Greenspan's Blindness

The former Fed chief seems oblivious to his role in the housing bubble, the financial crisis, and the recession.

The Map and the Territory: Risk, Human Nature, and the Future of Forecasting, by Alan Greenspan, Penguin Press, 388 pages, $36

If we saw a dramatic rise in traffic accidents in Manhattan during lunch hour, a traffic light malfunction would be a much more plausible explanation than a sudden outburst of irrationality among New York drivers. And if the lights were all stuck on green, the resulting accidents could hardly be blamed on the drivers; they were responding rationally to an erroneous signal.

Similarly, you can understand the so-called "irrational exuberance" of the years preceding the financial crash of 2008 as a rational response to the incentives created by the Federal Reserve Bank's artificially low interest rates. Unless you are Alan Greenspan, the man who chaired the Fed from 1987 to 2006.

In Greenspan's new book, The Map and the Territory, the once-lionized monetary "maestro" never considers the possibility that his own actions contributed to the housing bubble and ensuing financial collapse. Instead he focuses on government subsidies for housing, including implicit guarantees for government-sponsored mortgage lenders and congressional mandates that "historically underserved" populations get in on the home ownership binge.

This analysis is accurate as far as it goes. But the housing binge would not have been possible without the cheap credit created as a result of Greenspan's low interest rates.

Greenspan blames an influx of foreign savings, combined with irrational herd behavior, for driving up housing prices and creating the risky financial instruments, such as mortgage-backed securities and their derivative products, that were at the center of the financial collapse. But he does not so much as raise the possibility that the Fed's expansionary policies had something to do with driving the inflation-adjusted federal funds rate-the rate that banks charge one another for short-term loans of reserves-below zero for almost two years.

Greenspan, like many behavioral economists, is quick to blame market actors for irrational choices rather than asking whether policy makers have distorted signals or incentives in ways that lead rational actors to bad outcomes. Rational responses to bad signals result in patterns of economic behavior that are ultimately unsustainable. The savings needed to support the level of investment in housing simply did not exist, thanks to policy-induced distortions in interest rates and other costs.

Ironically (or maybe not), Greenspan is at his best in this book when he is not talking about the Fed, money, or inflation. For example, he effectively criticizes the government response to the financial crisis, heaping particular scorn on the Dodd-Frank Wall Street Reform and Consumer Protection Act, which he warns will reduce capital formation and financial market efficiency. He is rightly skeptical of the bailouts, saying they have only worsened the problem of "too big to fail," the belief that a single bank has such a large influence on the financial system that it cannot be allowed to go out of business. He argues that in 2008 the failing banks "should have been put through the normal time-tested process of balance sheet restructure" associated with bankruptcy.

When Greenspan turns to data-driven economic analysis, as in his chapter on "Productivity and the Age of Entitlements," he is as accurate as he is blunt. He argues that the increasing costs of benefits for the elderly in the form of Social Security and Medicare have come "largely at the expense of the lower income quintile households, almost wholly through suppressed wage rate gains." The resources necessary to fund entitlements have crowded out private savings, thereby reducing capital formation, leading to lower worker productivity and wages. Greenspan concludes that "short of major entitlement reform, it is difficult to find a benevolent outcome to this clash between social spending and savings in this country."

Shining a light on the limits to human rationality is a good thing, but that light needs to be turned on political actors as well as market forces. Much of Greenspan's economic analysis is on target, but he fails to acknowledge his own role, and that of the institution he ran for so many years, in digging the very hole from which he now wants to help extract us.

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  • Longtorso, Johnny||

  • steedamike||

    Excellent link, thanks.

  • Dances-with-Trolls||

    Maybe he just needs thicker glasses

    +2 yoots

  • Almanian!||

    [Alan Greenspan] never considers the possibility that his own actions contributed to the housing bubble and ensuing financial collapse.

    Because:

    1) BOOOOOOOOOOOOSH!
    2) RAAAAAAAAAACISM
    3) Evil teahadist rethuglican do-nothingcingress obstructionazis!

    Duh!

  • The Late P Brooks||

    Alan Greenspan, American hero.

  • Raven Nation||

  • The Late P Brooks||

    Plosser was on Bloomberg this morning. He daintily tiptoed around an explicit recognition that the Fed's ongoing monetary gusher might actually be "masking" price signals, and encouraging misallocation of resources.

  • OldMexican||

    Greenspan, like many behavioral economists, is quick to blame market actors for irrational choices rather than asking whether policy makers have distorted signals or incentives in ways that lead rational actors to bad outcomes.


    Let's blame animal spirits!

    Or pixies!

    [H]e effectively criticizes the government response to the financial crisis, heaping particular scorn on the Dodd-Frank Wall Street Reform and Consumer Protection Act


    Racist!

  • WC Varones||

    Greenspan's Body Count:

    http://greenspansbodycount.blogspot.com

  • John||

    Greenspan blames an influx of foreign savings, combined with irrational herd behavior, for driving up housing prices and creating the risky financial instruments, such as mortgage-backed securities and their derivative products, that were at the center of the financial collapse.

