Greenspan Says It's the Crisis We Had to Have


If securitised US sub-primes had not emerged as the weak link in the global financial system, some other financial product or market would have. Eventually, the underpricing of risk had to collide with innate human risk aversion: the crisis was a psychological certainty.

The asset bubble was destined to follow the course of tulip mania and all the other bubbles of economic history – prolonged euphoria culminating in an abrupt and destabilising outbreak of fear. Even the most sophisticated private sector risk management was unable to neutralise the burst of euphoria and its inevitable consequences.

The clear evidence of underpricing of risk did not prod private sector risk management to tighten the reins. In retrospect, it appears that the most market-savvy managers, although conscious that they were taking extraordinary risks, succumbed to the concern that unless they continued to "get up and dance", as ex-Citigroup CEO Chuck Prince memorably put it, they would irretrievably lose market share. Instead, they gambled that they could keep adding to their risky positions and still sell them out before the deluge. Most were wrong.

But I am also increasingly persuaded that governments and central banks could not have importantly altered the course of the boom either. To do so, they would have had to induce a degree of economic contraction sufficient to nip the budding euphoria. I have seen no evidence, however, that electorates in modern democratic societies would tolerate such severity in macroeconomic policy to combat a prospective problem that might not even materialise. Periodic surges of euphoria and fear are manifestations of deep-seated aspects of human nature, and realistically there is little that governments or central banks have been able to do to divert or defuse them.

Being unable to effectively thwart the waves of speculation, the best strategy is to ensure that our markets at all times have enough flexibility and resilience, unencumbered by protectionism or rigid regulation, to absorb and mitigate the shock of crises.

I do not mean that it is necessarily futile to try to regulate financial risk. There are areas where I believe we need more rather than less official intervention, such as the prosecution of fraud. Fraud undermines a central pillar of competitive markets: voluntary market exchange. Prosecuting it more widely, I believe, would have discouraged the more egregious lending practices of recent years.

Since fraud, especially in the form of blatant misrepresentation, is illegal, no new statutes to my mind are necessary. What we need is far greater enforcement. In my experience, bank regulators, who are expert in accounting, banking law, and risk management, are not equipped for this job. It requires law-enforcement professionals.

Perhaps I should not have been, yet I was appalled and shaken when the financial system failed to protect itself more effectively against a euphoric boom. We at the Federal Reserve had always counted on banks in particular to avoid the most troublesome risks. The elaborate counterparty surveillance procedures of bank loan officers have long been the financial system’s first line of defence against breakdowns. Yet there is persuasive evidence that in this crisis, those in charge of counterparty surveillance failed.

I was doubly dispirited by this failure because the world has no one who can do the job better. Financial regulators, in my experience, know far less than private-sector risk managers. Indeed, the open secret about regulation in the free-market world is that regulators take their cues from private-sector practitioners. The Federal Reserve and other supervisory institutions continually seek the advice of the best and brightest risk-management professionals. Basel II, the international consensus on bank regulation first published in 2004, mirrored the risk valuation models of the private markets.

Not surprisingly, Basel II is undergoing significant review as the banking industry revises its own standards; new US regulation governing capital requirements, if it comes, will reflect the private sector’s already revised market practices.

Despite the recent failure of risk-management professionals, we need to be wary of the notion that less qualified people can do better. If a physician misdiagnoses, we do not turn to the patient for greater insight.

We prod the physician to come up with a better diagnosis. The system of private-sector risk management needs to be repaired. We have no better alternative.

The markets will continue to adjust on a massive scale. Even so, given the vagaries of human nature, it is doubtful in the extreme that the result will be a crisis-proof financial system. Does government need to do more?

The question is somewhat moot, because modern political reality requires elected officials to respond to virtually every economic aberration with a government program. Given the number of voters whose lives have been directly affected, the pressures on legislators in today’s crisis are especially intense. If history is any guide, new regulations will focus mainly on the causes of the current crisis: lax and fraudulent mortgage lending practices, the indiscriminate securitisation of credit products, and over-reliance on risky short term funding for long term assets.

