Greenspan concedes

There’s been a fair bit of debate about what, if anything, the current crisis means for economic policy and political philosophy more generally. A lot of this has been hung up on issues of terminology, which I will do my best to avoid here and in future.

Coming to substance, quite a few people have argued that the crisis doesn’t really signify very much, and that, once it is resolved, things will return to pretty much the way they were a couple of years ago. I disagree.

This concession of error by Alan Greenspan is, I think, pretty strong evidence against the view that the crisis is not so significant, in policy or ideological terms.

First up, Greenspan gave little or no support to the silly Republican talking point (repeated by quite a few commentators here in Australia) that the crisis was caused by marginal government interventions like Fannie&Freddie and the Community Reinvestment Act. On the contrary, he stated

The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations* (undeniably the original source of the crisis) would have been far smaller and defaults accordingly far lower

And Greenspan conceded that his faith in deregulation had led him into erroneous policy decisions

“You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others,� said Representative Henry A. Waxman of California, chairman of the committee. “Do you feel that your ideology pushed you to make decisions that you wish you had not made?�

Mr. Greenspan conceded: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.�

To sum up, Greenspan’s concessions and the big interventions we’ve seen already lead me to believe that this crisis will result in much tighter regulation of financial markets and a much more central and explicit role for governments in the management of financial and economic risks.

How much this matters for bigger questions of what kind of political philosophy will predominate depends very much on the importance you attach to risk management as a central feature of public policy and as ground contested between democratic governments and financial markets. I’ve argued for a long time that risk is crucially important, and therefore see the failure of financial markets to manage it as having fundamental implications for the way in which society will be organised in future.

* Note, BTW, that CRA loans were mostly not subprime and that Fannie&Freddie only entered the subprime business very late in the development of the bubble.

82 thoughts on “Greenspan concedes

  1. “If one rejects laissez faire on account of mans fallibility and moral weakness, one must for the same reason also reject every kind of government action.”

    That’s a obtuse reading of the point. I don’t reject “laissez faire” broadly interpreted, or the efficiency of markets. I think markets should be preferred whenever possible, but I would argue we need to be clear about market interdependency on government to exist.

    The argument is that there are minimum structural requirements which need to be imposed by state-coordination in order for us to benefit from flourishing competition and market efficiency.

    This argument is a matter of degree, as nobody here would deny property rights are necessary and courts to enforce them. It’s about getting more precise and realistic about the best legal environment to prevent this kind of calamity happening, whilst still promoting maximin market freedom for agents to take risks and enjoy option luck advantages for their decisions.

    Coming back to your point, that view is entirely compatible with the idea of man’s fallibility having conjoint implications for limited government AND markets. You don’t get to redouble a strawman on government coordination simply because of fallibility, and things like agent-principal problems, exist in both domains.

    This thread is ultimately about a rhetorical lion of free-market faith ostensibly coming to grips with a more systemic level failure in his thinking. Many of us find this to be a justified reconciliation with reality, and are not satisfied with accounts of this crisis which try to divert us to a call to return to the Gold Standard, or simply to focus entirely on his monetary policy at the Fed.

    In that sense, I find myself in the camp of those who think too much of push-back, and their ought to be some unless we want to slip back too far into economic populism, is not facing up to the myopia of deregulation. It’s basically like a classic “no true Scotsman” fallacy, which then tries to double down on the same cynicism of government itself was premise of regulatory defects and omissions.

  2. The main causes of the crisis, being poor investments, are:

    1) The implicit system of government guarantees to intervene in a financial crisis.
    2) Lack of transparency and collateralization in certain trades and transactions. In other words, more precision in the trades to determine the correct level of capitalization, and the guaranteeing that the collateral be there.

    I understood him to be conceding 2. We need enough regulation, or better, supervision, to guarantee that these trade conditions are always met, especially in trades that involve the shifting of risk to a third party or the magnification of risk, where the correct amount of capital is difficult to determine.