    There was nothing "irrational" about the herd behavior. To call it irrational is to not understand incentives and how markets work. The rational thing to do in an inflating bubble market is buy and then try and sell just before it collapses. Moreover, even if you do not want to chance that, if you need the product, since you don't know how long the bubble is going to inflate, the rational thing to do is buy as soon as possible so you can get a lower price and either make more money if you sell in time or at least lose less if you don't. The worst thing that can happen to you in a bubble is to buy at the top of the market. So the rational thing to do if you are going to buy is buy as early as possible.

    This is why bubbles happen and get so big. Once the bubble starts to inflate and people realize it, the whole herd jumps into the market and the bubble blows up even faster making the bubble bigger and that much more damaging.

    That is not "irrational behavior" on anyone's part. That is the rational and expected market reaction to a bubble. Greenspan seems to not understand that.

  • John||

    He is a central planner and doesn't understand why all of these irrational people keep doing things he didn't plan on them doing and screwing up his plans. He thinks he would have been able to give out easy money and gently inflate housing prices without creating a runaway bubble. And damn it, if it hadn't been for those meddling irrational housing buyers, he would have gotten away with it. Amazing.

  • Raven Nation||

    Greenspan seems to not understand that.

    No, no. It only appears to you that Greenspan doesn't understand. This is because you have not gone to the right schools, do not have the right degrees, and, to be quite frank, you are just not smart enough.

    Greenspan suffers from the same problem that Obama does. They are just SO intelligent that, to us poor uneducated boobs, they APPEAR to be clueless. The only way to resolve this is for us un-smart people to just let them do what they want.

    Also: go Chiefs.

  • John||

    I just didn't get enough education to beat all of that common sense out of my head. I just can't see the nuances like they can.

  • Raven Nation||

    See, that's more like it.

  • Free Society||

    If you were smart like me, you'd know the problem was that we didn't give enough money and power to Top Men. There's no problem you can't solve with political power!

  • mtrueman||

    " the rational thing to do is buy as soon as possible.... The worst thing that can happen to you in a bubble is to buy at the top of the market"

    This is pretty muddled thinking. Buying low is rational but buying high is not irrational. Buying high is something that 'can happen to you,' like getting caught in the rain apparently, without involvement of your own personal decision making. Buying high is a bad thing, indeed the worst thing, but it is not an irrational choice.

  • John||

    It didn't say it was an irrational choice. I said doing your best to avoid that and buying as soon as you can is the rational choice. There is nothing muddled about my thinking. It is your comprehension that is muddled.

  • mtrueman||

    "It is your comprehension that is muddled."

    I kinda doubt that. I suspect your writing and thinking is to blame. Anyone who characterizes someone going into a market and buying something, as you have here, ie going into a market and 'something happening to them' is clearly determined to remove the buyer's agency and responsibility for their own irrational decisions. Care to explain yourself?

  • John||

    You need to read closer. I never said getting into the market is something that happens to you. I said, buying at the top of the market, meaning it crashes the next day, is something that happens to you. Yes, you certainly choose to buy. But you have no control over what the market does after you buy. So the market crashing the day after you buy, is most certainly something that happens to you and not a reflection on your agency.

    People want to avoid that happening. So they rationally buy as soon as possible so that they are buying as far from the top of the market as they can. This is why bubbles happen and once they start become self reinforcing.

    There is nothing muddled about that thinking. You just can't seem to grasp it for some reason. All I can do is explain it to you. I can't make you understand.

  • mtrueman||

    "I said, buying at the top of the market, meaning it crashes the next day, is something that happens to you."

    I can accept this. Is it also true that buying at the bottom of the market, and it crashing some time in the distant future, as 'something that happens to you?' If it is true, you haven't said as much til now.

    Sorry, John, if I come across as quibbling. Just came across a very oddly put argument here and thought if I pick at it a little, something interesting might be behind it.

  • John||

    I can accept this. Is it also true that buying at the bottom of the market, and it crashing some time in the distant future, as 'something that happens to you?' If it is true, you haven't said as much til now.

    Sure it is and yes I have. Several times I explained that the advantage of buying early in the bubble is that you either sell at or near the top and make more money or lose less money when the market crashes. It is a linear relationship. The further from the top you buy, the better off you are.

    Perhaps I just haven't explained it well enough. But I can assure you there is nothing novel about my observation and I am hardly the first one to make it.

    To put it in simple terms, if people think the price of something is going to go up in the future, they will choose to buy it sooner than they otherwise would have. When this happens, the increase in demand causes the price to rise even faster which in turn motivates more people to buy even sooner than they otherwise would have. That is how bubbles in a particular product happen.

    Greenspan considers this behavior to be "irrational". But as I explain, it is completely rational and expected. And it is also why central planners cannot gently inflate the price of housing without creating a runaway bubble like we had in the 2000s. Once the price of housing starts to rise, the feedback loop I describe above starts to kick in and it is just a matter of time before the bubble gets out of control.

