Greenspan decided to launch a frontal attack on critics of his tenure at the Fed, via a Financial Times comment, “The Fed is blameless on the property bubble.” Needless to say, his defense does not stand up to scrutiny.
Greenspan was happy to take credit for the commonly-held view that central bankers were responsible for the so-called Great Moderation, the 20 years of sustained growth and not-too-severe recessions that proceeded our current crisis. But you can’t have it both ways: either the Fed has influence (and its influence is admittedly limited) or it doesn’t. You can’t take credit for an economy’s gains and then disavow its subsequent performance, particularly when the problems all developed on your watch. But then again, it’s the regulatory analogue to the “privatize the gains, socialize the losses” posture of the financial services industry.
In the first paragraph, Greenspan notes that:
I am puzzled why the remarkably similar housing bubbles that emerged in more than two dozen countries between 2001 and 2006 are not seen to have a common cause. The dramatic fall in real long-term interest rates statistically explains, and is the most likely major cause of, real estate capitalisation rates (rent as a percentage of a property’s value) that declined and converged across the globe.
This is clever, since Greenspan presents the US bubble as part of a global phenomenon, and by implication, the Fed could and should not have done anything to prevent it. Yet this account conveniently ignores the fact that the Fed deliberately created negative real interest rates, which is guaranteed to fuel speculation. In addition, Greenspan glosses over the large number of adjustable rate mortgages which played off short rates which were issued on his watch, an estimated $1.2 trillion subprime and $500 billion to $1 trillion of Alt-As.
Moreover, other central bankers did recognize the existence of a bubble and tried to let some air out of it. Australia’s Reserve Bank governor Ian MacFarlane made repeated statements warning consumer against the frothiness of the real estate market, and presumably also had some tough conversations with local banks. A couple of interest rate increases in 2004 led to a slackening of prices, particularly in the speculative market for units. So contrary to Greenspan’s assertions elsewhere, it is possible for central bankers to recognize bubbles and take judicious action.
Back to Greenspan:
But the US bubble was close to median world experience and the evidence that monetary policy added to the bubble is statistically very fragile. Paul De Grauwe, writing in the Financial Times’ Economists’ Forum, depends on John Taylor’s counterfactual model simulations to conclude that the low funds rate was the source of the US housing bubble. Mr Taylor (with whom I rarely disagree) and others derive their simulations from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the basis for policy.
Mr De Grauwe asserts that “signs of recovery” (I assume he means sustainable recovery) were evident before 2004 and hence the Fed should have started to tighten earlier. With inflation falling to quite low levels, that was not the way the pre-2004 period was experienced at the time. As late as June 2003, the Fed reported that “conditions remained sluggish in most districts”. Moreover, low rates did not trigger “a massive credit … expansion”. Both the monetary base and the M2 indicator rose less than 5 per cent in the subsequent year, scarcely tinder for a massive credit expansion.
Greenspan again conveniently chooses to focus on the monetary base and M2 and ignores the massive growth in credit. Private estimates of the no-longer-published M3 has shown double-digit growth for several years. Similarly, the ratio of debt to GDP has rose to unprecedented levels, and consumer savings plunged to zero. These were all warning signs of an economy seriously out of balance, yet Greenspan chose to ignore them.
Greenpan’s defense gets even more ridiculous:
Bank loan officers, in my experience, know far more about the risks and workings of their counterparties than do bank regulators. Regulators, to be effective, have to be forward-looking to anticipate the next financial malfunction. This has not proved feasible. Regulators confronting real-time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act pre-emptively. Most regulatory activity focuses on activities that precipitated previous crises.
If you take Greenspan’s the regulated always knows more about his business than the government does” to its logical conclusion, there should be not regulation at all. And that was Greenspan’s ideological bias.
But even his statement, at least in terms of the housing bubble, is a baldfaced lie. Who, pray tell, are these “counterparties” of bank loan officers? He chooses to obfuscate because any straightforward statement would be patently ridiculous. Bank loan officers weren’t responsible for on-selling the mortgages; they make credit decisions. Bank loan officers, or in this case, mortgage brokers who met with customers and filled out loan applications, whether internal or external, knew close to nothing about their borrowers As Tanta has said repeatedly, the drive for efficient loan processing drove both prudent protection (like verifying income and employment) and the old practice of knowing your customer out the window. I am told by contacts in the industry that one of the impediments to modifying loans is that the servicers don’t know anything about the borrowers beyond their current FICO, their payment history, and the initial terms of the loan. The loan files, which historically were a valuable source of background information about borrowers, have very little information, and even that is largely inaccurate.