    I don’t see either of these as having any large claim on the worthwhile nature of our capitalist system.

  3. “Except self interest rarely creates great contributions to mankind and is rapidly forgotten as they will be in time.”

    Did Michelangelo paint for the love of Art or did he do it for the money?

    But to the wider point, Altruism and Egoism, or a false choice because they are essentially the same thing. In Eastern Philosophy the issue they see is enlightenment and stupidity, they really dont use the terms good or evil ect, maybe we have something to learn from them.

    and to add Socrates is also known as the Buddha of the West.

  4. P52, Will

    I agree with a lot of that, as said, Austrian economics is loosely, Free market trial and error leading to an “Ideal” of Laissez faire, which is an ongoing goal.

    In Post no.18 I set out an alternative monetary system that is not the gold standard. That I believe would root Fiat money better in reality.

    I think a lot of the problems with Economics is that they don’t treat Money seriously enough, that’s both the Pols, the pubic and the financiers.

  5. P25, Stuart

    “Unless the value of Fiat money is derived from the need to pay government taxes. In which case trust is next to irrelevant, only the capacity of the government to levy and collect taxes.”

    So in short you are saying it comes from Power?

    If so where does power come from in a democracy?
    Afterall we could arm ourselves and not pay the required taxes, in which case we are back to trust again.

    I pay my taxes not because I support my pig headed government, I pay it because I support the democratic system, I trust it.

  6. Don, I agree with what you’ve said above, but the theory side of this has long been more humble than the actual rhetoric which rules us.

    It’s easy to say this doesn’t very challenge anything when the reference is academic economics, which has kept pace with critiques of systemic irrational exuberance; but unfortunately, our political discourse and practice has not kept pace with academic economics.

    So, whilst it may be easy to talk about matter-of-degree regulatory advocacy now, I think, if we are being realistic, we must admit that it has not been like this for the last couple of decades. People who dared stray too far from uncritical acceptance of the invisible hand, and the default mantra against government, would be risk being labelled as confused apostates against the moral certainties of an unfettered market. Or worse, they might be accused of harbouring socialist views and some kind of wrong-side-of-history Malthusian mistake.

    Now, there is no one single cause, but I do believe it is partly this bounded political discourse stunting incentives to pay attention that has allowed the burgeoning securities market to get to this point. Of course, the inattention wasn’t all ideology – some of it was simply expertise. The fact is these instruments were getting more and more sophisticated, and government was arguably happy to believe firms and the rating agencies knew what they were doing.

  7. #42 As Alanna says, the sensible response was to get money out of the stock market and some of us did. The idea that, having said that derivatives are opaque and subject to wild fluctuations, default risk and so on, the sensible response is to try to construct a derivative portfolio which pays out if derivatives display wild fluctuations and default risk is precisely the kind of thing (practised on a scale much larger than that of individual investors) that helped to amplify this disaster.

  8. Yes Will the governments also wanted to believe too in fairy tales, the banks where paying billions in tax, its very hard to say stop sending us the money, or where are you getting all this money from? because the truth was the governments where printing it for them.

  9. The best account I ever read of how selfishness (or self interest) can lead logically and consistently to altruism was in a book about biology by Richard Dawkins. It’s called “The Selfish Gene” and I think it’s a brilliant book. Although I’ll freely admit that in drawing the gene/organism analogy into the realm of human/society we might reason that the mechanism for creating altruism in society could be either selfish acts in the market or selfish acts via government or both. Either way it’s a great book.

  10. The idea that, having said that derivatives are opaque and subject to wild fluctuations, default risk and so on, the sensible response is to try to construct a derivative portfolio which pays out if derivatives display wild fluctuations and default risk is precisely the kind of thing (practised on a scale much larger than that of individual investors) that helped to amplify this disaster.

    True, but this sorry state of affairs aroseonly because those risk-takers grievously underpriced the risk premium.

    The same collapse would happen to insurance companies if insurance companies grievously underpriced the risk of bushfires. This isn’t an argument against bushfire insurance, it’s an argument against underpricing the risk premium.

