Alan Greenspan

The gist of his argument appears to be that it is just too hard to regulate today’s global economy. He failed, or, to use his own words, was “caught flat-footed” by the crisis, and therefore so will all future regulators. Greenspan has always been known for being a man of few, and very obscure, words, but his analysis explaining this reasoning includes an interlocution that will go down in history as one of the greatest examples of purposefully idiotic misdirection of all time.

The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems. Today’s competitive markets, whether we seek to recognize it or not, are driven by an international version of Adam Smith’s “invisible hand” that is unredeemably opaque. With notably rare exceptions (2008, for example), the global “invisible hand” has created relatively stable exchange rates, interest rates, prices, and wage rates.

The Interwebs are already having too much fun with that clause, so there’s little need to belabor it here — but feel free, if you so wish! Suffice to say, it should only require one global economic catastrophe that throws tens of millions of people out of work, threatens the entire  banking system with bankruptcy and destroys the finances of governments from Wisconsin to Portugal before we feel inspired to do a little tinkering with the rules that govern the financial sector.

But that’s too easy. There are two other substantive parts of Greenspan’s editorial that deserve attention. The first is his little list of unintended outcomes in the aftermath of the passage of something as complicated as the Dodd-Frank bank reform bill. For Greenspan, the fact that there have already been “regulatory inconsistencies whose consequences cannot be readily anticipated” is evidence, again, that we should never have dared attempt to master the unruly beast.

But I don’t think any fair-minded person would be surprised that an undertaking as complex as bank reform (or healthcare reform, for that matter) would include kinks in the system. A responsible approach would be to treat reform as an iterative process. You try something, and then adjust as the situation warrants. If legislators of both parties were committed to the same goal — a better regulated financial system — we might even be able to make some progress. But when one side shrugs off recent disaster as a “notable exception” and immediately returns to its fundamental, bank-lobbyist mandated position, that regulation is bad for business, then incremental process becomes impossible. Republicans don’t want to fix Dodd-Frank, they want to destroy it. Greenspan is giving them cover.

The second major thrust of Greenspan’s editorial is his theory that higher levels of financial complexity are inextricable from rising standards of living.

Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago? That may not be possible if we wish to maintain today’s levels of productivity and standards of living. During the postwar years, the degree of financial complexity has appeared to grow with the rising division of labor, globalization, and the level of technology. One measure of that complexity, the share of gross domestic product devoted to finance and insurance, has increased dramatically.

So suck it up, America! If you want your flat-screen TVs, iPhones and organic gourmet food, you’re going to have to accept unregulated derivatives trading and excessive Wall Street CEO compensation.

Oh, and the possibility of occasional massive financial disasters. At Marginal Revolution, Tyler Cowen produces a neat chart that track the GDP share of U.S. financial industry. And yes, it does rise steadily since 1940.

But it also rose steadily between 1880 and 1929, when it reached a height that would not be matched gor another 50 years.

Something happened right about then, but best not to dwell on it, because, after all, it’s obviously just another one of those “notable exceptions” — since it only happened once in the entire 20th century.

(Atlanta Fed president Jack Guynn is discussing his negative views on the housing boom:)

My supervision and regulation staff thinks this is an accident waiting to happen in our area. And while the local market excesses probably do not represent systemic national risk, the shakeouts could have serious regional consequences. My bank supervision staff points out that housing-related credit risks to our bank lenders are not so much from defaults on permanent mortgage financing that we talked about yesterday, but rather from lending for land acquisition, development, and construction. The ugly picture we have seen before — and that they think we may very likely see again before long — goes something like this: the drying up of sales of new units; the painful decision of developers to go ahead and complete the construction of additional units to make them saleable, further depressing the market; and speculators who had hoped to see big capital gains walking away or defaulting on their contracts, giving their properties back to the lender. Perhaps it’s because of where I sit, but I am less comforted than some of my colleagues about the housing situation …

CHAIRMAN GREENSPAN. Let’s take a break for coffee.

Most economically damaging coffee break of all time? Perhaps, but skimming through the report, I was also taken by a long summary of the subprime mortgage market, delivered by Fed Gov. Mark Olson.

… I, too, looked at the mortgage market in anticipation of the theme of our discussions yesterday. But I also had a concern about the extent to which the mortgage market might be creating froth in the market … mortgage terms are indeed becoming more flexible and less restrictive, creating certain defined risk exposures …

There is a lack of consensus as to how the relaxation of credit standards will impact safety and soundness. To date, loan delinquencies have remained modest, both within and outside of the banking industry. However, the undiminished appetite, particularly for the nonconforming mortgage product, has allowed for the flexibility to continue. And there is no slowing in sight, despite all the warnings that we have heard and indications in some markets that there has been a leveling, and even a decline, in some property values …

… As for the secondary market, why is that market so avaricious? I’d cite a number of reasons. There are many new investors, including the hedge funds, with minimal experience in dealing with market uncertainties. There are many new products; 50 percent of the mortgage-backed products are either alt-A or nonprime. That’s the flow, as we discussed yesterday. There is evidence of a lack of secondary market discretion, including the ability to price for risk; the risk premium simply does not reflect the risk embedded in that product … It’s not clear at this point if the MBS market will be an efficient distributor and disseminator of risk or if those in that market will be the last to recognize the risk that’s embedded in what they’re doing and know how to price it.

The warning signs were written in blazing Day-Glo orange on the Fed temple walls. Greenspan ignored them, and the U.S. economy hurtled directly into the worst economic disaster since the Great Depression.

