In the first part of this response to Alan Greenspan’s draft paper for the Brookings Papers on Economic Activity titled “The Crisis” I presented the political and economic canvas of the economic circumstance that Alan Greenspan was attempting to explain.
Robert Samuelson of Newsweek had called his critique of Greenspan’s paper “Greenspan Strikes Back”. That title is revealing, coming from the Washington media establishment. If the fourth episode of Star Wars is called “The New Hope”, reminding the readers of Bill Clinton and Hope, Arkansas, not to forget the hope leitmotif of Barack Obama, “Greenspan Strikes Back” will trigger images of its sequel, the fifth episode, which George Lucas had called “The Empire Strikes Back” in 1980. Even Dick Cheney, a good friend of Alan Greenspan’s, had been compared to Darth Vader during the last election campaign. The ruptures in the Clinton economic coalition under the stress of this crisis are becoming evident as Greenspan is attempting to recover his reputation that was assaulted by the crisis and delineate his legacy from the rest of Clinton’s economic team.
In this part I will attempt to provide a detailed critique of Greenspan’s largely technical paper to set the stage for a less partisan but a more policy oriented debate about the issues that were involved in the crisis using the structure of Greenspan’s paper itself.
It is interesting that Alan Greenspan calls this section “Preamble” as if to remind his readers of the United States Constitution. For a sophisticated man who likes to speak in nuances and between the lines, opening his argument with the word “preamble” could be suggestive of his belief that the crisis was in the interest of the American people, on net. As they say in baseball, it is not over until it is over, and therefore, that judgment will have to wait, even if the intent was to promote the general welfare of the American people.
The structure of the paper does not mention the key cause of the crisis: a trade policy that resulted in the present global imbalances. He sticks to what the Fed had done when he was Chairman. Without an elaborate discussion of trade policy as I have presented in Part 1 of my critique, Alan Greenspan’s technical monetary and regulatory policy explanations and advice would be inadequate.
II. 1. The Arbitraged Global Bond Market and the Housing Crisis
1. In this section he directly shifts to the economic core of the problem: the bond market and the related housing crisis. He is correct because the housing crisis was indeed caused by a policy of offering the bond desks in the global investment banks an alternative, enabled by financial innovation, to government securities that returned better yields, while in the process overextending Fannie Mae and Freddie Mac, the two government sponsored enterprises (GSEs) that support the U.S housing market.
2. Still, Greenspan, a master of linguistic legerdemain especially when providing explanations for economic outcomes of policies, uses the word “toxic”, a populist word to characterize the problem. This description, that implicitly pleads ignorance, is highly contentious because the subprime crisis, fueled by teaser introductory rates that would adjust up once that period expires, was entirely predictable when making those loans based on the income statements of the borrowers. Even when housing loans were being originated without verifying incomes, it was in the interest of the originators to originate those loans to collect origination fees, transferring their risk to the financial institutions that were funding the cottage industry of mortgage origination. The toxicity of subprime mortgages was a self-fulfilling prophecy.
3. Had there been no confidence on the part of the financial markets that once these loans reset and the risk of foreclosure and hence the depreciation of cash flow from them increased the government would come to their aid, those loans would not have been made or financial innovation would have created alternative instruments to restructure the reset loans to keep collecting the mortgage payments by keeping the borrowers in their homes. This implies that the expected toxicity was introduced intentionally without regard to the consequences for the borrowers because the Fed and the Congress would be there to save their homeownership policies.
4. Alan Greenspan who has a high regard for elected officials has always been careful not to incur the wrath of his political masters and this sentiment comes through. But given the evidence of his own rhetoric while at the Fed that, as a standard practice, presented all sides of the issues involved at all times even as he remained politically correct bending to the wishes of the Congresses and the presidents he served, sometimes central bank independence demands having to incur the displeasure of the politicians as Paul Volcker had done from 1979 to 1987, because but for Volcker’s independent streak Alan Greenspan would not have inherited 5 per cent CPI inflation in 1987.
5. Greenspan’s skewed assessment of China which continues in this paper from his book “Age of Turbulence” for which he had received a handsome book advance of $8 million as soon as he left the Fed only to open his private consulting firm to advise large clients that include foreign governments makes his credibility when opining about U.S economic policy highly suspect because of the non-transparent nature of carrying out what a small group of people in U.S policy making may be thinking is in the U.S interest without democratic public accountability. It is precisely such shadow behaviors, very much in tune with the crowd that congregates annually at the World Economic Forum in Davos, which must be made transparent.
6. China is not replicating the model of Asian Tigers but is emulating the rise of the United States after the Industrial Revolution. It is also employing its vast dollar reserves, even as it prepares to float its currency, to compete with the United States in the same vein that the G7 employs global resources for its benefit as I discussed in Part 1 of this response. American-led globalization, to its own detriment, is teaching the rest of the world how not to behave. One can only wonder if this is in the national interest or in the self-interest of the shadow, unaccountable elites.
7. Alan Greenspan claims that one of the two factors that led to low consumption in emerging markets is culture. The implication is that cultural change elsewhere is necessary for economic development. And that cultural change is a steady push of foreigners to adopt Anglo-American cultural behaviors similar to the assimilation of countless immigrants into the United States at the expense of their native cultures and languages, or to put it differently, the transaction for a better life is to tow the Anglo-American line, globally. Such a warped, neocolonial view of globalization, inculcated in the top Anglo-American universities where most of the recruits into the influential public and private institutions around the world come from, does not advance the national security interests of the United States. The desire to be free far precedes the establishment of the British monarchy a mere 1000 years ago and the environmental and geopolitical imbalances brought about by the Industrial Revolution must now be cleaned up to ensure the sustainability of the planet.