    Insurance should be one of the market signals to dissuade folks from doing certain things, like building houses in areas of unacceptable bushfire risk, or buying dodgy CDOs.

  11. JQ@57,
    This in not an improvement on your previous argument. Given your certainty you could have made a great deal of money with a fairly simple, transparent, low cost trade. Your choice implies that you were not very certain of the prediction*. I’m convinced you don’t need a lecture on revealed preference to understand this.

    Taking money out of the equites is fine, but it is very weak evidence. If you were certain you would have gone much further. Default risk is not relevant unless you were worried about the exchanges defaulting. Your “Wild fluctuations” argument is also not relevant because you could have paid a small upfront premium and not had to worry about margins.

    I’m not just making this point to be annoying. I think it demonstrates a more important general point that markets have a strong collective incentive embody available information. It’s also a sobering proposition for the many who think they know better.

    * I’m hesitant to make assumptions about how you derive your utility, but I think this is true under plausible specifications. Still, it’s your utility and I’m happy to concede the argument if this is the issue.

  12. Joseph, this is utterly unconvincing. You’re essentially advocating a strategy of short selling. You may not have noticed but it was banned at a crucial time. There was talk of doing the same for put options. Similarly, investments that were allegedly as good as cash (auction-rate securities, money market funds) have turned out to be illiquid. Insurance against default through CDS swaps has turned out to be problematic to put it mildly. And talk of the possibility of a market shutdown is not confined to the likes of Nouriel Roubini – it was under consideration yesterday morning after the futures market hit the downward limit on Wall Street.

    So to take up your invitation – show me an investment that will pay out in the event that any counterparty involved goes bankrupt and the stockmarket closes down (or the relevant trade is banned) when I want to realise it. If you have one, I’ll be glad to back my beliefs with dollars.

  13. Since exchange traded options (just to take one example) are margined daily the largest amount of profit you could lose would be the change in value on one day. And that would only happen if the exchange defaulted.

    If the four horsemen rode and Satan came to collect the souls of the damned the exchanges probably would stop requiring margins but even then you would only have lost one day’s profit.

  14. Joseph said

    If the four horsemen rode and Satan came to collect the souls of the damned the exchanges probably would stop requiring margins but even then you would only have lost one day’s profit.

    I think the four horsemen have indeed arrived Joseph and people’s behaviour right now is more likely to be based on uncertainty. Animal spirits alive and well and people are moving with the rest of herd or being forced there by fear or debt constraints (the market itself).

    I dont believe individuals en masse have perfect information for if they did they would be trading to a greater extent in your exchange traded options if what you suggest is true. Im sure lots of of people really dont want to understand the complexity of financial derivatives and these products and organisations that deal in them have arisen simply in response to too much liquidity in financial markets (and I dont mean central banks interventions).

    Its an imperfect world full of imperfect markets, and people do not have perfect information, markets are not always efficient and they fail.

    Governments also fail. The ratchet effect applies too often to policy direction. We will go on permitting medium density construction until we reach the crisis of high density congestion. In the same way, anyone who has examined the growth of the financial sector as a component of GDP over the past decade or longer may have asked where all the growth was coming from – well in fact it was probably coming from people’s wages – some 9 to 17% of it. An ordinary person could also not have failed to notice the rise in household debt levels (not enough money from wages to pay the mortgages of the inflated real estate values driven by profits made perhaps in the share market?). I still maintain that mandatory super underlies the distortion obvious in the financial sector. The push to deregulate the outputs (and institutions) of this sector – whilst its inflows were guaranteed by regulation was a long brewing recipe for just such disaster as has arrived.

    The arguments for de-regulation have in essence been producer biased and thus entirely lop sided.

  15. Joseph, if the bets are margined daily, what would have stopped me being wiped out before my predictions were proved correct? Markets can (and did) stay irrational longer than I can stay solvent, after all.