Paulson made minor headlines a few weeks ago when he donated $20 million to his alma mater, New York University’s Stern School of Business. But I did not learn until this morning, via The Big Picture, that a portion of those funds was designated to endow the Alan Greenspan Chair in Economics.

“His generous gift will … further strengthen Stern’s research capability, particularly in the areas of finance and economics,” said Thomas F. Cooley, dean of NYU Stern.

Alan Greenspan is on record as supporting the innovation in mortgage products that ended up going kablooey in the dot-com bust. He was warned that mortgage lenders were running amok but did nothing to stop it. One can even argue that no single person has done more than Alan “the Maestro” Greenspan to intellectually support the thesis that the financial sector should be regulated as little as possible.

So, to be blunt, Alan Greenspan’s hard work made John Paulson’s big bet possible. Let’s hope at least some of the students taught by whoever occupies the Greenspan chair devote their energies to understanding exactly how that happened.

I’m having a little trouble parsing those sentences. If the stock market is a leading indicator, then the ten percent drop in the Dow Jones Industrial Average in the last quarter (the worst performance since the fall of 2008) suggests that the economy is headed south. But Greenspan also appears to be saying that the slumping stock market is now responsible for the slowing economy. Can the stock market be a leading indicator and the prime actor at the same time?

I don’t think there is much mystery as to what is going on in the stock market. GDP growth for the most recent quarter has been revised downwards twice. The labor market recovery has stalled out — on Thursday, the Bureau of Labor Statistics reported that jobless claims in the U.S. rose again last week. Europe has all kinds of problems and manufacturing growth is slowing in China. The U.S. government is hamstrung — despite a phenomenally low cost of borrowing (the yield for a ten-year-maturity Treasury bond is under 3 percent) — the prospect of additional counter-cyclical government spending is nil.

I would like to believe Greenspan is right, but where’s the evidence?

First, two paragraphs from his Journal piece.

The current federal debt explosion is being driven by an inability to stem new spending initiatives. Having appropriated hundreds of billions of dollars on new programs in the last year and a half, it is very difficult for Congress to deny an additional one or two billion dollars for programs that significant constituencies perceive as urgent. The federal government is currently saddled with commitments for the next three decades that it will be unable to meet in real terms. This is not new. For at least a quarter century analysts have been aware of the pending surge in baby boomer retirees….

We cannot grow out of these fiscal pressures. The modest-sized post-baby-boom labor force, if history is any guide, will not be able to consistently increase output per hour by more than 3 percent annually. The product of a slowly growing labor force and limited productivity growth will not provide the real resources necessary to meet existing commitments.

Sounds grim, doesn’t it. We’ve seen this coming for 25 years, but in the last year and a half, we’ve lost all restraint and the only hope now is massive cuts in spending.

With that in mind, let us jump in Alan Greenspan’s hot tub time machine (yes, I conjured up that image on purpose) and return to 2001, when the U.S. federal government was sitting on a fat budget surplus. Back then, Alan Greenspan’s big fear was that the government might actually end up paying off the national debt, and then start using its surplus to accumulate assets that rightfully belonged to the private sector. The future looked too bright!

The most recent projections from OMB and CBO indicate that, if current policies remain in place, the total unified surplus will reach about $800 billion in fiscal year 2010, including an on-budget surplus of almost $500 billion. Moreover, the admittedly quite uncertain long-term budget exercises released by the CBO last October maintain an implicit on-budget surplus under baseline assumptions well past 2030 despite the budgetary pressures from the aging of the baby-boom generation, especially on the major health programs…

Indeed, in almost any credible baseline scenario, short of a major and prolonged economic contraction, the full benefits of debt reduction are now achieved well before the end of this decade — a prospect that did not seem reasonable only a year or even six months ago. Thus, the emerging key fiscal policy need is now to address the implications of maintaining surpluses beyond the point at which publicly held debt is effectively eliminated.

So what happened? As Tim Fernholz reminds us, the fiscally prudent policies pursued and implemented by President Bill Clinton were summarily abandoned — with Greenspan’s tacit approval. The Bush tax cuts, the Iraq and Afghanistan wars, and the prescription drug benefit — none of which were matched by spending cuts, or balanced by offsetting revenue — quickly erased the surplus. Meanwhile, the new spending initiatives of the last year and a half were a direct response to a “major and prolonged economic contraction.”

Funny how it works, huh? When running a budget surplus, Greenspan did not foresee a problem in dealing with the expenses likely to ensue from baby boomer retirement. Instead, the problem was the surplus! But when running a deficit because of policies executed by a Republican government while he was in charge of the Federal Reserve, combined with a rescue effort aimed at counteracting the effects of the financial disaster for which he was at least partly culpable, suddenly, the future is a threat.

I am reading, right now, Liaquat Ahamed’s stunningly good “Lords of Finance,” an exceedingly well-written and fascinating look at the central bankers who bungled the world’s way into the Great Depression. At the outset, Ahamed notes that while the four men who are the focus of his attention, England’s Montagu Norman, the U.S.’s Benjamin Strong, Germany’s Hjalmar Schacht, and France’s Emile Moreau were, during the ’30s, towering figures of international renown, their names have mostly been forgotten now.

Greenspan, I hope, will not be so lucky. But if he is, here’s hoping that the 22nd century spawns a historian as excellent as Ahamed to remind a new generation just how disastrous the tenure of Alan Greenspan was as Federal Reserve chairman, and how the Wall Street Journal regularly provided a venue for his self-serving, blind hypocrisy.