8. Greenspan’s technical analysis of global savings is just as warped. There are three components to disposable income allocation by emerging and transition countries: low consumption (C), mediocre conventional savings (O) and high rates of hoarding (H) in the absence of well-developed financial markets and social safety nets.
If D is the disposable or after tax income and C is the consumption, then savings
S = D – C
If S = H + O then
H + O = D – C
Because the investment I = O, or the non-hoarded savings circulating in the economy,
O = I < H + O (or < S = D – C), globally.
A major portion of the O found its way into advanced country financial markets, gradually declining over time as the Great Moderation ended.
H = D – C – I = D – C – O, globally.
The distribution of H worldwide was prevalent mostly in the emerging, transition and underdeveloped countries. Hoarding implies the need for well-developed financial markets and social safety nets in those countries.
9. It is possible that in the last decade, domestic savings have risen in the developed countries and hoarding has fallen in the developing countries, raising investment and consumption in developing countries without necessarily doing so in developed countries which partly explains the end of the Great Moderation and continued higher growth rates in the developing countries. The trend of advanced country savings finding their way to developing economies is more pronounced than those savings remaining within developed countries in the form of higher domestic investment.
10. Lower long-term interest rates were due to foreign non-hoarded savings returning, in part, to the safety of well-developed financial markets. The convergence of inflation and long term rates can be explained by the flight to safety of global capital and the reinvestment of the same in developing countries through foreign trade to reduce inflation. Further, the economic slowdown may have also contributed to lower levels of inflation due to downward pressure on resource consumption. 2000-2005 data may indeed be showing stability in interest rate fluctuations as well in the interest rates themselves, following and dominated by the U.S trend in the federal funds rate from 2000-2003, given the negative shocks to the global economy beginning with the collapse of the tech bubble.
II. 2. Securitization of Subprimes: The Crisis Story Unfolds
1. Alan Greenspan argues that housing demand was inelastic at a higher level of demand. True. But not because the incentives were politically mandated but because the mandated incentives were used and abused by the market place. Had the incentives been removed, the housing demand would perhaps have gone down. But the policy question is if those incentives should be removed or if lending and borrowing should be better regulated in two scenarios: with and without the GSEs.
2. Once again, Alan Greenspan uses the phrase “in retrospect” which is almost reminiscent of Robert McNamara’s book of the same title about Vietnam, to describe the fact of grossly inflated credit ratings. Just as it is with the word “toxic”, the credit ratings were well known to have been compromised during the housing bubble. After all, the best and the brightest who were involved in JFK’s and LBJ’s Vietnam knew what was going wrong. And it seems, so do those in the Clinton economic team. All competent doctors realize that there can be no cure until the patient is willing to acknowledge the presence of the disease.
II. 3. A Classic Euphoric Bubble Takes Hold
1. Most fundamentally, the data on the prices and yields of housing related securities is not reliable within the framework of conventional economic analysis of general equilibrium because these assets are all, without exception, traded over the counter (OTC) .
2. Alan Greenspan says “[a]lmost all market participants of my acquaintance were aware of the growing risks, but also cognizant that risk had often remained underpriced for years.” If this is so, then why was the knowledge of the credit ratings in retrospect but not in real time as I argue above?
3. True to his style of analysis, Alan Greenspan says “I raised the specter of [‘]irrational exuberance[‘] in 1996 only to watch the dotcom boom, after a one-day stumble, continue to inflate for four more years, unrestrained by a cumulative increase of 350 basis points in the federal funds rate from 1994 to 2000. Similarly in 2002, I expressed my concerns before the Federal Open Market Committee that [‘]. . . our extraordinary housing boom . . . financed by very large increases in mortgage debt – cannot continue indefinitely.[‘] It lasted until 2006. Clearly with such experiences in mind, financial firms were fearful that should they retrench too soon, they would almost surely lose market share, perhaps irretrievably.” True. Similar fears must exist with the ongoing Chinese trade bubble.
4. Continuing, Alan Greenspan bolsters his argument with a dose of Wall street sentiment by citing Citigroup’s Charles Prince’s “now famous remark in 2007, just prior to the onset of the crisis, that [‘]When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing [‘].” Wall Street, perhaps privately echoing the Fed’s worries while being unable to do much through their actions begs the question as to why the music stopped after 2006 when the Fed raised interest rates during a bubble to a supposed, but unstable, neutrality at 5 per cent federal funds rate.
5. The FOMC raised rates during a bubble solely driven, for good reason in spite of the bubble conditions, due to inflation and inflation expectations and this is something the markets must bear in mind because the markets could have restructured the failing underlying cash flows preemptively to prevent a crisis from precipitating. Expecting the music to stop was indeed rational and the Fed was credible in raising rates. The Fed’s credibility was hurt because of the expectation that it would cut rates in the event of a crisis, without which the markets would have demonstrated precautionary motives in the housing market.
6. Given the largely technical context of the paper, it appears that Alan Greenspan is avoiding all mention of the political environment after 2006. He can also be afforded the benefit of doubt because he had left the Fed in early 2006. As the presidential elections drew near and Hillary Clinton’s candidacy became viable and particularly, as the Iraq war began receding as a wedge issue between the Democrats and Republicans, the tactical politics of electioneering clearly resurrected the ghosts of Bill Clinton’s 1992 campaign theme of “It’s the economy, stupid” against George H.W. Bush. Within the Fed, during the farewell ceremonies for Alan Greenspan, this sentiment was pervasive and nakedly transparent.
