greenspan (1)

The Man Who Knew by Sebastian Mallaby is an excellent biography of Alan Greenspan, but it may have greater value in understanding the power and limitations of the Federal Reserve itself.

Greenspan has been accused of being an ideologue by some and a betrayer of free market economic ideology by others.  He was a brilliant thinker and in his early career in his consulting firm, Townsend and Greenspan, consumed vast quantities of technical industry specific data long before econometrics was a word.  He gathered unique insights facilitating valuable forecasts clients paid for dearly and willingly.

His close relationship with Ayn Rand fit with his market bias, but was tempered with pragmatic realities when he entered the political halls from Nixon to the second Bush. He served as Fed Chairman from 1987 to 2006.

With the analytical skills of a technocrat, he also possessed the depth of a philosopher.  He understood the limitations of models. For example, in 1977 his firm realized that mortgage extraction was providing a spending source that was not included in the current models.  Fueled by higher home prices it was also a vulnerable retardant if the home price boom ended.

Greenspan was one of the first to realize the value of financial assets in economic forecasting. As the financial sector grew in importance this moved to the center of many of his economic analysis and decisions.  Yet while he knew that the financial sector was subject to excesses he was sharply criticized for failing to act in a way that would have prevented the calamity of the 2007-09 bust.

There were several reasons.

Volcker was considered a hero for staying with painful and politically unpopular actions to bring the inflation of the 1970’s under control.  Following Volcker at the Fed, Greenspan remain stubbornly focused on managing inflation and protecting the difficult accomplishment of Volcker.

He became quite adept at digesting data and raising interest rates just enough to head off inflationary expectations while avoiding larger increases that would slow down the economy too much.

When his board viewed wages increasing and not matched by productivity they saw inflation on the horizon and recommended higher rates to avert the inevitable growth in inflation.  Alan saw this did not fit with frequent stories about the productivity gains CEOs of industry spoke.  Further diligent study saw that the industrial sector was reaping very strong productivity gains, but was offset by weak productivity gains in the service sector. This insight led him to a much smaller boost which proved correct.

Should the Fed act to prick financial asset bubbles?  This was a frequent question as his tenure spanned a stock bubble in 1987 and 1999, a bond bubble in 1993 and of the course the mortgage bubble which burst painfully immediately after his term. Financial bubbles often occurred in a low inflation environment and this further complicated his work. The Fed had a mission to fight inflation and unemployment; bubbles seemed at best a peripheral issue.

Greenspan remained focused on inflation because it was easier to assess than market bubbles.  He well understood that financial markets tended to excess but assumed self-discipline would generally yield better results than regulation. There was just too much information to process for most regulators to be able to assess effectively.

He assumed that the basics of the system were strong. When he learned of the accounting irregularities of Enron he was furious, understanding how the system depended on accurate accounting information. Still he understood that to supervise at this level would require a fivefold increase in the size of regulatory bodies, and weaknesses in the regulatory solution would remain.

He also assumed that in the event of a failure that would have serious economic consequences that the Fed would remain the lender of last result and could impose its power only when necessary.

For some this was a unacceptable inconsistency. The Fed would support failures, but not prick bubbles. The would protect firms on the downside, but not limit any risk on the upside.  This would encourage excess risk.

He also recognized the risk of a long string of successes at the Fed though the 1990s.  Success breeds confidence, confidence breeds complacency, and complacency breeds failure.  The confidence in the Fed to act to reduce downside risk became known as the Greenspan Put.  (A put is an option contract designed to profit from or protect from a market loss.)

Greenspan understood the risks of the insanely complicated financial and mortgage options. Even though he was warned about the unregulated derivatives by Brooksley Born in 1999, he understood how they helped availability and targeting of risks, and remained skeptical of regulatory solutions. He was alarmed at the massive size of the GSEs, Fannie Mae and Freddie Mac and the damage that would ensue from a housing bust.

He knew of the risks of bubbles but underestimated the size of the damage.

While he commanded interest rate and price stability quite well, this did not translate into financial stability. While we can see in hindsight the failures of reliance on self discipline, that does not mean that we understand the failures of excess regulation.

We have designed a fragile system that depends on regulation, rather than a robust system that requires less regulation.  The regulatory system stifles competition rather than encouraging it.  Fewer firms following the same rules may increase risk rather than mitigating it.  We also suffer from a fractured regulatory system.

We need fewer rules more firmly enforced.  Higher cap requirements for banks would reduce the need for bailouts, but Greenspan warned that this should vary greatly depending on the assets held.  Low cap requirements for mortgages from the regulatory agencies led banks to prefer these instruments and made the mortgage collapse more painful.

The Fed firewall, the lender of last result, is necessary for ultimate stability, but such bailouts should come at a stiff price.  Wage contracts and terms at the banks requiring such rescue should become null and void.

print