Friday, April 11, 2014

Alan Greenspan: How to Break the Back of a Market-Bubble

While being interviewed on CNBC on March 7, 2014, Alan Greenspan spoke a bit on the problem of irrational exuberance in a market. Pointing to the failure of the Federal Reserve under his chairmanship to innocuously dissolve the “” bubble in the 1990s, Greenspan said he had come to the conclusion that asset-appreciation bubbles cannot be “defused” (for reasons he says are in his new book) “unless you break the back of the actual euphoria that generates the bubbles.”[1] Alas, piercing that wave would involve nothing short of unplugging a basic instinct in human nature; both monetary and fiscal policy would doubtless come up short. However, I suspect that the field of rhetoric may have something to say about how we can deflate societal exuberance, but only on the condition that greater clarity will have been achieved in identifying whether a given market is overvalued due to emotional excess (i.e.g, emotive greed having reached a critical mass) circumventing normal risk-aversion.

Greenspan’s prescription may have more to do with social psychology than economic theory. Even though the former central banker’s expertise or ken does not extend to psychology or sociology, the advice darts right to the central question to be researched. I am not suggesting that the claim be swallowed whole; back in 2008 after Lehman Brothers’s financial collapse and the subsequent  portent of a tsunami so powerful it could take the entire global financial system “by Monday,” Greenspan admitted in Congressional testimony that his mental model of financial economics suffers a fatal flaw he had had not seen coming.

Having held a free market, or laissez faire (let it make or do), theory firmly ensconced in his head, Greenspan suddenly realized that the market mechanism may not “price additional risk” once the market volatility reaches a certain point. Instead of asset-prices plummeting until enough buyers return to the market after having been spooked, the financial markets themselves freeze up. This is why Greenspan’s successor, Ben Bernanke, told Congressional leaders in September 2008 that without a bailout “we might not have an economy by next Monday.”

In other words, Greenspan’s paradigm or theory, which had insisted that markets can always self-correct could not account for the credit-freeze that began in the commercial paper market (over-night inter-bank loans). High volatility in a system combines with the high risk (from anticipations of system risk being actualized) shuts down the market mechanism itself. When he ran the Federal Reserve, Greenspan had been very wrong about the impact of the systemic risk on the ability of markets to keep operating.

As if Greenspan's admission had been part of some nightmare or some figment of the imagination, Andy Sorkin, a financial markets host at CNBC, welcomed Greenspan on the air five years later with such vaunted praise that viewers could be forgiven for not having remembered that Sorkin had pointed to Greenspan’s fatal flaw as one factor among several in the near collapse of the housing market in the wake of Lehman's bankruptcy. Surely Sorkin was hardly oblivious to the ex-central-banker's grave error. Why then did the journalist act as if Greenspan were one of the priests at the Greek oracle? 

Even after admitting the fatal flaw he had held at the Fed, Alan Greenspan still enjoyed considerable respect. (Image Source: The Guardian)

The short answer may be that Sorkin did not want to lose any of the rich and powerful friends on Wall Street he had interviewed in 2008 for his book. For a person to admit the existence of a fatal flaw in his or her ideology and therefore in any supporting theoretical models as well, and then be treated as though infallible on another body of knowledge (i.e., international relations) stretches the mind's capacity for holding a logical contraction (i.e., cognitive dissidence). Rather than being limited to Sorkin, I suspect that the refusal or inability to put a person's present statements in the context of his or her past track-record is by now "hard-wired" into American society. The over-valuing of the new at the expense of the past probably enables the denial. 

Regarding Sorkin, his fawning before his notable interviewee, including exclaiming "wow" as Greenspan went on bragging at the beginning of the interview, strikes me as blatant enough to be misleading. Especially in having written a non-fiction book about the financial crisis of 2008, Sorkin should have prepped the television viewers up front, so they would not find themselves back to swallowing wholesale what Greenspan says as the Gospel truth. In fact, Sorkin may have inadvertently opened the door to another systemic bubble hitting us as a complete surprise. 

1. “Greenspan Revisits ‘Irrational Exuberance,” CNBC, March 7, 2014 (accessed same date).