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Alan the Penitent

Posted By Russ Roberts On October 23, 2008 @ 6:07 pm In Politics | Comments Disabled

Alan Greenspan has been forced to admit the heresy of his youth. He has recanted. The New York Times reports [1]:

Facing a firing line of questions from Washington lawmakers, Alan Greenspan [2], the former Federal Reserve [3]
chairman once considered the infallible maestro of the financial
system, admitted on Thursday that he “made a mistake” in trusting that
free markets could regulate themselves without government oversight.

Note that the phrase "free markets could regulate themselves without government oversight" is from the reporter, Michael Grynbaum. It’s a very strange phrase to apply to financial markets that have substantial government oversight and regulation. The story continues:

A fervent proponent of deregulation during his 18-year tenure at the
Fed’s helm, Mr. Greenspan has faced mounting criticism this year for
having refused to consider cracking down on credit derivatives [4], an unchecked market whose excesses partly led to the current financial crisis [5].

he defended the use of derivatives in general, Mr. Greenspan, who left
office in 2006, told members of the House Committee of Government
Oversight and Reform that he was “partially” wrong in not having tried
to regulate the market for credit-default swaps [6].

Oh I see. Greenspan thought derivatives didn’t need their own regulation. But that wasn’t enough of a confession for the Great Waxman:

But in a tense exchange with Representative Henry A. Waxman [7],
the California Democrat who is chairman of the committee, Mr. Greenspan
conceded a more serious flaw in his own philosophy that unfettered free
markets sit at the root of a superior economy.

Again, that last part is Michael Grynbaum talking, not Greenspan. Now for some actual quotes from Greenspan as the article continues:

“I made a mistake
in presuming that the self-interests of organizations, specifically
banks and others, were such as that they were best capable of
protecting their own shareholders and their equity in the firms,” Mr.
Greenspan said.

Referring to his free-market ideology, Mr.
Greenspan added: “I have found a flaw. I don’t know how significant or
permanent it is. But I have been very distressed by that fact.”

Waxman pressed the former Fed chair to clarify his words. “In other
words, you found that your view of the world, your ideology, was not
right, it was not working,” Mr. Waxman said.

precisely,” Mr. Greenspan replied. “You know, that’s precisely the
reason I was shocked, because I have been going for 40 years or more
with very considerable evidence that it was working exceptionally well.”

So let me take a crack at this. Alan Greenspan thought that banks would never put themselves in a position where they might go bankrupt. Investment houses would never take on too much risk. After all, that could mean disaster and the threat of disaster should encourage prudence. And yet, many banks and investment houses evidently did take on too much risk. The incentives failed.

I too am surprised at how imprudent they were.  Did they miscalculate? Trust the ratings agencies too much? Misread the systemic risk if other firms failed? Did they fail to appreciate the bite of mark-to-market accounting rules that the government required? Or perhaps, this whole incentive thing that is at the root of capitalism, the profit and loss system that incentivizes firms is overrated. People are impulsive and make systematic errors

Those are the key questions of this mess. I have not seen them answered yet.

Meanwhile, I keep coming back to this quote:

“I made a mistake
in presuming that the self-interests of organizations, specifically
banks and others, were such as that they were best capable of
protecting their own shareholders and their equity in the firms."

And the alternative? What should protect the shareholders? The altruism of regulators?

Too bad Henry Waxman never has to answer the questions.

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URL to article: http://cafehayek.com/2008/10/alan-the-penite.html

URLs in this post:

[1] reports: http://www.nytimes.com/2008/10/24/business/economy/24panel.html?_r=1&hp&oref=slogin

[2] Alan Greenspan: http://topics.nytimes.com/top/reference/timestopics/people/g/alan_greenspan/index.html?inline=nyt-per

[3] Federal Reserve: http://topics.nytimes.com/top/reference/timestopics/organizations/f/federal_reserve_system/index.html?inline=nyt-org

[4] derivatives: http://topics.nytimes.com/top/reference/timestopics/subjects/d/derivatives/index.html?inline=nyt-classifier

[5] financial crisis: http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_crisis/index.html?inline=nyt-classifier

[6] credit-default swaps: http://topics.nytimes.com/top/reference/timestopics/subjects/c/credit_default_swaps/index.html?inline=nyt-classifier

[7] Henry A. Waxman: http://topics.nytimes.com/top/reference/timestopics/people/w/henry_a_waxman/index.html?inline=nyt-per


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