The view from Mount Greenspan

I continue to be astonished by Alan Greenspan’s timing. It is quite uncanny. In a column for National Journal last September (pasted after the jump, if you're curious) I applauded the timing of both his departure from the Fed and the subsequent publication of his memoirs, which coincided beautifully with a spike in concern for the mess he left behind. And now—a smaller achievement, admittedly, but impressive nonetheless—he has a long column in the FT on the very day that the paper leads with news of the extraordinary “rescue” of Bear Stearns by J.P. Morgan and the Fed (something which nobody saw coming when the column was commissioned and written). The man is a magician.

In this new article Greenspan says that the current financial implosion is mainly due not to poor regulation but to the inescapable complexity of modern finance, and to the fact that the science of risk management has not yet caught up.

The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world. In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

The answer, Greenspan says, is not to move away from “counterparty surveillance and, more generally, financial self-regulation as the fundamental balance mechanism for global finance”. He is less clear on what the answer actually is, except to be patient while the finance experts improve their models.

I do not count myself among the claque of registered full-time Greenspan critics, but I have to say it takes some nerve to contemplate conditions in the financial markets today and talk of the virtues of self-regulation. If that view has not been discredited by recent events, one has to wonder what it would take.

The fundamental problem, in my view, was not insufficiently clever risk-management models. It was moral hazard (operating at multiple levels); a gross failure of regulation in mortgage lending (for which Greenspan is substantially responsible: remember that he was a cheerleader for the subprime lending business); a structure of finance-industry incentives that rewarded greed and recklessness indulged at others’ expense (itself a failure of regulation); and last but not least the most credit-friendly tax regime in the world.

One remedy that Greenspan does advocate in his article is larger “capital buffers” for banks and other lenders—he notes that private investors are already demanding this. Yes, that is putting it mildly. But whether private investors continue to demand it or not, a new and much tougher approach to capital adequacy is (among other changes) something regulators must now insist upon. The real lesson of this crisis is that the authorities will do anything—at any cost to taxpayers—to shore up a financial system on the point of being wrecked by greed and incompetence. For the sake of minimizing the harm to innocent bystanders, they may very well be right to take that view. But the quid pro quo is stricter regulation. Implicit uncapped guarantees plus “self-regulation” is a formula for the very disaster now unfolding.

09-22-2007 Wealth of Nations - Greenspan and the Art of Good Timing
Clive Crook © National Journal Group, Inc.

The Wall Street crash of 1987 happened almost immediately after Alan Greenspan was appointed chairman of the Federal Reserve. It was his only case of bad timing -- assuming that the episode actually qualifies. You could argue that the crash served him well. Financial markets set him a test before he had even unpacked his spreadsheets, and he sailed through. Wall Street was impressed, calm was soon restored, the economy kept growing, and the new chairman made a fast start on building his reputation to its current awesome proportions. Luck was with him ever after.

This week, Greenspan's new book, The Age of Turbulence, came out. From an author who took pride in the leaden opacity of his statements as Fed chief, it is surprising: engaging and well-written (Penguin's editors know their stuff), a successful blend of memoir and economics. But look at the timing. The book was released on the eve of the Fed's most keenly awaited interest-rate decision in years, in an atmosphere of financial alarm that made every interview with the suddenly available author seem urgent and significant. Best of all, readers cannot expect the book to address the recent market turmoil, because it went to press before the storm blew in. No point in searching for Greenspan's answer to the charge that this mess is his fault: maximum topicality, minimum requirement to apologize and explain. Every central banker should have this godlike mastery of time and chance (not to mention the reported $8 million-plus advance).

On Tuesday, with Greenspan all over the media, the Fed cut its benchmark interest rate by half a point. It was no great surprise: Ben Bernanke, Greenspan's successor, had already coached the markets to expect a drop of a quarter-point or more. Because it was a slightly bigger cut than the smallest one the Fed might have risked, Wall Street rallied on the news. Is this Bernanke's 1987 moment -- the point from which his reputation begins to soar? Possibly, but I doubt it.

The problem is that the housing bubble has finally burst -- even though interest rates are still low, and despite a pretty strong economy. Indications are that the housing market is still worsening: Housing starts and permits fell in August to their lowest levels in 12 years; measures of confidence in the building industry are at 16-year lows. And the full consequences of the reckless lending that caused credit markets to seize up in the first place are still only beginning to show.

The surge of adjustable-rate mortgages will continue to reset at higher rates for the remainder of this year and into next. The number of distressed borrowers and foreclosures is certain to climb. As housing wealth retreats -- house prices are already falling nationally for the first time since the 1930s -- the decline in construction investment will be compounded by weakening consumer demand. Lower interest rates will help, but they cannot be cut with impunity while the dollar is so weak. A dollar rout is a possibility and complicates the Fed's job. Just weeks ago, Bernanke was fretting about inflationary pressure, hence his hesitation until now in cutting rates. All in all, this is a more threatening situation than any that Greenspan had to cope with.