7. It was amply clear that the Democrats would benefit by slowing down the economy just in time for the 2008 election to get Senator Clinton elected the first woman president of the United States. Barack Obama happened to be the dark horse who had unwittingly benefited from those economic machinations, lacking an economic team of consequence until the Democrat primaries were finished in June of 2008 at which time the Clinton economic team had moved to support the Democrat party nominee. Such behavior is unbecoming of the Federal Reserve given its statutory independence from politics because such revealed institutional preferences cast a shadow on the independence of the economic judgment of the Fed board and its large economist bureaucracy: does Fed policy mask its political preferences with the veil of independence?
8. Greenspan, an ardent advocate of hands-off bubble policies that have defined his many terms as Chairman of the Federal Reserve (and continues to hold that view at the end of his paper), defines “a bubble as a protracted period of falling risk aversion that translates into falling capitalization rates that decline measurably below their long term trendless averages. Falling capitalization rates propel one or more asset prices to unsustainable levels.” He is saying that financial assets are demanded more than they are supplied, raising prices or to put it differently, the demand curve for the assets shifts up, to the right, with the supply not sufficiently shifting out to meet the rising demand. Still, because the market is not exchange traded for these assets, how do we know what the Marshallian demand and supply curves are to ascertain the veracity of the equilibrium prices of these assets?
9. In a footnote, Greenspan, on perceptions of risk, notes that he is “defining risk aversion more broadly than the narrow economic definition in terms of utility over different outcomes.” He says:
“[r]isk aversion, as I use the term, encompasses all factors that govern individuals’ willingness to engage in risky actions. Most notably, it encompasses not only their preferences toward risk, but their perceptions of risk. Risk aversion is the primary human trait that governs the pricing of income earning assets. When people become uncertain or fearful, they disengage from perceived risk. When their uncertainty declines, they take on new commitments. Risk aversion can thus range from zero to full.
The extremes of zero and full risk aversion, of course, are outside all human experience. Zero risk aversion – that is, no aversion at all to engaging in risky actions – implies an individual not caring about – or not being able to discriminate among – objective states of risk to life and limb. Such individuals cannot (or do not choose to) recognize life-threatening events.
To achieve the food, shelter, and the other necessary contributors to living requires action, that is, the taking of risks, by either an individual or by others on the individual’s behalf. Eschewing all objective risk is not consistent with life. Thus full risk aversion, like zero risk aversion, is a hypothetical state that we never observe in practice.”
Alan Greenspan is not redefining risk here in any fundamentally different way. He is effectively restating risk averse, risk neutral and risk loving behaviors as defined in standard microeconomic theory. The reality of portfolio management in the markets is that these same distinctions exist but a higher level of mean risk: it is risk aversion, neutrality and risk loving behaviors among risk lovers who on average take a higher level of risk in the equity and derivative markets that are not risk-free, explaining the equity premiums over risk-free assets.
10. Large bank buffers were replaced by the promise of the Fed to stand by in the event of any market crash, similar to 1987. Basel II negotiations after Gramm-Leach-Bliley (GLB) exempted large banks from holding large capital buffers. Now, it is the same group of policy makers, Alan Greenspan included, who are arguing for the opposite, a day late and a dollar short, but the reform is not as simplistic as raising equity capital cushions because equity capital is worthless in a crisis. It is as good as not reforming the financial regulatory system. Models do not anticipate crises. Trader judgment does because the timing of the precipitation of sharp declines in asset prices is the only factor that validates the judgment, which has normative components based on the power relationships in the financial markets, especially given that this crisis was entirely caused by the unregulated markets.
11. Alan Greenspan diagnoses the underestimation of tail risk as the principal cause of the failure in risk management. The tail risk underestimation seems to be only now apparent to Greenspan (even though he is using a positive analytical framework to argue subtly for more data) because the cumulative concentration of misallocated capital since 1987 effectively tied the hands of the Federal Reserve to continue to unconditionally recapitalize the poorly managed balance sheets of the financial institutions because the political and social forces have rendered such unconditional recapitalization untenable, even though the Fed may have attempted to buy credibility for such policies through the voices of Nobel Laureates such as Edmund Phelps in the opinion pages of the Wall Street Journal (WSJ) and the World Economic Outlook (WEO) of the International Monetary Fund (IMF).
The unacknowledged and neglected political and social factors in neoclassical economics together with the known reasons for market failure ― lack of transparency and moral hazard ― contributed to the collapse and the inability of the government to act, without significant reform, in ways other than the confines it set up for itself: unconditional recapitalization with an ideological trust in the capacity of the markets to repair themselves.
Further, even if the political establishment succeeds in convincing the populace in the United States of a persistently higher level of structural unemployment to shift the American capacity to consume into a smaller but wealthier consumer base in the top two or three quintiles of American consumers, still financed by debt, the social unrest of the rest being contained by an expanded social safety net to continue the mode of Clintonomic globalization, it would be detrimental to the balance of geoeconomic and political power in the world, driven by singular faith in a policy paradigm to economically integrate the world through American political and economic power.
There are better and more sophisticated ways to do the same in a manner that can be a win-win for all the stakeholders rather than controlling the balance sheets of countries in a neocolonial fashion. It is this failed policy paradigm of engendering negative economic competition that has resulted in the current crisis finally hitting home, because an “insatiate cormorant soon preys upon itself” proving Lenin’s analysis that capitalism has the seeds of destruction within it correct, but only because of the failure of democratic checks and balances: economic crises, and more generally crises, need not be instruments of democratic change.
