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24th Oct, 2008

Greenspan Testifies

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Several days ago I wrote an essay theorizing that the pundits were using the wrong depression as an analogy to the current crisis. Now confirmation comes from an unexpected source, none other than Alan Greenspan.

As you know, the Committee on Government Oversight and Reform has been holding hearings on the financial crisis. Greenspan was among the latest to testify.

The Wrong Analogy

In his testimony Greenspan admitted that the models being used to forecast the economy were wrong. He stated:

In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology.

The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.

Failure to Mention Glass-Steagall

Greenspan, who supported the repeal of Glass-Steagall, failed to mention deregulation as a cause for the crisis. He did state:

Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.

In other words, Greenspan’s faith in the market which underlay the repeal of Glass-Steagall was misplaced.

The End of the Market Ideology?

Much of the ideology of the Counterrevolution has stood firmly on the belief that the markets are better regulators than government. Greenspan’s testimony shot huge holes through this dubious assumption:

The consequent surge in global demand for U.S. subprime securities by banks, hedge, and pension funds supported by unrealistically positive rating designations by credit agencies was, in my judgment, the core of the problem. Demand became so aggressive that too many securitizers and lenders believed they were able to create and sell mortgage backed securities so quickly that they never put their shareholders’ capital at risk and hence did not have the incentive to evaluate the credit quality of what they were selling.

That’s a nice way of saying something Liberal Americans have known since at least the nineteenth century and economics has shown at least since the infamous tulip bulb depression: in a runaway market, those raking in the cash have little incentive to regulate themselves or even question what they are doing. Like gamblers on a roll they figure the cash will just keep coming in, the cards will keep falling their way.

Greenspan implies that because they were “gambling” with other people’s money (their shareholders) that would cause them to exercise restraint, but what the business scandals of the Bush years have demonstrated is that over-compensated CEOs care only about immediate gains and their own stock options.

What Greenspan does not tell us is that one flaw in the market theory is that those CEOs who perform poorly rarely suffered serious consequences. If they screwed up they received a golden parachute. Meanwhile someone else had to try to fly the out-of-control aircraft.

The Current Situation

The most astounding part of Greenspan’s testimony was his callous assessment of the consequences of the current crisis:

Given the financial damage to date, I cannot see how we can avoid a significant rise in layoffs and unemployment.

It is as if he is talking about statistics, not human beings.  There are my friends, neighbors and family behind those words, Mr. Greenspan. And they are where they are because of mistakes you made. Surely your owe them something more than the lame apology you gave this week. It would help a lot that instead of merely saying their faith was misplaced, that you screwed up.

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