  16. Only sellers have to post margin. You would only have lost the premium you paid which could have been quite small if you had bought when risk premiums were low. I’d do the numbers for you but I doubt any amount of evidence would change your stance.

  17. You could have bought a 900 strike put on the December S&P 500 futures contract for $1.05 on 28/9/08, less than two months ago. It last traded at $99.25.

  18. Joseph, that would have been great if I could have got the timing right as well as the direction. And maybe you did better than I did.

    But I’m still well ahead of the market and well ahead of the hedge funds who are supposed to have this kind of thing covered.

    I think your crucial claim is this one “I think it demonstrates a more important general point that markets have a strong collective incentive embody available information.”

    Fairly clearly, this incentive hasn’t worked. Maybe that’s because those (like me) who could see that the whole thing was heading for a big crash were (as you’ve seen) unwilling to trust any security offered under these conditions, and therefore didn’t bet on our beliefs. But certainly the market didn’t get this right.

  19. My point is not a criticism of your investment strategy or an endorsement of mine.

    In any case I agree very strongly with your last point. I think it’s important that those with information are able to express that information into prices and confidence is a big part of that. That’s why I think gagging the market by banning certain types of trades is incredibly counter-productive.

  20. One thing I certainly got wrong about my predictions of the crisis was my expectation that the US dollar would fall, and that US bonds would become very unattractive relative to those of other countries.

    It seems to me that the rise in the dollar largely reflects various market participants getting squeezed, rather than a belief that the US economy is less exposed to the crisis than others, or that the US government is less likely to inflate its way out of trouble.

    But, either way, this is another reason I’m glad I only took the safe bet on my beliefs and not the risky bets I might have taken.

  21. There is no shortage of economists who could see trouble ahead and attempted warnings but the volume of propaganda being generated by some organisations (with self interested invariably wealthy funders and backers and little real research) in defence of free market theory has been like a WW11 air raid where planes dropped silver paper shreds to confuse radar.
    See Stilwell 2003

  22. Alanna

    every day there are economists issuing warnings and advice, you would run yourself ragged acting on every claim.

    One economist called Greenspan was regularly upbeat.

  23. It took 7 or more years to build a consensus around Keynesian policies after the 1929 crash.

    I hope we don’t have a disaster of that scale to contend with.

    If we don’t, on the other hand, I can’t really see what real changes are in the offing? So far it seems that we’re going to abandon our efforts to mitigate climate change and cancel immigration. That should improve things shouldn’t it now?

  24. You can say what you like Ayn Rands Toy boy, but the one thing he did see coming was the systemic risk posed by Fannie and Freddie.

    Yes securitisation was the gunpowder, but plenty of things carry explosive power, its the IGNITION that matters.

    125% mortgages and sub prime mortgages came about because Banks with the Nod of the politicos (who coined it in as well thru taxes) thought lending did not have to be insured by such trivial things as deposits. By putting down a good deposit the customer takes the risk, the bank takes the house and gets the rest of its money if you go under.

    The simple fact is IF banks were capitalized at twice the amount of the last 10 years, then you would never have heard of securitisation.

    Root cause is our desire to give people money who should not have been given money, or the socialization of lending by private banks and pseudo private banks.

    So then the weight of money kicked in and the seemingly self fulfilling prophecy of higher and higher property prices feed on itself and onto of the Gunpowder of secularization we added TNT in the form a massive market distortion.

  25. Rog

    Im sure I could find no end of quotes of politicians giving themselves a pat on the back for their sound economic policies delivering abundance and happiness, between 1925 and 1928 if I looked.

  26. John, if I may reply Freedom lover by saying who gives a stuff about the free market and competition when those in need of urgent medical treatment are left out in the cold. At least our public hospitals do provide a service to all comers including foreigners like you who might one day be in need of urgent medical treatment for a small fee and if you cannot pay the fee I believe it is waivered.

  27. This crisis will change the way the economy operates permanently, not to many people saw this coming, but lessons will be learnt and it will permanently change the way people look at risk and investment. At least for one generation anyway.

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