12. Alan Greenspan hypothesizes that the regulatory system had failed under crisis pressure. The system did not fail because of poor regulation under crisis pressure. If this is entirely true, it means the regulatory system is inadequately prepared for crises and therefore needs some kind of enforcement and/or structural reforms. But the crisis had resulted from chronically treating monetary accommodation, in the event of a crisis, as a substitute for ex ante effective regulation, which still means that the regulatory system requires internal checks and balances (political independence being an important part of it) as well as structural reforms to be parsimonious, yet effective.
III. 1. The Purpose of Finance
1. Financial globalization through the U.S. dollar since WWII has contributed to the trend increase in the share of finance as a part of U.S GDP. The trendlessness since 1990 perhaps represents a deviation from the historic trend up, as an outlier, because of the end of the Cold War, which implies, the outlier can be brought into the explanation using the transition and emerging economies as instrumental variables in three epochal episodes: (a) getting off the gold standard after 1929; (b) exiting the Bretton Woods fixed-exchange rates system in 1971; and (c) the end of the Cold War.
Given the short time period since 1989, the trends will be well mapped out with the structural breaks ex post (the future of the dollar as a global reserve currency is uncertain and is dependent on several normative factors, which could make the world dollarized or confine the dollar to a time period of a 1989-2029 trend), once all the data is in, because econometrics cannot predict structural breaks nor can it definitively ascertain causality.
2. Alan Greenspan quite correctly points out the steadily rising share of employment in the finance industry since 1947. The nature of the purely knowledge-based services industry is that it is less labor intensive relative to the rest of the economy. However, this may have also changed since 1989 because the thrust of financial globalization since 1993 has been to shift the human capital of the United States labor force into the knowledge-based services sector and to outsource the rest of the non-farm labor-intensive production abroad to reduce inflation (Robert Reich). This strategy has not been very successful because the theoretical expectation of knowledge-based management of the global economy cannot continue forever. At some point, unless U.S knowledge services employ a significant proportion of the taxpaying households persistently because of the higher value embedded in U.S knowledge-based services that comparative advantage fades very quickly because of geopolitics.
3. Even if Alan Greenspan is claiming that the salutary net effect of Clintonomics has been to add about 500 million people into the global labor markets, the process of that integration has exposed the world to the currently persistent and serious threat of global imbalances and the consequent geopolitics. Classical long run market clearing, as much as Alan Greenspan wishes it, could imply disruptive geopolitical changes in the stable parts of the world such as the G7 countries. It is not a sacrifice worth making because global economic integration can be salvaged through better policies that correct the excesses of the Bill Clinton-Alan Greenspan era and put the world on a more balanced path of global integration that upholds the democratic values of the post-World War II world order. The unequivocal implication of this is that China is not yet a well integrated country but the most important country awaiting political-economic integration.
4. Still, Alan Greenspan sees regulation as a market friction that can lower GDP growth. He sees regulatory reform as necessarily increasing the amount of regulation perhaps because he is apprehensive of the possibility that any regulatory reform in the aftermath of the crisis will bring into its fold the currently unregulated markets which make up about 40 per cent of all financial market activity. Whatever may be Alan Greenspan’s sentiments on this issue, all financial market activity must be subjected to government regulation and supervision, varying only in its structure as a function of the type of financial market activity. Government regulation must flexibly evolve, with minimal inertia, with the changing market structure at all times to facilitate market clearing. Designing such a regulatory structure should not be counter to Alan Greenspan’s belief that market flexibility must be held paramount at all times. Regulation is a pure public good. The freedom of the very wealthy from government oversight at the expense of the rest of the society, trusting their good intentions, is fundamentally antithetical to the values of democratic governance and the American structure of government.
III. 2. Risky Financial Intermediation
1. Perfect markets largely regulate themselves by punishing poor business practices and rewarding sound business practices. This is known as the Efficient Markets Hypothesis. That the converse has been the outcome indicates that government intervention had made that possible through ill-designed de facto and de jure incentive structures because of political contamination. Meaning, regulatory reform was necessary and it had not occurred.
2. Greenspan, along the lines of his preference for unregulated financial innovation, likes leverage and prefers the markets to regulate their own leverage through better counterparty surveillance though he is unsure as to how that can be achieved. Simplicity demands that all financial market transactions take place in open markets with all instruments traded on exchanges. The market for leverage could be similar, charging high interest rates for unrealistic expectations of leveraged returns and reasonable rates for sensible market practices. What has transpired thus far has been market manipulation through financial innovation rather than the increase of market efficiency.
3. The directionality of the movement of economic variables is being influenced in all markets: equity, commodity, government debt and currency by the shadow markets normatively to obtain higher than average rates of return on a consistent basis, with the governments of the world losing control of the global economy to the unregulated financial interests such as Davos. The conventional economic analysis of the equity premium puzzle has become irrelevant. Is U.S government paper as riskless as it used to be because of Clintonomics? Exposing sovereign debt to the fault lines of financial intermediation can raise the risk of sovereign default even for the G7 countries, because financial intermediation at its root is predicated entirely at the moment on sovereign debt.
4. In this crisis, very interesting and paradigm shifting policy possibilities emerge from the phrase “unusual and exigent” in the Federal Reserve Act as amended by the United States Congress to which neither the Federal Reserve nor other central banks have paid as much attention as is necessary.
5. The positive analysis of risk distribution, even if accepted for the purposes of assumption, does not naturally lead to the reversal of Base II capital requirements for large banks given the normative nature of the unregulated financial market activities. The banks can no longer be trusted with a needlessly complicated Basel II regime even if capital levels are made progressive. They must save with the Fed for their rainy days, on a progressive but simple and refundable contingency tax schedule.
