Alan Greenspan had a brief moment when he seemed capable of being redeemed, when he admitted before Congress that he was wrong about his assumptions that firms could regulate themselves. I have yet to see another central figure in the banking meltdown admit error. But he has now gone back to trying to salvage burnish his reputation.
Irving Fisher, arguably the most famous economist of the 1920s and a big backer of that era’s new financial and economic paradigm, was virtually impoverished by the crash and spent the next few years trying to figure out what went wrong. Although his contemporaries (save Keynes) saw him as hopelessly tainted, posterity has been more kind. Fisher’s debt deflation theory is now seen as a useful, perhaps even fundamental framework for viewing financial crises.
But Greenspan when he was chairman of the Fed, and to this day, still wants to be liked. And that means he is still far too willing to enable those in power, no matter how destructive their pet plans may be. Yet the most effective counsellors I have seen are able to tell people when they think their ideas stink (admittedly, it takes a great deal of interpersonal skill to pull that off without offending often insecure people in high places) and in fact, are sought out for their candor.
From the Financial Times:
The extraordinary risk-management discipline that developed out of the writings of the University of Chicago’s Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators.
But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions….
Yves here. Dear God, Greenspan prostrates himself before the false icon of bankrupt methodologies. This is embarrassingly bad.
Has NO ONE clued him in that the Markowitz based constructs are close to rubbish? They assume Guassian (normal, bell curve) price distributions. Benoit Mandelbrot proved back in the 1960s that that just ain’t so. There have been, as John Dizard put it, terabytes written about this. Worse, these models work really well on a day to day basis, but they are terrible at accurately measuring the risk of a big blow up, and that was one of their important uses.
Did the FT edit this piece? Obviously not, The idea that the flaw of the models was…..that they rested on enlightened self interest? I’l admit to not having read any of the seminal papers, but modern portfolio theory pretty clearly endorses leverage (ie, you can use leverage to create portfolios superior to ones on the efficient investment frontier) and does not appear so imply any limits on leverage. Plus it has a ton of assumptions that do not correspond with reality (continuous pricing is a biggie, which means markets are ever and always liquid, and it rejects the notion that diversification can break down, that it, that formerly weakly correlated assets can move strongly together at times of stress). Back to the article:
Even with the breakdown of self-regulation, the financial system would have held together had the second bulwark against crisis – our regulatory system – functioned effectively. But, under crisis pressure, it too failed. Only a year earlier, the Federal Deposit Insurance Corporation had noted that “more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards”
Yves again, I see, it’s all the FDIC’s fault. Notice no mention of the Fed or SEC? Or more important, that the belief in the virtues of “free markets” which for many meant unregulated, meant that the watchdogs had been neutered. It was the Fed that actively promoted the notion of securities firms and banks coming up with their own risk management and valuation models, and was affirmatively opposed to the idea of regulators having an independent point of view. All they were supposed to do was (at most) look over banks’ shoulders.
And he also conveniently fails to mention that credit default swaps were unregulated, or that financial institutions were exempted from Sarbanex-Oxley rules barring the use of off balance sheet entities. Oh, and that the FDIC approved of Goldman, Morgan Stanley, Merrill, Bear, and Lehman gearing themselves much more than had been previously allowed. Back to the article:
US banks are extensively regulated and, even though our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still took on toxic assets that brought them to their knees….
Yves here. Again, misleading. The Fed was taking the line at the time that banks were handing out credit like Santa Claus that there was no reason to worry about consumers’ levered balance sheets, since their net worth was growing. As Tim Duy has pointed out, they seemed to forget that debt is serviced out of cash flow, meaning income. The authorities also refused to consider that housing prices could ever fall nation-wide, even though quite a few countries (Japan, the UK, the Nordic nations, to name a few) have seen 25%+ falls in modern times. The Fed also acknowledged that housing price would have to moderate, but merely argued that they’d flatten, rather than contemplate that they might actually fall. Back to the article:
The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralised debt obligation will default, or even if the financial system will seize up. A large fraction of such difficult forecasts will invariably be proved wrong.
Yves here. Again, misleading. The “let a thousand flowers bloom” attitude meant it was OK to let banks acquire paper (remember, banks did buy paper in the secondary market) that they and the regulators did not fully understand. That is an absolute no no that became acceptable behavior. Again to the story:
What, in my experience, supervision and examination can do is set and enforce capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future. It can, and has, put limits or prohibitions on certain types of bank lending, for example, in commercial real estate. But it is incumbent on advocates of new regulations that they improve the ability of financial institutions to direct a nation’s savings into the most productive capital investments – those that enhance living standards. Much regulation fails that test and is often costly and counterproductive. Regulation should enhance the effectiveness of competitive markets, not impede them. Competition, not protectionism, is the source of capitalism’s great success over the generations.
Yves here. Huh? Since when were banks EVER in the business of making productive investments (save in their PE or VC entities, for those that have them)? They extend credit! A loan is about finding borrowers that can make principal and interest payments on time, and charging enough to earn a decent return on capital, cover origination and loan servicing expenses, and reasonable loss expectations. On a portfolio basis, you want good diversification among loans.
And what about “enhance the effectiveness of competitive markets”? The problem with competition in banking is banks are horribly imitative and all rush off the cliff together every 10 or 15 years. I have serious doubt about competition being a great measure of success in banking, particularly since the losses generated by undue zeal get fobbed off on taxpayers. Back again to Greenspan:
New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage. In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals.
Yves here. This gets worse. The pricing advantage the big players had was NOT due to their too-big-to-fail status. No one assumed anyone (save Citi) had that until they got in trouble. The big firms were de facto funded cheaply because they geared themselves like crazy. And the not rushing to reform argument is rubbish. The time to impose reform is when the problem is acute. If we wait and conditions start improving, the industry will argue changes are no longer necessary, the crisis passed without them. Greenspan knows full well delay works to the advantage of the incumbents. Back to the article:
Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles and rare but devastating economic collapse that engenders widespread misery. Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-term interest rates. Euphoria-driven bubbles do not arise in inflation-racked or unsuccessful economies. I do not recall bubbles emerging in the former Soviet Union.
Yves again. This is truly scary. Not only is the ideology so thick you can cut it with a knife, but we have ignorance on top of it. The French economy was a mess when John Law created the Mississippi Company in 1717, whose bubble and collapse created an economic crisis. And there certainly weren’t any banking regulators back then to meddle with “free market capitalism.”
Believe it or not, there is more tripe of this sort, but I’ll leave it for your delectation
Originally published at Naked Capitalism and reproduced here with the author’s permission.