Irrational Exuberance or Irrational Policies?

Former Fed chief Alan Greenspan seems blind 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 the lunch hour, the theory that something was wrong with the traffic lights would be much more plausible than the notion that New Yorkers had suddenly become irrational. If the lights all got stuck on green, the resulting accidents could hardly be blamed on the drivers; they were responding rationally to an erroneous signal. Likewise, you can understand the "irrational exuberance" of the years preceding the crash of 2008 as a rational response to the Federal Reserve Bank's artificially low interest rates.

But not if you are Alan Greenspan, the man who chaired the Fed from 1987 to 2006. In his new book The Map and the Territory, Greenspan never considers the possibility that his own actions contributed to the housing bubble and the 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. But that binge would not have been possible without cheap credit via 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. He does not 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. Given Greenspan's belief about the cause of lower interest rates, the only explanation he can offer for over-building is irrationality. He never seems to consider the alternative hypothesis, that the Fed might have turned all the lights green.

Ironically (or maybe not), Greenspan is at his best when he is not talking about the Fed, money, and inflation. He effectively criticizes the 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 rather than bailed out.

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. He 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 actors. 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 putting us in the hole from which he now wants to help extract us.