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.
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By Lawrence Summers

Neither US financial institutions nor the economy are likely to suffer from a lack of central bank liquidity provision. New lending facilities are coming along almost weekly, the safety net has been expanded to include non-bank primary dealers, the Fed has demonstrated a willingness to take on directly the most problematic parts of Bear Stearns’ balance sheet, and the Fed funds rate has been reduced by 200 basis points within 7 weeks.

At the same time, processes are in motion that may lead to new demands for more than $1,000bn in mortgages, directly or indirectly. Recent regulatory actions will enable Federal Home Loan Banks along with Fannie Mae and Freddie Mac (the government-sponsored enterprises) to purchase more than an additional $300bn in mortgage-backed securities.

There is substantial scope for further regulatory action as only a third of the punitive capital charge placed on Fannie and Freddie years ago has been lifted. Moreover, legislation to reduce foreclosures being pushed by Senator Christopher Dodd and Representative Barney Frank could result in the federal government purchasing or providing guarantees that enable the purchase of several hundred billion dollars worth of mortgages.

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By Charles Wyplosz

In 1971, with the greenback weak and falling, US Treasury secretary John Connally famously told the rest of the world that the US dollar was “our currency and your problem”. Thirty years later, with the dollar strong and still rising, Robert Rubin, his successor, no less famously stated that “a strong dollar is in the interest of the United States”.

These days, because the dollar is weak and falling, we would have expected US officials to return to Connally’s mantra but they unexpectedly chose Rubin’s. On reflection, glorifying a strong dollar when it is so weak means they do not care. Connally without compassion, if you prefer.

Jean-Claude Trichet, president of the European Central Bank, is thereby left bemoaning “excessive exchange rate moves”. This, too, is an extraordinary statement. In the past week the dollar has barely lost 1 per cent vis a vis the euro. That is significant, but “excessive”? Yes, he may be reacting to the 6 per cent dollar depreciation in the past month. Or to the 17 per cent change over the past 12 months. Or perhaps the 31 per cent depreciation since the dollar was last strongish in late November 2005.

Well, currencies float. They are bound to be sometimes overvalued and sometimes undervalued. This is what they do and these numbers are not especially large by historical standards. Margaret Thatcher, former UK prime minister, was right when she said that exchange rates were a matter for markets to decide.

Of course, markets react to monetary policies. As the US economy faces a recession, a weak dollar is in the country’s interests. As inflation exceeds its own definition of price stability, a strong euro is in the interests of the eurozone. End of story? Not quite. (Continued)

Charles Wyplosz is professor of economics at the Graduate Institute of Geneva. The remainder of his column can be read here. Comment from our expert panel and guest members can be read below.

By Lawrence Summers

Over the past 20 years major financial disruptions have taken place roughly every three years, starting with the 1987 stock market crash; the Savings & Loans collapse and credit crunch of the early 1990s; the 1994 Mexican crisis; the Asian financial crises of 1997 with the Russian and Long-Term Capital Management events of 1998; the bursting of the technology bubble in 2000; the potential disruptions of the payments system after the events of September 11 2001 and the deflationary scare in the credit markets in 2002 after the collapse of Enron.

This record suggests that by 2007 the world had been overdue a major disruption. Sure enough the problems of subprime mortgages – initially seen as a confined issue – went systemic as the market began to doubt the creditworthiness of even the strongest institutions and rushed to buy US Treasury debt. Financial crises differ in detail but, just as there are plot cycles common to literary tragedies, they follow a common arc.

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“Over the past decade a combination of diverse forces has created a significant increase in the global supply of saving – a global saving glut – which helps to explain both the increase in the US current account deficit and the relatively low level of long-term real interest rates in the world today.” Ben Bernanke, chairman of the Federal Reserve.*

Has the Federal Reserve been a serial bubble-blower? Or has it been responding to exceptional macroeconomic conditions? Not surprisingly, the implication of Ben Bernanke’s celebrated speech on the global “savings glut” implies the second view. Yet his self-exculpatory perspective is far from universally shared. So who is right? My answer is both. The Fed can indeed be accused of being a serial bubble-blower. But this is not because it has been managed by incompetents. It is because it has been managed by competent people responding to exceptional circumstances.

The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.

By Kenneth Rogoff

The Bush administration was beside itself with glee earlier this month when it announced that the fiscal year 2007 federal deficit was set to fall to just over $200bn, or 1.5 per cent of US gross domestic product. Although the continuing deficit hardly makes the US a picture of fiscal prudence, the dollar amount is less than half what it was in 2004.

Publicly, some Democrats are still condemning Bush II profligacy and preaching a return to Clinton I fiscal conservatism. Privately, though, many are starting to question why a 2008 Democratic president should bother improving the government’s balance sheet if the end result is just a bigger pot for a future Republican president to lavish on his or her friends. Certainly the 2000s, even as long-term interest rates normalise, seem to have thrown cold water on the notion that sustained US budget deficits will automatically lead to high interest rates and low growth. Or have they?

