Wednesday, July 27, 2011

Greenspan reverts to form

Alan Greenspan is as hard to follow as ever. Seemingly, too, as convinced of the transcendent wisdom of the market as ever.  Today, in a Financial Times op-ed, he argues that governments in wealthy countries overreach in trying to shield citizens from a variety of major risks. Along the way, he seems to equate strict earthquake-proofing standards for buildings, high capital ratios for banks, and a propensity to bail out banks that get in trouble as different manifestations of the same government malady. 

Those equations are hedged a bit. I don't think that Greenspan means to suggest that Japan's earthquake-proofing standards are as ill-advised as bank capital ratios that he regards as excessive or the bailout of Bear Stearns. But that's how I read it the first time:
The buffer may encompass expensive building materials whose earthquake flexibility is needed for only a minute or two every century, or an extensive stock of vaccines for a feared epidemic that may never occur. Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment...

If policymakers choose to buffer their populations against every conceivable risk, their standards of living would almost certainly decline. It is no accident that earthquake protection of the extent employed in Japan has not been chosen by less prosperous countries at similar risk of a serious earthquake... Buffers are largely a luxury of rich nations.

Well yes, earthquake-proof materials may be needed only for only a minute or two, but the consequences of lacking them are felt rather longer than that, e.g., by the survivors of 100,000 dead.  This argument can't be as callous as it sounds.  Just almost...
How much of its ongoing output should a society wish to devote to fending off once-in-50 or 100-year crises? How is such a decision reached, and by whom? In the 19th century, when caveat emptor ruled, such risk judgments were not separable from the overall price, interest rate and other capital-allocating decisions struck in the marketplace.

Today, while the decisions of what risks to take remain predominantly with private decision-makers, the responses to the global financial and, of course, the Japanese earthquakes have been largely government scripted. In the immediate aftermath of such crises, it is very difficult to convince people that the recent wrenching events are not likely to recur any time soon....
Is that nostalgia for 19th century caveat emptor?  Not quite.  Greenspan does not extend the metaphor completely enough to suggest outright that Tokyo should be built like Sichuan, China, where the 2008 earthquake killed 70,000 people as shoddily built schools and apartment buildings collapsed in droves. He does recommend, however, that banks be given more rope to hang themselves again, and he does suggest that governments' move to impose modestly higher capital requirements in the wake of the financial meltdown flows from the same mother-hen impulse that led to a rash of bank bailouts in said crisis.  He betrays no concern that banks used their enormous permitted leverage prior to the crash largely for wildly unproductive purposes, or regret that he failed to use the Fed's powers to rein in a mortgage market infested with fraud and predatory lending. He appears to believe that all forms of government intervention, from bailouts to diverse forms of regulation, are essentially similar manifestations of interference with a market that otherwise prices risk efficiently. 

Ultimately, Greenspan argues that imposing market discipline -- allowing failure -- is a more effective form of government "regulation" than imposing stricter rules:

The “frozen” reserves appear the result, at least in large part, of the unexpected sequence of bank bail-outs in 2008. Had Bear Stearns failed in March 2008 (without government intervention), Lehman Brothers, and possibly AIG, would have been induced to take capital-building actions during the subsequent six months to fend off insolvency.
Perhaps he's right about Bear Stearns. Sheila Bair agrees.  But the example is rather cherry-picked.  Did Greenspan oppose all subsequent bailouts? No, he called for more. More to the point, does willingness to let failure happen preclude imposing strict rules of the road?  In February 2009, Greenspan answered no:

“All of the sophisticated mathematics and computer wizardry essentially rested on one central premise: that enlightened self interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring and managing their firms’ capital and risk positions,” the Fed chairman said. The premise failed in the summer of 2007, he said, leaving him “deeply dismayed.”

Self-regulation is still a first-line of defense, Mr. Greenspan said. But after the financial collapse of 2007 and 2008, “I see no alternative to a set of heightened federal regulatory rules of behavior for banks and other financial institutions.” He said hoped hoped it would come in the form of tougher capital requirements for banks.
Recall, too, Greenspan's own confessed astonishment in the wake of the meltdown that bank managers' own instincts for self-preservation (or preservation of their institutions, which proved not to be the same thing) did not deter them from taking wildly excessive risks. He himself seems to have forgotten.


  1. I think it's easy to pick on Greenspan right now, but you have to give him credit when he went to Congress and took responsibility for this mess when no one else was willing to do it.

    I don't see these instances as flip flops as much as I see them adjustments in policy. Economists were arguing with each other the entire time about what to do, and in thinking fast, it's easy to contradict yourself.

  2. "bank managers' own instincts for self-preservation (or preservation of their institutions, which proved not to be the same thing) "

    That's the crux of the matter right their...pure self-interest led people to take bad risks. THEY didn't go under when their firms did.

    How about, if your financial institution is bailed out, you have a 1 in 100 chance of having to fight a bear (get it) to the death? On national TV ideally.

  3. @ roseonpolitics: Adjustments in policy is far too charitable. His 2008 statements of contrition were probably genuine. Since then I imagine he's reread The Fountainhead a few times and he's back to his old self.