Alan Greenspan on the Self-Regulatory Market

Two days after the LTCM bailout was agreed to in 1998, a worried Alan Greenspan, leaning toward raising rates at the time, cut the federal funds rate. It was not enough to calm the markets, and he cut it again three weeks later. . . . It was not the self-correcting powers of the markets but aggressive central bank intervention plus a new round of irrational speculation that provided a floor under the downward financial prices and the calamitous consequences of bad Wall Street decisions. It was not even the LTCM rescue alone by private banks that saved Wall Street” Madrick, p. 281). “Alan Greenspan learned no lessons from these events about the inherent instability of a completely free market in finance. He still insisted markets regulate themselves” (Madrick, p. 282).

Analysis:

Milton Friedman believed that government regulation keeps markets from being efficient; he assumed that the market mechanism is capable of regulating itself. That increasing uncertainty and risk might reach a point that a market mechanism would freeze up, or collapse, rather than simply incorporate the increased volatility through pricing is a point extrinsic to the efficient market thesis. That theory submits that markets tend toward equilibrium, rather than spiraling out of control.
Testifying before Congress after the credit crisis of 2008, Alan Greenspan was asked by Henry Waxman (D-Calif) whether the government-averted credit-market collapse had prompted any revision of the retired Fed Chairman’s economic paradigm. Greenspan admitted to a flaw in the ointment of self-regulatory market theory. In spite of 40 years of evidence to the contrary, official Washington’s font of economic wisdom had drawn a blank.
Lest the human mind be left without an operative paradigm by which one can make sense of the world, by mid June 2011, Greenspan had mentally reduced the fly in the ointment to a mere footnote. Asked by Charlie Rose on The Charlie Rose Show what how the crisis had changed his understanding of the market mechanism and economics, Greenspan admitted his surprise that bank CEOs do not always operate their banks so as to keep them solvent. This is how the financial crisis of 2008 had changed his view of the market mechanism after all. Of course, such a fault could be attributed to distortive government regulation (e.g. regulation Q limiting deposit interest) rather than to some inherent weakness in the market mechanism being able to regulate itself.
Greenspan had backtracked; he had unlearned his lesson much like an alcoholic “forgets” that he or she has admitted to having a drinking problem.  Faced with a fundamental flaw in a paradigm on which it relies, the human mind can succumb to retreating to the safety of denial. In his Structure of Scientific Revolutions, Thomas Kuhn tells us that it can be a generation before the downfall of a reigning paradigm is finally recognized, after the current proselytizers have passed and the people to come, without a vested interest in the prevailing paradigm, have taken their place. Perhaps it is only the human mind writ large (i.e, intergenerational) that advances, or really learns.
Lest we have to wait for the dead to bury themselves, we can affirm and acknowledge right now that the market-mechanism is not inherently self-regulating, and that this flaw is not caused by government regulation. Instead, markets can collapse—just as a human being freezes up from fear when risk and uncertainty hit a certain threshold—only to be revived by governmental intervention.  

Source:

Jeff Madrick, Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present (New York: Alfred A. Knoff, 2011).

See also Skip Worden, Essays on the Financial Crisis, available at Amazon.

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 “dot.com” 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. 

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

Conflicts of Interest and Paradigm-Shifts: The Case of Financial Regulation

It is perhaps all too easy to perceive a sea-change in perception when the reality of societal change is much more gradual. There is something to the argument that John D. Rockefeller’s reputation was salvaged in the 1930s not because the old man was passing out dimes, but, rather, simply because he had outlived his critics. Similarly, Thomas Kuhn, in his text on paradigm changes in scientific revolutions, bemoans that the advocates of a default theory must finally die off before their darling can finally be replaced by a new one. In other words, any given person is not apt to shift paradigms. The culprit, I suspect, is pride, which Augustine suggests in his writings is inherently self-idolatrous. I believe the human brain is capable of accepting inter-paradigmatic change, just as a person can be humble. That this is not the norm does not mean that we ought not raise our expectations to it.

The full essay is at Institutional Conflicts of Interest, available in print and as an ebook at Amazon.

On the Arrogance of Power: Greenspan, Rubin, and Summers in the Clinton Administration

Over two years after the financial crisis of 2008, a commentator on Fox News said that the banks should not stop the foreclosure process because that would not be good for the free market. He said that people who cannot afford their houses should lose them. Another commentator remarked that there was still too much government in the financial sector. This, according to the commentator, is “the problem.” It is particularly striking that Alan Greenspan’s stark admission to a U.S. House committee in 2008 that the deregulated laissez faire market paradigm contains a fundamental flaw was lost on the two commentators. In May 2011, House Speaker Boehner charged that business is over-regulated. This comment too is remarkable given Greenspan’s realization. If a people disowns its own lessons, history is destined to repeat itself.

The full essay is at Essays on the Financial Crisis.