The response by US authorities to the crisis on Wall Street raises a broader concern. It is one thing for a central bank to lend to solvent institutions putting up "good" collateral; it is quite another for it to purchase liabilities of an institution that is failing, or to do the equivalent by extending non-recourse loans. Such government bailouts must be extremely rare: if market participants came generally to view a firm as "too big to fail", then, in anticipation of government support in the event of financial trouble, the firm would be able to sell its obligations at interest costs lower than it could were it being judged solely on its own credit merits. Such distortions to the competitive use of financial capital reduce the effectiveness of a financial system in channelling a nation’s savings into the most productive uses.

History tells us there is a cost in standards of living from such misuse of capital, if it becomes widespread.

The risk-management systems of banks generally lead them to carry enough capital to meet all contingencies with the exception of disasters on a scale that happen only once or twice per century. The burden of containing the consequences of such events ends up on the doorstep of central banks. The only alternative would be for commercial banks to hold significantly more capital all the time at levels that might be needed only once every 100 years. Bankers strongly resist that approach; apparently they prefer instead to risk bankruptcy once a century.

No one knows for sure, of course, but the evidence is quite persuasive that the current crisis is one of those rare, once in a century or half century events.

Our country has long since abandoned the notion that we should leave crises to be resolved solely by the marketplace. To minimise the impairment of market efficiency from bailouts, the critical need, in my judgment, is to formalise and somewhat revise procedures for federal bailouts. This should ensure that, in the future, government financial assistance to lending institutions does not impact the Federal Reserve’s balance sheet and monetary policy.

We need laws that specify and limit the conditions for bailouts – laws that authorise the Treasury to use taxpayer money to counter systemic financial breakdowns transparently and directly rather than circuitously through the central bank. We need a mechanism akin to the Resolution Trust Corporation (RTC), the government company founded in 1989 to deal with the aftermath of the savings and loan crisis.

Most other calls for additional regulation of financial markets are far less compelling to me. It seems superfluous to constrain trading in some of the newer derivatives and other innovative financial products of the past decade. The worst have failed; investors no longer fund them and are not likely to in the future. Others, such as credit default swaps, have over the years proven very useful vehicles for diversifying risks (though in the case of such swaps there are as yet unresolved and worrisome operational risks).

I am similarly skeptical of notions that stepped-up regulation of financial markets could improve their performance – particularly the idea of expanding the mandate of the Federal Reserve to become the market-stability regulator, with broad authority to unearth incipient imbalances and bubbles.

That is mission impossible. Indeed, the international financial community has made numerous efforts in recent years to establish such oversight, but none prevented or ameliorated the crisis that began last summer. Much as we might wish otherwise, policymakers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances. Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated – if people see them coming, then the markets arbitrage them away.

In recent years, critics have pointed to the US current-account imbalance as indicating a major foreign-exchange-rate crisis in waiting. Instead, exchange rates have moved in the direction needed to rebalance supply and demand. But at least so far, there has been no abrupt discontinuity. Another feared crisis in waiting was a financial implosion of a number of hedge funds, leading to a cascade of bank defaults.

Many hedge funds did liquidate following the crisis of August 2007, but, as of June 2008 at least, without important consequences to the financial system overall. The same is true of any crisis or adjustment process-it will never happen exactly the way it is envisaged. That’s why I favour requiring that institutions have adequate capital and liquidity buffers to weather unexpected turns.

This is especially the case as government regulation gradually gives way to the self-correcting adjustments of global markets. The shift is probably inevitable because the world economy has become so awesomely complex that no individual or group of individuals can fully understand how it works. That it does work is evident from the high degree of stability apparent in markets almost all the time and the ever-rising standards of living on average from generation to generation across the globe.

The exceptions are the crises that arise from human foibles. I know of no regulatory system or degree of protectionism that can transmute irrational exuberance or debilitating fear into a stable growing economy. Those who imagined that the solution lay in an economy organized and run by an intellectual elite of central planners rather than competitive markets failed time and time again during the past century.

If material well-being is our goal, I see no alternative to global market capitalism. Its Achilles’ heel is the widespread perception that its rewards are not justly distributed. That issue sorely needs to be addressed. But the abandonment of this remarkable global economy, which some critics increasingly advocate, would reverse a paradigm that has elevated hundreds of millions of people from grinding poverty and has enabled a significant segment of the world’s population to enjoy a standard of living that was once the exclusive province of elites in the developed world.

This is an edited extract from The Age of Turbulence: Adventures in a New World by Alan Greenspan (Penguin, RRP $35.00).

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