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2017-01-13 08:02:23
The Fed chairman's record is a case study in cognitive dissonance
MORE than ten years have elapsed since Alan Greenspan stepped down from the
Federal Reserve; a decade that has not been kind to his reputation. Having just
read Sebastian Mallaby's comprehensive biography*, "The Man Who Knew", it
struck me that his career was a classic example of cognitive dissonance.
The main post-crisis criticism of Mr Greenspan was that he was a naive believer
in market efficiency, failing to pop bubbles in the late 1990s or mid-2000s and
failing to regulate the financial sector properly. He was, for a while, a
disciple of the libertarian novelist, Ayn Rand. But Mr Mallaby shows that
things were rather more complex than that characterisation suggests.
In a paper written back in 1959, for example, Mr Greenspan clearly seemed to
understand the detrimental effect that bubbles could have. He wrote that
The higher the stock market gets at its peak and hence the greater decline
required to return to "normal", the deeper the decline in economic activity
In 2002, after the Enron scandal, Greenspan also spoke in favour of greater
regulation of corporate accounting standards. Smacking the table, he told a
meeting that
There is too much gaming of the system until it is broke. Capitalism is not
working.
It is pretty clear that Mr Greenspan's thinking evolved over the years; he
dropped, for example, his belief in the gold standard. In 1994, he seemed happy
to surprise the markets with rapid monetary tightening, as an antidote to
speculation; but by the mid-2000s he had become committed to a very
transparent, predictable policy.
Some of his earlier thinking remained, however; he tended to believe that
regulation had perverse consequences (for example, American interest rate caps
in the 1960s led to the establishment of the eurodollar market in London). In a
speech in October 1999, he said that
Heavier supervision and regulation designed to reduce systemic risk would
likely lead to the virtual abdication of risk evaluation by creditors. The
resultant reduction in market discipline would, in turn, increase the risks in
the banking system, quite the opposite of what is intended.
But by this stage, this was a very perverse argument for Mr Greenspan to make
since he had participated in several different rescue programmes from the Black
Monday exercise of 1987, through Mexico in 1994 and the Long-Term Capital
Management rescue of 1998. There was certainly an austere logic in arguing that
the private sector could enforce discipline on the finance sector through the
threat of default. But that threat was bogus because of the willingness of the
Fed to rescue the finance sector when it got into trouble. Given that backstop,
investors had little incentive to monitor bank creditworthiness that closely.
Indeed, the growing use of complex derivatives meant that even bank executives
did not understand how risky their own balance sheets were.
This attitude was combined with an approach to markets that has been described
as "asymmetric ignorance"; the Fed professed not to know when markets were too
high (and thus in bubble territory) but to be sure when the markets had fallen
too far and thus needed rescuing.
So the result was the worst of both worlds. As Mr Mallaby writes
Greenspan continued to favour the deregulation of finance: but it grew obvious
that government safety news were there to stay; financiers would not pay for
their errors. An affluent democracy was simply not willing to let its
financiers go bust. Yet Greenspan continued to support deregulation anyway.
The failure to recognise this contradiction led inexorably to the crisis. Debt
built up within the system. The more it grew, the greater the risks to the
economy from a crisis, and thus the more the central banks were tempted to
intervene. This is, of course, the problem of "moral hazard". But such hazards
tend to be ignored in a crisis. Tim Geithner, a NY Fed governor and Treasury
secretary, explained why in his book "Stress Test"
Trying to mete out punishment to perpetrators during a genuinely systemic
crisis by letting major forms fail or forcing senior creditors to accept
haircuts can pour gasoline on the fire. it can signal that more failures and
haircuts are coming, encouraging creditors to take their money and run.
Old Testament vengeance appeals to the populist fury of the moment, but the
truly moral thing to do during a raging financial inferno is to put it out.
In theory, regulators should step in to control the finance sector during the
good times. But they tend not to act because the system seems to be working
well at such times. And the sheer growth of finance means it is has incredible
lobbying power.
The ironies are huge. A man who once believed in the gold standard saw his
successor preside over a vastly-expanded Fed balance sheet and near-zero
interest rates; a man who believed in the free market saw a vast bailout of a
banking sector that depends on an implicit government subsidy (via deposit
insurance). Indeed this legacy of Mr Greenspan can be seen today, with the
Trump administration proposing to undo some of the post-crisis financial
reforms; that's why bank stocks have done so well since November 8. No one has
worked out how to shrink the banking sector without damaging the economy. Mr
Greenspan, for all his intellect, made the problem worse.