6. The tendentiousness in the Clinton administration has been to fit economic reality, globally, to prefabricated policies to serve overarching ideological agendas. And Alan Greenspan is continuing this unsavory tradition in his paper: compromising on reversing Basel II capital levels for large banks in exchange for continuing the status quo on Clintonomics. Risky financial intermediation has become risky for its stakeholders.
III. 3. The Hundred Year Flood
1. The ordinality of the Fed’s post-crisis intervention could have focused more on the discount window to clear liquidity constraints. Instead the Fed, without communicating firmly to the markets to go to its discount window, focused on the broken transmission mechanism of the Federal Funds market for those funds to trickle into the rest of the banking system through the primary dealers, expecting a lizard that lost its tail to heal itself. The Fed could have bought itself more time to cut rates gradually rather than expect the federal funds rate market to quickly transmit the funds where they were needed by dropping rates by 75 basis points overnight. Only later did the Fed create a facility to induce the markets to overcome their stigma of borrowing from the discount window.
2. Greenspan, in his paper, promptly opposes the notion that the Fed can fix the broken transmission mechanism through a more interventionist monetary policy. However, that opposition is constrained by his well known ideological predilection to not intervene in the markets through monetary policy.
3. Contrary to Alan Greenspan’s assertion, short term markets are currently functioning well. But are the long term markets? Are financial institutions borrowing short and lending long to invest? No. Not to the extent that is necessary yet. Even if they are, they are not doing so domestically in the G7, but borrowing short at low rates in the G7 and lending long elsewhere, exacerbating the global imbalances by not only concentrating economic risk abroad but also political risk.
4. Then why, given the abundance of liquidity from central banks, financial institutions are not also lending long within the G7 and long rates are rising on the G7 sovereign debt? Because of the endogeneity of policy (policy has become the outcome of locked-in market trends and therefore is unable to make the necessary course corrections) and hence long term uncertainty, 10-30 years from 2010. What will the world be like by 2020? By 2040? If the prognosis for 2020 is for the dollar to gradually collapse into being just another major global currency along with the rest, by buckling under the weight of U.S debt, and the prognosis for 2040 is for China to retain its political status quo while growing economically, all G20 long rates will rise except those in China.
5. A more interesting scenario emerges here: lending short or long on interest is the price of risking capital in a decentralized, specialized economy. Interest, by definition, is the opportunity cost of money. Then why cannot the large financial firms vertically integrate with the real sector and minimize the risks from decentralization and still be competitive to create a system of central planning by Wall Street? In fact, it is likely that this trend has already begun in a loosely-coupled manner around the world with the financial markets exercising ever greater control over the real production possibilities.
6. Alan Greenspan’s concerns about hundred year floods becoming more frequent are therefore not assuaged by his preference for non-intervention.
IV. 1. Principles of Reform
1. Alan Greenspan is skeptical that natural economic forces can be regulated in any system of political-economic organization. However, central planning in the former Soviet Union could have succeeded but for risk concentration in few sectors at the expense of the rest, including agriculture. China is attempting to prove that point by diversifying centrally planned allocations flexibly over time through its 5 year plans. Still, it is doubtful if that process can continue indefinitely, just as laissez-faire tendentiousness can also become inefficient in resource allocation.
2. The original American model espoused in the Federalist Papers of limited government is the plumb-line approach but with a stronger role for the Congress in regulating the economy to achieve a sense of balance between raising the general welfare and the self-interest of the market participants, rather than relying on regulation by litigation. Again, regulation is a pure public good. And this is precisely the lesson that can be derived from this crisis.
3. Regulation is a pure public good. Though specific behaviors may not be regulatable, the purpose of regulation can mathematically be best described as being fractal. All regulations must be designed to intrinsically maintain checks and balances similar to the framework of the United States government so that the markets are structurally self-regulating, with the government acting as its overseer and not a micromanager.
4. Perfect markets are efficient because:
a. The market size can accommodate multiple firms.
b. All known factors of market failure such as negative externalities, adverse selection, moral hazard and lack of transparency in pricing are mitigated by the regulatory structure.
c. The political causes can be mitigated by achieving time consistency in economic policy. For example, monetary policy rules and budget rules. Trade policy rules that encapsulate values to employ trade policy as an instrument of foreign policy, which is currently absent with China but present up to the mid-90s: opening China was about projecting U.S values but putting all the eggs in the Chinese basket is not.
d. The social causes can be mitigated through the even handed enforcement of the laws pertaining to Equal Employment Opportunity (EEO) and equal credit opportunity to achieve an equal opportunity society without forcing social integration directly as Brown v. Board Of Education (BOE) attempted to do. Civil rights and voting rights that came later without school busing but with equal access to government funding through redistribution would have been more beneficial.
e. Further, the standard neoclassical models of economic growth over the very long run with technical change being exogenous cannot fully explain the transition mechanism at each point of technical change, when technologically the reduction of information asymmetries is feasible. Structural mechanisms of regulation to increase market transparency have only become feasible because of information technology. Information technologies enable production processes with increasing returns to scale, virtually guarantee scale effects, and can potentially produce lock-in but under quality uncertainty because of lock-in over time (e.g., Microsoft).