To get a sense of how threatening, take a look at Britain. Last week, one of its biggest mortgage lenders, Northern Rock, fell victim to the subprime mortgage scare and the seizing up of cross-border credit. Northern Rock was among the British banks most actively engaged in the new securitized-mortgage and derivatives markets. It is solvent, but it ran out of short-term finance. The Bank of England offered emergency lending, but far from restoring confidence, the announcement made things worse. Lines of depositors formed and a classic run began, the first in Britain since the 19th century. The panic continued for several days, with billions of pounds of deposits being withdrawn and the bank's stock market value collapsing. The shares of other banks began to slide, and it started to look as though the run might spread.

This week, the government took the astonishing step of saying it would guarantee Northern Rock's deposits without limit, and those of any similar institution that gets into trouble. That stopped the run, but be clear about this: It is a semi-nationalization of the banking system. The head of the Bank of England, Mervyn King, a highly regarded economist, had previously ruled out milder measures for fear of seeming to reward mismanaged institutions. This week, he stands overruled and humiliated, the bank's vaunted independence overthrown at a stroke.

The manner of this policy reversal is already a political disaster -- and it gets worse. Northern Rock's shares are still severely beaten down, as they deserve to be, but they revived a little on news of the blanket guarantee. The danger in this is self-evident. If the bank's managers survive, and if its shareholders in the end escape unharmed (admittedly a remote prospect at this point), what discipline at all is there to encourage prudent banking? The corollary of a willingness to intervene so massively, completely displacing financial market disciplines, can only be far stricter regulation. You cannot underwrite the banks and then say do as you wish. In short, Britain is facing an extraordinary financial upheaval -- its entire system of bank regulation called into question -- because of the securitized-mortgage disease it picked up on Wall Street.

Could a similar upheaval happen here? You bet. The United States has fuller deposit insurance than Britain (until this week, that is, when Britain's insurance became total). Larger sums are covered and the system is designed to work faster and more smoothly. That helps, but I'm not sure it would be enough to block a run if depositors thought their bank was in trouble. Better to have the cash in your hand than to wait to see how the deposit-insurance system copes. At any rate, Britain shows beyond a doubt how fragile banking systems are in difficult times -- and despite the instant delight on Wall Street as rates were cut this week, these are still difficult times.

So is it all the maestro's fault? Greenspan's critics are in the minority, and I think they exaggerate their case, but they do have a point. Greenspan accommodated the tech-stock bubble of the late 1990s and the subsequent housing market bubble with low interest rates. His thinking, as the book affirms, went like this: It is hard to know except in retrospect when asset prices are overinflated; higher interest rates are usually not enough in any case to break market euphoria once it is rolling; and it is better to deal promptly with the mess once the bubble (if it turns out to be a bubble) bursts. In the meantime, low rates keep the economy growing.

While there is truth in this, it is a stretch to say that the tech-stock and house-price inflations were bubbles only with hindsight. Tech-stock prices reached literally unsustainable levels. People were hoping to sell before they crashed, but nobody was surprised they did. And by a variety of objective measures, house prices are grossly misaligned right now -- way above historic norms, way above previous peaks, in fact -- in relation to both earnings and rents. Prices can come back into balance with incomes and rents either by growing slowly for a long time or by falling a lot all at once. But again, something had to give. Yes, in the end, whether a boom is a bubble is a judgment call -- but many of the Fed's decisions are judgment calls.

The real issue is whether Greenspan is right about the costs and benefits of pre-emption versus damage control. When you know you see a bubble, is it better to attack it early, or let the market puncture it and then clean up the mess? Greenspan says the latter.

The aftermath of the tech-stock bubble tends to support the maestro. The effects on the real economy were contained by lower interest rates and looser fiscal policy. It is plausible to think that the Fed would have done more harm than good by trying to steer the market down. But the story is unfinished. The fiscal surplus has all been spent, and then some. A bold fiscal response to the next incipient recession will be much more difficult. And the Fed's sustained dose of very low interest rates set the scene for the next bubble, which is bursting right now.

Can you look at Britain and say it is better to let a bubble pop and deal with the aftermath, rather than try to anticipate? I find that hard to swallow. But there are no certainties here. Maybe the current financial turbulence, properly managed, will do as little harm to the wider U.S. economy as the crash of 1987 or the tech-stock collapse. Greenspan still believes that -- and he has staked Bernanke's reputation on it.