Moreover, despite Greenspan’s assertion otherwise, there are ways the regulators can have insight. One is that unlike any individual institution, they have a vantage on the entire industry and can look at activity and trends on an aggregate basis. Second is that they can (and should) have a different perspective on risk and rewards. Public companies have become fixated on short-term results, and thus dismiss the troubles that may show up in later reporting periods (after all, they will probably be on someone else’s watch). Regulators can serve as an important check (management can tell their equity holders they had to take certain measures).
Third, which is related to but distinct from two, is that the financial firms have little in the way of institutional memory and keep making the same mistakes over and over again (witness in the investment banking industry, how bridge loans proved to be a costly adventure in the last LBO boom yet the industry went and got themselves more deeply exposed to the contemporary version, leveraged loans, this time around). Again, a regulator can provide useful external discipline when the internal instincts for self-preservation are impaired.
Fourth, Greenspan assumes that objective outsiders cannot have any insight. If that were so, there would be no management consulting industry, since the consultant is in a similar position to the regulator, of not knowing the clients’ business as well as he does. Yet that industry grown enormously since it started in the 1920s (admittedly, like regulators, with some controversy). Its survival and growth indicates that companies recognize that they are often too enmeshed in their own assumptions and practices and can sometime use a disinterested party’s help.
But the biggest problem with Greenspan’s posture is that he fails to accept the rationale for regulation. Banking is an industry that can create enormous externalities, namely, financial panics, asset bubbles (which suck investment out of more productive uses) and busts. Even a mere nasty credit contraction exacts a toll on the real economy. We accept the rationale of regulating polluters, food producers, and drug makers because the costs to society when they get it wrong can be large.
Greenspan is basically saying we shouldn’t regulate banks because it’s hard to be smart enough about their business. That’s a pathetic excuse.
Aside from far greater efforts to ferret out fraud (a long-time concern of mine), would a material tightening of regulation improve financial performance? I doubt it. The problem is not the lack of regulation but unrealistic expectations about what regulators are able to prevent. How can we otherwise explain how the UK’s Financial Services Authority, whose effectiveness is held in such high regard, fumbled Northern Rock? Or in the US, our best examiners have repeatedly failed over the years. These are not aberrations.
I note that Japan. France, and Germany (aside from stupid investment by their banks in US paper) have been free of our credit binge problems. In Japan, you may be able to argue that its economic malaise is the main cause. However, all three countries share a different attitude towards regulation than ours. Our attitude is that everything is permitted unless specifically prohibited. Theirs hews more closely to everything is forbidden unless specifically authorized. Regulators can be quite powerful if they have the societal backing (and these countries also have a tradition of attracting members of the elite into regulatory positions, perhaps because they do enjoy real power). Greenspan may be unwittingly saying that the Anglo-Saxon regulatory model is ineffective.
More from Greenspan:
The core of the subprime problem lies with the misjudgments of the investment community. Subprime securitisation exploded because subprime mortgage-backed securities were seemingly underpriced (high-yielding) at original issuance. Subprime delinquencies and foreclosures were modest at the time, creating the illusion of great profit opportunities. Investors of all stripes pressed securitisers for more MBSs. Securitisers, in turn, pressed lenders for mortgage paper with little concern about its quality. Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle.
Oh, come on. This wasn’t “investors pressing securitizers” this was “securitizers pressing lenders” because they made such rich fees from this paper. And a lot of this paper was created to help generate more collateralized debt obligations. If anyone had properly disclosed that CDOs were more subject to massive downgrades (from AAA to junk in a single downgrade is not unheard of) would anyone have bought this stuff?
Greenspan next claims that there is no example of a central banker successfully leaning against the wind as regards asset bubbles. Guess he can’t find Australia, whose real estate market was twice as overvalued as ours circa 2004, on a map.
I could go on, but you get the point.
When Richard Nixon tried to rehabilitate his reputation, he didn’t dispute the horrific errors of judgment he made while in office. He instead made useful, substantive intellectual contributions on other fronts. But Greenspan is an ideologue and intellectually bankrupt, so this option may not be open to him.