5. The purpose of regulation (not its lack of) is to facilitate flexibility or market clearing when prices of factor inputs are especially sticky. The purpose of the short run in economic stabilization policy is the classical long run where the inflation-unemployment trade-off no longer applies, technical change still being exogenous but having occurred to achieve price stability. It is true, as Greenspan agrees with the accepted economic wisdom of dynamic general equilibrium, that markets are continuously clearing and that the equilibrium is not static, but the price variation over time of all things bought and sold always ideally must represent real scarcity and technical change and in practice, on average, must exhibit relatively constant variance and a trend, typically up (except in obsolescence), when controlled for economies of scale.
6. Credit and interest rate risk decisions at the firm level always point to the policy credibility of the central bank, which in turn, in part, is a function of the regulatory structure. The firm size matters to manage interest and credit risks, but independent of the firm size, relatively conservative management of risk does not factor in moral hazard in interest rate policies or other government policies to cushion failures: if the firm is not counting on the government to cut rates in the event of failure, it will, at all times, manage its balance sheet responsibly subject to economic conditions. That is, no firm thinks that it is too big to fail. Therefore, what makes the current crisis salient is a change in the market culture that has come to expect the government to save firms from themselves in the event of failures.
7. Greenspan appears to be believing in the impossibility of normal risk distributions in the financial markets. Is not the purpose of the regulatory framework to normalize the risk distribution by enabling near-perfect markets? If this is not risk management, even under a hypothetical regime of pure self-regulation, what is? An important question to ask here therefore is: did firms take Fed intervention into account in the event of crises in one or more major financial institutions, even if not systemic, to assume normal distribution of risk because Fed intervention would act to mitigate non-normal fat tails, capital adequacy being treated as the Fed’s responsibility? This hypothesis appears to be valid given that the risk preferences of the government have risen through the decade of the mid-’90s through mid-2000s, giving the markets the assurance that the government is tolerant of risky behaviors to actively promote financial innovation, seeing any regulation, even the Financial Services Authority (FSA)-type reform that had occurred in the United Kingdom (U.K), as hindering financial innovation. Alan Greenspan and the Clinton Treasury were complicit in this argument and on record in the ’90s.
IV. 2. Upward Revisions of Economic Capital
1. Alan Greenspan assumes the notional values of equity capital and financial assets in computing the ratios, which, when marked to market periodically, vary over time (they should have during the housing crisis to appropriately value the derivative assets over time but they did not). In a crisis both equity and other financial assets are as good as being illiquid and useless.
2. The capacity of public limited firms to raise capital in a crisis, whatever the equity capital cushion, is limited as this crisis has well demonstrated. What financial institutions need is non-equity cash capital cushion or rainy day savings as the first resort, similar to what the Fed would give them through a lower federal funds rate or the discount window. For example, financial institutions could raise capital and repay the Troubled Asset Relief Program (TARP) funds (most of the legitimate TARP critique notwithstanding) because of the Fed’s hard money liquidity facilities and the Fed enlarging its balance sheet with unconventional assets such as mortgage backed securities (MBS) but not because of the capacity of the firms to raise capital readily. Foreign capital to acquire some viable Lehman assets and into Citigroup had arrived only after the Fed’s intervention.
3. As to the Credit Default Swaps (CDS) market, when financial assets on a bank’s balance sheet experience stress, because the CDS’ are typically purchased to insure the possible defaults of some of those assets, the probability of bank equity’s market value to decline is much higher contrary to Greenspan’s scenario that equities could rise. This means, the market value of bank equity, in the absence of the injection of exogenous funds, relative to its financial assets is likely to be equal or lower. And this is what led to the failure of Lehman and Bear Stearns because their equity was shorted in spite of the viability of their financial assets.
IV. 3. What Regulation Can Do
1. Prevention and anticipation of crises are not mutually exclusive. Prevention is to mitigate potential crises but not avoid them altogether because crises are unavoidable. Anticipation is to expect the possibility of a crisis, however uncertain that possibility may be.
2. Risk and Knightian uncertainty are two distinct concepts. Risk is measurable. Uncertainty is white noise. By definition, risk management is the anticipation of the probability of success and hence 1 – success = failure. Therefore, if risk management is to be expected, anticipation is built in.
3. Conversion of corporate paper to equity in the event of equity capital becoming impaired necessitates interventions such as the Fed’s recent corporate paper purchase program to inject fresh money when there is no market demand for that paper and until market demand returns. Risk diversification must happen as a part of market behavior and government policy such as fiscal incentives and trade policies which act to diversify investment. Value Added Tax (VAT) is another useful tool in lieu of, not in addition to, corporate taxes, to change consumption behaviors which cascade along the production chain. Tobin tax on financial transactions can be a part of the VAT. The government cannot arbitrarily put restrictions on investments in certain products or services such as portfolio limits.
4. Off-balance sheet funds such as structured investment vehicles (SIVs) that hemorrhaged like sieves both in the United States and in the U.K, and even contemplated as potential candidates for clearing derivative transactions by former Secretary of the Treasury Henry Paulson at the outset of the crisis, need not always necessarily be reconsolidated but their transparency is more crucial: financial market participants must know, at all times, the extent of off-balance sheet liabilities and assets and their relationship with the balance sheets being reported to the stakeholders at periodic intervals for the markets to appropriately factor in the entire balance sheet condition of a firm.
IV. 4. Regulatory Capital History
1. Here Alan Greenspan is adding financial activities to traditional national bank activities, perhaps since GLB, but that would be a broad brush approach because GLB benefited larger financial institutions among national banks but not all national banks. Net income to asset ratios should have risen and been higher than 70 basis points particularly after GLB. That data is missing to make his historical point more consistently. What is the ratio now? Closer to 1870s and 1880s in spite of higher taxes? If so, have the tax burdens that have risen in the last century been offset by GLB? And has the fear of regulatory reform largely been because of losing the higher net income to asset return ratio enabled by GLB, consistent with Greenspan’s regulatory biases?
