Greenspan v the Regulatory State

Alan Greenspan reflects on the recent financial crisis and has second thoughts on the ability of the private sector to regulate itself.

The End of an Era

Alan Greenspan rethinks regulation in testimony before Congress.

Alan Greenspan, the former Federal Reserve chairman, said Thursday that the current financial crisis had uncovered a flaw in how the free market system works that had shocked him.

Mr. Greenspan told the House Oversight Committee on Thursday that his belief that banks would be more prudent in their lending practices because of the need to protect their stockholders had proved to be wrong.

Mr. Greenspan said he had made a “mistake” in believing that banks operating in their self-interest would be enough to protect their shareholders and the equity in their institutions.

Mr. Greenspan said that he had found “a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”

Rethinking Greenspan

The NYT has a critical re-appraisal his career.

Explaining the Current Financial Crisis

Two stories in the current issues of Foreign Policy attempt to explain how the United State's current financial situation.

The first outlines the eights steps that got us to where we are today.

1. The Fed spikes the punch bowl. In the wake of the dot-com bust and 9/11, the Fed lowers interest rates to 1 percent, the lowest since 1958. For more than 2½ years, long after the economy has resumed growing, the Fed funds rate remains lower than the rate of inflation. For banks, in effect, money is free.

2. Leverage soars. Financial sector debt, household debt, and home prices all double. Big banks shift their business models away from executing transactions for customers to “principal trading”—or gambling from their own accounts with borrowed money. In 2007, the principal-trading accounts at Citigroup, JPMorgan Chase, Goldman Sachs, and Merrill Lynch balloon to $1.3 trillion.

3. Consumers throw a toga party. Soaring home prices convert houses into ATMs. In the 2000s, consumers extract more than $4 trillion from their homes in net free cash (excluding financing costs and housing investment). From 2004 through 2006, such extractions exceed 7 percent of disposable personal income. Personal consumption surges from its traditional 66 to 67 percent of GDP to 72 percent by 2007, the highest rate on record.

4. A dollar tsunami. The United States’ current-account deficits exceed $4.9 trillion from 2000 through 2007, almost all for oil or consumer goods. (The current account is the most complete measure of U.S. trade, as it encompasses goods, services, and capital and financial flows.) Economists, including one Ben S. Bernanke, argue that a “global savings glut” will force the world to absorb dollars for another 10 or 20 years. They’re wrong.

5. Yields plummet. The cash flood sweeps across all risky assets. With so many people taking advantage of cheap loans, the most risky mortgage-backed securities carry only slightly higher interest rates than ultra-safe government bonds. The leverage, or level of borrowing, on private-equity company buyout deals jumps by 50 percent. Takeover funds load even more debt onto their portfolio companies to finance big cash dividends for themselves.

6. Hedge funds peddle crystal meth. Aggressive investors pour money into hedge funds generating artificially high returns by betting with borrowed money. To maximize yields, hedge funds also gravitate to the riskiest mortgages, like subprime, and to the riskiest bonds, which absorb losses on complex pools of lower-quality mortgages known as collateralized debt obligations or CDOs. The profits from selling bonds based on very risky underlying securities override bankers’ traditional risk aversion. By 2006, high-risk lending becomes the norm in the home-mortgage industry.

7. A ratings antigravity machine. Pension funds cannot generally invest in very risky paper as a mainstream asset class. So, banks and investment banks, with the acquiescence of the ratings agencies, create “structured” bonds with an illusion of safety. Eighty million dollars of “senior” CDO bonds backed by a $100 million pool of subprime mortgages will not incur losses until the defaults in the pool exceed 20 percent. The ratings agencies confer triple-A ratings on such bonds; investors assume they are equivalent to default-proof U.S. Treasury bonds or blue-chip corporates. To their shock, investors around the world discover that as pool defaults start rising, their senior CDO bonds rapidly lose trading value long before they suffer actual defaults.

8. The Wile E. Coyote moment arrives. Suddenly last summer, all the pretenses start to come undone, and the market is caught frantically spinning its legs in vacant space. The federal government responds with more than $1 trillion in new mortgage lending and lending authorizations in multiple guises from Fannie Mae, Freddie Mac, the Federal Housing Finance Board, and the Federal Reserve. Home prices still drop relentlessly; signs of recession proliferate; risky assets plummet.

The second places blame on the actions of ex Fed chief Alan Greenspan (accusations he is attempting to rebuff).

Alan Greenspan’s fingerprints are all over what is fast becoming the worst financial calamity since the Great Depression. Sensitive to mounting criticism that his stewardship of the Federal Reserve led to today’s wrenching crisis, the former Fed chairman has launched a massive public relations campaign to set the record “straight.” Greenspan does make an inarguable point in stating his case for the defense—that it is critical to get the lessons of this crisis right. I couldn't agree more.

But methinks the man doth protest too much. Unfortunately, Mr. Greenspan has been blinded by a dangerous combination of politics and ideology in his own search for those very lessons. It was much the same during the 18 ½ years he spent at the helm of the Fed, guided by the belief that the U.S. public wants rapid, albeit noninflationary, economic growth. A politically compliant central banker, he has stated in his best-selling memoirs that he believes the independence of the Federal Reserve is not set in stone—implying that there is always huge pressure to keep the growth machine humming. A market libertarian, he has long argued that regulatory intrusion slows the economy. Presto—the rest is history—and an increasingly painful one at that. Greenspan’s blend of politics and ideology led to bad economics and a succession of policy blunders whose severity is only now becoming clear.

The Feds Cut Interests Rates

Monetary policy is in the news today. The Federal Reserve Board cut the federal funds rate and the discount rate today by large margins. Each by half a percentage point.

This was the first time the federal funds rate was cut in four years and the first time since Ben Bernanke became chair of the fed.

Both actions reduce the cost, to banks, of borrowing money, and in turn affect the amount that they then charge you and I in interest rates on credit cards, car loans and home mortgages.

Their actions are an attempt to infuse cash (liquidity) in to the economy following the collapse of the subprime mortgage business. It also provides an indication to the business community how the fed under Bernanke will act in the future when faced with financial issues. The rates had risen in small increments over the past four years, which indicated that the fed was worried about an overheated economy that could become inflationary. The chief concern right now is recession.

The markets do not like uncertainly. Once they figure out the behavior of a fed chairman (like Alan Greenspan) they tend to want to keep them in place so they know what to expect when they are called to make a decision. Chairman tend to hold on to their jobs for 10-15 years, which allows a degree of stability to the economy. Now they have their first indication about what Bernanke is inclined to do.

1--Give a clear statement regarding the fed's intent ("The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."
2--And make a significant change that will make it less likely that further changes are necessary.

Both are different than the activities of his predecessor who was famously cryptic in his statements and gradual in his rate cuts or increases.

When we cover the fed and economic policymaking in the last section of 2302, I try to point out that an advantage of monetary policy as a macroeconomic instrument is that it allows for quick response to changing economic circumstances. The fed already has statutory authority to raise and lower rates and so we don't have to worry about the politics associated with congressional action.