Jeremy Warner: Greenspan admits to 'flaw' in his free market thinking
Friday 24 October 2008
Outlook Alan Greenspan, quoting Keynes, insists that when the facts change, he changes his mind. It wasn't exactly a mea culpa we had from the former Federal Reserve chairman in Congressional testimony yesterday, but it was about as close as we are likely to get to it.
Mr Greenspan has spent much of the last two years trying to justify what, with the benefit of hindsight, were plainly a series of mistakes, both in the exercise of interest rate policy and in the regulation of banks, for which the Fed is partly responsible in the US. Central banks shouldn't attempt to deflate asset bubbles, he has argued, but only deal with their aftermath, while banks are best left alone to regulate themselves in their own self interest.
Yesterday, he admitted for the first time that at least some of this thinking was flawed. Rather in the manner of religious disillusionment, his realisation that the market isn't always right has come as a terrible shock to the former monetary wizard. Yet Mr Greenspan is not entirely repentant. As far back as 2005, he insists, he raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences.
Unfortunately, it may already have been too late by that stage, and in any case, he failed to act on his own wake-up call, despite ample authority and opportunity to do so. He also admits to having failed to act on the concerns of Ed Gramlich, a former member of the Federal Reserve's board of governors, who had warned him in terms as far back as 2000 of the perils of predatory pricing in sub-prime mortgage lending.
It is always easy to be wise after the event, and I'm not sure we should be too hard on Mr Greenspan for failing to recognise the significance of the boom in sub-prime lending. Hardly anyone else did either until it was too late. On the other hand, it is the job of a central banker to take away the punch bowl just as the party gets interesting, to quote another former chairman of the Fed, William McChesney Martin, and this Mr Greenspan notably failed to do.
Yet it was not for failings in monetary policy that Mr Greenspan was apologising, but rather for flaws in his whole world view. As he has said before, those who look to the self-interest of lending institutions to protect shareholders' equity are in a state of "shocked disbelief". For him at least, 40 years of faith in the ability of the free market system to protect and heal itself has gone up in smoke.
Personally, I cannot see why an economist as ancient and accomplished as Mr Greenspan, brought up in the crucible of the Great Depression, should find this shocking at all. Down the ages, banks have repeatedly proved careless both with their shareholders' capital and their depositors' money. As the good times roll, they invariably drop their lending standards and eventually find themselves crucified by bad debt. In that respect, there is nothing unique about the present banking crisis at all.
As Mr Greenspan points out in yesterday's testimony, the crisis is at root about failure properly to price risky assets. Again, all banking crises share this characteristic. What made this one a bit different was the extent of global demand for dodgy, mispriced US assets.
Yet it is not so much the present state of market failure Mr Greenspan is in shocked disbelief over, as the fact that self-surveillance and correction by banks should have broken down on such a scale. Again, it is hard to see why he should find this remarkable. As the boom times roll, banks always end up allowing risk controls to become eroded and thereby lending too much. The longer the boom, the more extreme the process becomes.
What Mr Greenspan should really be kicking himself about is not his naive belief in the idea that markets are self regulating in their own interests, but his own failure to spot the extent of the mispricing, and then act on it. He's hardly alone in this failing, but then it was his job to keep the children under control. In any case, Mr Greenspan has now joined the greater regulation bandwagon. Yet it is endearing to see that he has not entirely lost his free market faith. Whatever regulatory changes are made, he says, will pale in comparison with the change already evident in markets. "Those markets for an indefinite future will be far more restrained than would any currently contemplated regulatory regime". Quite so. When markets get it wrong, they really know how to punish themselves. Unfortunately, it is the little guy, and not the responsible bankers, who takes the brunt of it.
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