is not to blame (entirely) for the current US economic situation. Exact economics on a broad scale can never be achieved. But with the assistance of Greenspan’s key players–bank and government regulators, counterparties, investors (I add history)–backed by responsible actions by the investment community there can be progress. Capitalism, as described by the economist, Joseph Schumpeter, is a continuous evolutionary process without an end-point. Sadly, we are witnessing in the current evolutionary stage a betrayal of capitalism. An attempt by the Fed to “lean against the wind” is an exercise in futility because by its very intrinsic nature betrayal prohibits recognition a priori and thus likewise cannot be prevented through the vehicle of government regulation.
I am not saying vigilance and timely action by government regulators are not necessary. They, in fact, are eternally necessary. However, whatever actions the Greenspans of the world may take when confronted with practices that embody the negation of the system free-market economies support they will always to some extent take shape in the form of maintenance rather than prevention. A man must learn from his mistakes from making them, not from being saved from them, as Shelby Foote once said. This is the Fed’s mandate.
This is actually a good thing. It is not the Fed’s responsibility to stifle innovation, which in the form of creative destruction is the driving force not only of capitalism but of material progress in general. It is our responsibility to make sure as we pursue a better material existence within our current free market economy to maintain our organic social system within a “common good” capitalist system. Otherwise, as Schumpeter once said (and I’m sure Greenspan would agree), we will certainly achieve material gains but we will also become free to make a mess of our lives with sufficient rope to hang ourselves.
Posted by: Luke Eckblad | April 11th, 2008 at 12:27 am | Report this commentGreenspan is correct. The Fed is not to blame (entirely) for the current US economic situation. Exact economics on a broad scale can never be achieved. But with the assistance of Greenspan’s key players–bank and government regulators, counterparties, investors (I add history)–backed by responsible actions by the investment community there can be progress. Capitalism, as described by the economist, Joseph Schumpeter, is a continuous evolutionary process without an end-point. Sadly, we are witnessing in the current evolutionary stage a betrayal of capitalism. An attempt by the Fed to “lean against the wind” is an exercise in futility because by its very intrinsic nature betrayal prohibits recognition a priori and thus likewise cannot be prevented through the vehicle of government regulation.
I am not saying vigilance and timely action by government regulators are not necessary. They, in fact, are eternally necessary. However, whatever actions the Greenspans of the world may take when confronted with practices that embody the negation of the system free-market economies support they will always to some extent take shape in the form of maintenance rather than prevention. A man must learn from his mistakes from making them, not from being saved from them, as Shelby Foote once said. This is the Fed’s mandate.
This is actually a good thing. It is not the Fed’s responsibility to stifle innovation, which in the form of creative destruction is the driving force not only of capitalism but of material progress in general. It is our responsibility to make sure as we pursue a better material existence within our current free market economy to maintain our organic social system within a “common good” capitalist system. Otherwise, as Schumpeter once said (and I’m sure Greenspan would agree), we will certainly achieve material gains but we will also become free to make a mess of our lives with sufficient rope to hang ourselves.
Luke A. Eckblad is a Principal with Nova Capital Partners, an emerging markets investment bank headquartered in New York.
Posted by: Luke A. Eckblad | April 11th, 2008 at 12:47 am | Report this commentI have never liked Alan Greenspan; his fear of inflation was part of the reason the markets tanked in 2000 and subsequently led to a meltdown of the tech overweighted NASDAQ. I also believe that Mr. Greenspan would never have had the foresight to do what Ben Bernanke did and cut interest rates ahead of an FOMC meeting in a rapid and decisive response to market volatility. It was under Mr. Greenspan’s watch that the trend in subprime lending took hold and it was because of his policies that we have the market volatility we have today. Mr. Greenspan should be man enough to own up to his failings and accept his responsibility in the current state of the economy.
Posted by: Dan Dobrjanskyj | April 11th, 2008 at 1:38 am | Report this commentRichard Werner: Alan Greenspan argues that “the evidence that monetary policy added to the [US] bubble is statistically very fragile”. To the extent that he refers to evidence provided by counter-factual simulation models, I would agree. But the evidence of factual work is clear: Regulatory and monetary policy are practically the only two factors responsible for the creation as well as the nature of the aftermath of financial bubbles, and among these two, monetary policy is the more important.
Yet Dr Greenspan rightly criticizes counter-factual analysis. Indeed, too much of economics is based on counter-factual assumptions that bear no relationship to the realities of this world. Such as the assumptions of perfect information, instantly adjustable prices, no transaction costs, complete markets and so on. That is why it is necessary to build models and theories on firm empirical and factual foundations. But if we leave the economists’ neverland of perfect information and step into the real world, we find that markets do not clear. This is worse than the widely acknowledged existence of ‘market failures’ – it means that markets in reality operate by quantity rationing, whereby the short side dictates the quantity transacted. In the case of money – due to its usefulness – there is always excess demand for it so that the suppliers control its allocation. Money is supplied by commercial banks through the process of credit creation. They effectively make allocation decisions akin to Soviet central planners – with the difference that they are not concerned with the overall benefit to the country or national policy, but only their narrow short-term self-interest. Recent banking problems remind us of the reality that banks’ un-coordinated, short-sighted and self-interested credit allocation plans do not deliver the most beneficial possible outcome to society.
Dr Greenspan further maintains that regulators cannot feasibly act preemptively to prevent bubbles and that no such attempt has ever been successful. This is also not true. For instance, there has never been a housing bubble and bust or systemic banking crisis in Germany under the Bundesbank’s watch. There are examples from other countries of decades of prudent and preemptive regulatory and monetary policy. Such policy includes restricting loan-valuation ratios and monitoring bank lending for non-GDP transactions, especially in the real estate market, and giving banks incentives to limit or reduce such lending when it threatens to rise disproportionately.
This is neither difficult to grasp nor to implement. So isn’t the truth of the matter that Dr Greenspan – like the central bankers in the UK and many other countries – purposely chose not to take such prudent policies, because he was happy with the asset bubbles and their consequences, which seemed to suit his particular priorities? The conclusion, then, is that we need to make sure that central bankers are kept on a tighter leash and given the right goals and incentive structures – such as in the case of the Bundesbank – to look after the interests of the majority, not just a minority of bankers and speculators.
Professor Richard A. Werner is Director of the Centre for Banking, Finance and Sustainable Development and Chair in International Banking at the School of Management, University of Southampton
Posted by: Dr. Richard Werner | April 14th, 2008 at 9:57 pm | Report this comment