2. Equity capital is a liability on the balance sheet of the firm. The equity capital to asset ratio is subject to risk because the numerator is a liability and the denominator is subject to the liquidability of the assets. It is, therefore, a meaningless number that is predicated entirely on the earnings capacity of an institution or the quality of its business practices. The bottom line is that the institutions must follow sound business practices and maintain cash cushions as first resorts of liquidity.
IV. 6. Too Big to Fail
1. The nature of commercial banking has been such that commercial banks have neglected opportunities for economies of scale which have been filled by thrifts, pay day lenders and credit unions. There are large swaths of the global population with little or no access to credit. That the Fed has found evidence of larger economies of scale is a travesty for an institution as central to the global economy as it has been, particularly since the end of the Cold War.
2. All forms of contingent capital bonds in lieu of corporate paper to come to their aid during crises are to save them their cash cushions for use in other investments. The moral hazard would change in nature with contingent capital bonds but will not go away because the Fed may end up buying them or liquidating them instead of commercial paper. Further, how are contingent bonds any different from junk bonds that offer higher yields in the markets besides the government intervening to buy them at lower yields, subsidizing their failure?
3. The balance sheet of the U.S government must be completely off the hook when resolving financial market failures. Bankruptcy courts must be run by regular judges. Technocrats making up bankruptcy court benches are counter to the democratic tradition. Technical expertise in finance is unnecessary to judge a bankruptcy case. It is up to the expert witnesses on both sides to present evidence for their arguments.
IV. 7. Regulations Embodying a Forecast Fail with Regularity
1. Alan Greenspan is very accurate when he terms the current crisis as having been caused by firms that were too interconnected to fail and not too big to fail, because the crisis was systemic in nature and a system, by definition, is about interconnectivity. An economy is a system of systems and no single economic entity can be a standalone. Yet, in any system every entity is characterized by both autonomy and interdependence. To prevent systemic crises, the interconnectivity must not compromise the autonomy or the autonomy the interconnectivity. Hence, a perfect market.
2. When the crisis is not systemic in nature, are there firms that can be characterized as being too big to fail? Or the larger the firm size does it of necessity become far too interconnected to fail, potentially becoming a source of a systemic crisis? The resolution to this problem lies in the type of insulation that exists between firms, whatever their size and interconnectivity, which, by definition, is counterparty surveillance in a well-functioning market, both financial and non-financial. Honest dealing, as Alan Greenspan is well known to say, is the indispensable intangible of counterparty surveillance.
3. Economic planners always expect downturns and upturns. A better explanation for crises, given Fed policies, is that even if the regulators could see the crises coming, they chose to let them occur to clean up after. And when they see rapid expansions they also expect collapses but both the markets and the government are always uncertain of the timing of both upturns and downturns and bubbles and collapses. The large, well-managed interconnected firms in the financial markets can identify the onset of crises well in advance and can fuel bubbles but typically to serve the interests of the firms as for example, Goldman Sachs, J.P. Morgan Chase and others have behaved in the current crisis, nonchalant of the autonomy of the rest of the economic agents, including U.S debt. Therefore, in the absence of well-developed counterparty surveillance (or internal checks and balances in the markets supported by the third party oversight of the government or in the case of a hypothetical two-agent economy of one firm and the government, the government provides the counterparty surveillance function).
4. Given the dollar volume outstanding, U.S debt triggering a major run on the United States is unlikely. Between the prospect of dollar-induced inflation and the possibility of a crisis, inflation is the better of the two worse options because flooding the global economy with dollars before 2020 is a hedge against the dumping of U.S assets but it could produce inflation. The prospect of this inflation can be averted by creating a more expansive environment for the rise in global real investment and hence economies of scale for commercial banking which, Greenspan says, Federal Reserve research has determined to be saturated.
5. Risk is a function of economic structure and economic structure has changed in the last 150 years several times and it may not have been underpriced each time it foresaw structural change. Only as that change matured, did risk concentrations rise. Railways, the rise of industrial capitalism punctuated by the panic of 1907 and the Great Depression, modern post-war finance, currency markets, bond markets, information technology and post-cold war financial innovation are all examples of structural change. In abstraction, all major bubbles have structural change in common. The policy challenge is to achieve structural change without a bubble and the associated market and social disruptions.
6. Greenspan uses the context of financial globalization as an argument against the possibility of sound supervision. Elementary sound regulatory design dictates not a global, overarching supervisory regime which the G20 appears to be in favor of, but global financial institutions following the laws of the lands they operate in and maintaining adequate cash capital cushions within the demands of those regulatory regimes.
7. Madoff and the like is SEC’s business, not the Fed’s. The work of the Fed is to ensure that the financial institutions it regulates follow its regulations on the books. Not following regulations is a lapse of conforming to regulations, not misconduct. As yet, the Fed does not regulate all of the activities of its primary dealers.
V. 1. Monetary Policy and House Price Bubbles
1. Alan Greenspan is implying that Federal Funds rate is weakly correlated to the home price bubble. Still, the construction of the regression is wrong because the crisis was not precipitated by 30 year mortgages but by Adjustable Rate Mortgages (ARMs). Alan Greeenspan is conveniently bypassing his own promotion of ARMs which are tied to short-term rates which in turn are a function of the Federal Funds rate and the London Interbank Offering Rate (LIBOR). His promotion of ARMs was to encourage equity extraction to grow the U.S economy. His R-squared and t-statistic of the Fed’s intent to support the bubble would be unequivocally supportive of the hypothesis that the Fed wanted house prices to rise and consumer spending to increase through equity extraction to raise GDP if a proxy variable for Fed’s communications is entered into the regression. Further, home prices are not dependent on the type of mortgage. Even if 30 year fixed mortgage rates are used in the regression, in the period from 1997 to 2007 long rates declined as did 30 year fixed mortgage rates and home prices steadily rose. Long rates are still low.