First, the good news. Explosive financial globalisation has made US federal budget policy far less important as a determinant of global real interest rates. Instead of interest rates going up sharply, low levels of public and private saving in the US have helped sustain a massive current account deficit. Continuing foreign inflows are probably holding down US real interest rates by at least 1.5 per cent and possibly more.

And let us give credit where credit is due. The Bush administration’s decision to borrow massively, over a period where global long-term interest rates fell massively, was not a bad market call.

The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.

Is globalisation a leading cause of rising inequality in high-income countries? The outcome of the debate on this question may determine whether the US will remain open to trade. If policymakers do not craft an imaginative response, protection against imports may be the outcome, regardless of its (non-existent) merits. Ben Bernanke, chairman of the US Federal Reserve, laid out the issues in a thought-provoking speech last week.* He embedded his analysis in three principles: “That economic opportunity should be as widely distributed and as equal as possible; that economic outcomes need not be equal but should be linked to the contributions each person makes to the economy; and that people should receive some insurance against the most adverse economic outcomes, especially those arising from events largely outside the person’s control.” The question is how these principles apply today. It has become more compelling as inequality has risen. The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free.

By Lawrence Summers The 20th century was shaped by developments in the physical sciences. Issues of national and international security were transformed by the revolution in solid state physics that allowed mankind to take flight and split the atom. Advances in our understanding of physics also led to the development of the transistor, the semiconductor and ultimately to the information technology explosion that transformed economic life. The 20th century was an American century in no small part because of American leadership in the application of the physical sciences. While the foundational ideas of relativity and quantum mechanics were developed in Europe, the practical application of these ideas occurred in the US. If the 20th century was defined by developments in the physical sciences, the 21st century will be defined by developments in the life sciences. Lifespans will rise sharply as cures are found for chronic diseases and healthcare will come to be a larger share of the economy than manufacturing. Life science approaches will lead to everything from further agricultural revolutions to profound changes in energy technology and the development of new materials. The “drugs that help you study” that are now pervasive on college campuses are just a precursor of developments that will make it possible to alter human capacities and human nature in profound ways. (more…)

By Lawrence Summers A recent meeting with the incoming freshmen of the 110th House of Representatives made clear to me some of the forces that will shape American economic policy in the next few years. Coming from very different parts of the country and very different political perspectives, the new members of Congress have in common that they have all heard from the anxious middle class. They feel under enormous pressure to respond not just to the economic insecurity that middle-class voters feel, but also to voters’ resentment at what they see as disproportionately prospering corporate elites. If the new Congress sees itself as having a mandate for anything in the economic area, it is for policies that “stand up” for ordinary Americans against the threat they perceive from corporate and moneyed interests. These populist impulses have roots much deeper than campaign rhetoric. In the past, real wages and corporate profitability have moved together – increasing during economic expansions and when the US became more competitive, declining in recessions and when it encountered significant competitive threats. The unique feature of the current expansion is the divergence between the fortunes of capital and the fortunes of labour. While workers normally receive about three-quarters of corporate income, with the remainder going to profits and interest, the Economic Policy Institute has calculated that, since 2001, labour has received only about one-quarter of the increase in corporate income, as real wages have failed to keep pace with productivity growth. Indeed, for most groups of workers, wages have not kept pace with inflation over the past several years. College graduates have been particularly hard hit, with their wages struggling to keep pace with inflation over the past five years. At the same time, profits per share for companies in the Standard & Poor’s 500 index have increased at an annual rate of more than 10 per cent, even after taking into account inflation over the past four years. (more…)

US voters have now repudiated those who sought to impose democracy by force abroad. In spite of the gerrymandering of districts, the advantages of incumbency and renewed recourse to the politics of fear, common sense prevailed. George W. Bush is still president. But he is damaged political goods. That is good, because change is desperately needed. The signal feature of this administration has not been merely its incompetence, but its rejection of the principles on which US foreign policy was built after the second world war. The administration’s strategy has been based, instead, upon four ideas: the primacy of force; the preservation of a unipolar order; the unbridled exercise of US power; and the right to initiate preventive war in the absence of immediate threats. The response to the terrorist outrage of September 11 2001 reinforced the hold of all these principles. The notion of an indefinite and unlimited “war on terror” became the fulcrum of US foreign policy. It led to the idea of an “axis of evil” connecting Saddam Hussein’s Iraq to theocratic Iran and Kim Jong-il’s North Korea. It brought about the justified invasion of Afghanistan, but also the diversion into Iraq. Not least, the idea of the war on terror led to the indefinite imprisonment of alleged enemy combatants without judicial oversight, toleration of torture, “extraordinary rendition” of suspects, the extra-territorial prison at Guantánamo Bay and, by indirect means, the abuses at Abu Ghraib. The remainder of Martin Wolf’s column can be read here (FT.com subscribers only). Discussion from our guest economists is free - click ‘Comments’ below.