  • mtrueman||

    I think I get your point. But when you say,

    " the feedback loop I describe above starts to kick in"

    I'm not so sure. If there is a feedback loop that is dictating the price, that means the price is rising not as a matter of rational choice of the buyers, but something systemic - as you say a feedback loop. Isn't this an example of emergent behaviour, something that must be considered beyond the sum of individual rational choices that comprise any market? However rational the choices that form the basis of the bubble, the forces like this feedback loop that emerge may be irrational.

  • ||

    And to think that Greenspan was one of the people among Ayn Rand that converted Walter Block to libertarianism. What the hell happened to him?

    http://www.lewrockwell.com/201.....greenspan/

  • John||

    I think he got corrupted by his power and seduced by the intellectual bubble that is Washington. If you only interact with people who have a given set of assumptions, eventually you will naturally start to believe those assumptions no matter how much you didn't to begin with.

  • Michael Hihn||

    Greenspan was one of those who fought to regulate Fannie and Freddie, after Clinton pressured them into reducing their loan standards. Fannie and Freddie were granting taxpayer guarantees entirely on their own, which caused the crash when Clinton caused loan standards to be abandoned. It's insane to blame it on Greenspan who tried to stop it.

  • The Late P Brooks||

    What the hell happened to him?

    COCKTAIL PAAHTAYZ!

  • kmc212||

    Mises would say people were acting rationally.

  • John||

    And so would anyone else who has any sense and gives the issue some thought.

  • mtrueman||

    "Mises would say people were acting rationally."

    The question is whether Mises had a good grasp on the notion of emergence. I'm beginning to have my doubts. People acting rationally doesn't mean the system acts rationally.

  • ArbutusJoe||

    "the system acts rationally"

    Haven't read much of the Austrians, have you?

  • mtrueman||

    Correct. Any reason to start now? I'm not afraid to delve into antiquarian books.

  • John Aronson||

    It is interesting to compare the experience of Great Britain and France between 1700 and 1790.

    After the Glorious Revolution in 1688, the City of London created the Bank of England to take charge of GB's finances. Both entities were sympathetic to but quite distinct from the Crown. If the Crown wanted to issue paper, it had to do it through the Bank of England, which was a creature of the City of London, not the Crown.

    Sir Isaac Newton was first Warden and then Master of the Mint after 1696 and his re-coinage made British specie the standard for the world after 1707. The risk associated with British government debt was always measured in gold and silver of the purity demanded by Isaac Newton, who was personally liable for the purity of the coinage and who freely hanged counterfeiters and currency debasers.

    The effect was that the finances of individual Englishmen were kept quite distinct from the finances of the government and GB prospered mightily for 250 years.

    In France, the finances of the government and finances of the individual French were always inter-mingled and the French Crown lurched from one financial crises to another, periodically debasing the currency and issuing paper that worthless outside of France, until the economy collapsed and the people revolted.

  • Concerned Citizen||

    Exactly. That's why the Constitution has Article 1, Section 10.

  • ||

    Are there any books detailing the French and British banking system during the 1600's and 1700's?

  • John||

    It is not about that specifically, but Simon Schima's epic history of the French Revolution, Citizens, contains a very good explanation of the French financial system and why the old regime went broke.

  • John Aronson||

    Not that I know of. But I am a historian and lawyer, not an economist.

    The crucial period was during Cromwell's republican Protectorate and Commonwealth between 1650-60. He broke the old Crown monopolies and made peace with the presbyterian business interests in the City of London. The Restoration, 1660-88, was a period of political and economic reaction and the Glorious Revolution was the City of London's ultimate synthesis of all the social and economic issues raised during the English Civil Wars of 1640s.

    All of this is implicit in Adam Smith's works but it is not clearly stated either by historians or economists. British Marxist historians like Christopher Hill make similar observations but mostly in passing.

  • What's that smell?||

    Alt-text

    FIVE! FIVE!
    That's how many suppositories I have in RIGHT NOW!!!

  • Eric Bana||

    Unfortunately, I don't think Greenspan can get glasses that are any thicker.

  • Michael Hihn||

    This is a very shitty analysis, stacking the deck toward the writer's bias.

    Even at ZERO interest rates, we'd have never seen the subprime collapse if Clinton had not mandated a major increase in subprime mortgages ... and pressured Fannie and Freddie into reducing their mortgage standards .. and if Congressional Democrats had not blocked years of attempts at regulating Fannie and Freddie. And it was Greenspan arguing to Congress that we needed to regulate Fannie and Freddie -- so he knew what was coming, and why.

    In other words, the subprime mortgage explosion would have never happened if Clinton had not pressured the lower lending standards --standards which had protected taxpayers from the beginning.

    The NY Times reported it all ...in 1999 ... even predicting that CLINTON'S actions could cause another taxpayer bailout like the 1980s. (Obviously the Times NEWS pages, not editorial!)

    http://tinyurl.com/ce7hh3

  • judeoconnor@mac.com||

    I'd say he was paid to keep his mouth shut.

  • Michael Hihn||

    He testified -- strongly -- in favor of regulating Fannie and Freddie. He saw it coming, as did many others -- even the NY Times

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