2. The coefficient of correlation indeed signals a structural break in housing finance tied to depressed long rates due to the rise in the price of financial assets in the U.S and U.K capital markets because of the inflow of foreign savings. But that is not a glut of savings, to critique the current Fed chairman Ben Bernanke on semantics. Savings is always equal to investment, globally. So, when the explanation is globalization for the better or worse or some mix of both, it means the real investment went down in deference to more money chasing the newly minted financial assets which cannot be analyzed using general equilibrium because they had never traded transparently in exchanges as stocks and bonds do.
3. Alan Greenspan’s only error, other than of course the larger errors of introducing moral hazard and impeding regulatory reform, was to lend the weight of his voice to Bill Clinton’s Treasury. If Fed communications are factored into the regressions as a proxy variable, notwithstanding Milton Friedman’s irrational exuberance over the length of the expansion which Alan Greenspan cites here because Milton Friedman may have thought that liquidity smoothed market frictions and globalization depressed inflation, it is clear that the Fed periodically and preemptively fixed the pot holes of downward trends in the business cycle to artificially hold up the expansion. And the current crisis is the cumulative effect of that policy overreach and monetary complacency by the Fed. Money supply can only eradicate the business cycle when it is duly supported by the appropriate market structure and the structure of government regulation.
V. 2. Could the Breakdown Have Been Prevented?
1. Within the current epistemological constraints of the business cycle and bubbles caused by technical change and creative destruction, if prosperity has been on net created because technical change created the necessary conditions, upon transition, for higher income per person, then the issue becomes one of assuaging social disruption during the transition. It is entirely a separate question if this disruption can be mitigated to a large extent by enabling technical change without bubbles.
2. The one to two year lag of the impact of policy on the economy is perhaps true because of the dollarization of the world and the structure of globalization. Still, there is no reason why, even in a largely dollarized world, a balance in the spread of global business activities cannot occur for the policy lags to be smaller. Specifically, that the lag is so large points to a dysfunctional structure of globalization because U.S government debt markets borrow dollars from foreigners to encourage investment in the United States. The circuitous route of American currency is what contributes to the longer lags. And the need to sustain this circuitous route is political to feed both corporate profits and enlarge domestic government intervention in the economy a.k.a Clintonomics.
3. Alan Greenspan is falls back closer to the end of his defense into continuing to use monetary policy to regulate bubbles. He is correct that monetary policy cannot regulate bubbles but only when it has little or no support from regulation. However, monetary policy can regulate bubbles both ex ante by attempting to prevent their formation and in course when they are developing if it is adequately interventionist and is supported by a regulatory regime that does not favor risk concentrations because of well-functioning checks and balances in the market structure (not arbitrary restrictions on what the markets can or cannot do).
4. The Fed failed to control the housing bubble favoring the Taylor Rule trade-off over the housing market inflation. It is true that monetary policy can crush any bubble but the issue is overshooting on the slowdown. Can monetary policy alone gradually deflate a bubble? Thus far, the answer is no. That said, bubbles can form at any federal funds rate if fertile conditions for risk concentration exist. Likewise, Congressman Paul, for example, who wrote a book about ending the Fed, is wrong that cheap money caused inflation. The belief that cheap money causes inflation (Milton Friedman) is wrong. The Fed did not do a good job containing inflation, its primary responsibility, which is a real process not a monetary phenomenon.
5. The decline in home prices has indeed been gradual as was expected. The issue was not the decline in home prices as much as the withdrawal of home equity due to the prior rapid appreciation from 2003-2007 and the adjustment in the ARMs as Fed rates went up between 2003-2007.
6. First, central planning is unnecessary and China cannot prove its point in the long run not because, as Milton Freidman hypothesized, capitalism will eventually engender democracy, but because central planning, similar to laissez-faire, is bound to fail as a victim of its own success due to the inefficiencies arising from bureaucratic and market corruption.
7. The problem of deflation is solved due to the realization from the experience of the Great Depression and contributions to its economic understanding by economists such as the current Fed Chairman Ben Bernanke, because inflation is a better option than deflation when combined with activist government in the short run until the markets clear and returns to normalcy in the medium to long terms.
8. This does not justify the current high unemployment because, positively speaking, putting aside any normative political reasons of drawing analogies to the Great Depression prematurely, had another Great Depression been forecast, it should be preventable and its effects mitigated even if it results in a recession. That it did not happen and the economy is still teetering on the edge of consumer failure that could potentially lead to a depression, points to the need for better policy making and the complacency and the intellectual inadequacy of economic theory. The complacency that Alan Greenspan is pointing out in the financial markets is really the complacency in the understanding of the economy.
The ambition to change the world without firing a shot with economic policy after Reagan had done the same by ending the Cold War but by raising defense expenditures has created dangerous negative feedback loops in geopolitics since 1993. If this has been the desired objective it is a seriously flawed vision of the world that has created an economic system, with bogus interconnections predicated on lending flows of fiat money from the rich to the rest, favoring the adverse selection of ever higher consumption by a few at the expense of the rest. Adverse selection, even if the economic system is being ideologically seen as being free of moral hazard, causes market failure at some point. Perhaps, this crisis represents such a failure.