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.