Greenspan Concedes That the Fed Failed to Gauge the Bubble

[Cees Binkhorst]

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Groet / Cees

March 18, 2010


  Greenspan Concedes That the Fed Failed to Gauge the Bubble


            By SEWELL CHAN


http://www.nytimes.com/2010/03/19/business/economy/19fed.html

WASHINGTON — Is Alan Greenspan famous for his libertarian leanings and
hands-off approach to Wall Street, having some second thoughts?

After more than six decades as a skeptic of big government, the former
Federal Reserve chairman, now 84, is gingerly suggesting that perhaps
regulators should  help rein in giant financial institutions by
requiring them to hold more capital.

Mr. Greenspan, once celebrated as the “maestro” of economic policy, has
seen his reputation dim after failing to avert the credit bubble that
nearly brought down the financial system. Now, in a 48-page paper
<http://www.brookings.edu/%7E/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf>

that is by turns analytical and apologetic, he is calling for a degree
of greater banking regulation in several areas.

The report, which he is to present Friday to the Brookings Institution,
is by no means a mea culpa. But in his customarily sober language, Mr.
Greenspan, who has long argued that the market is often a more effective
regulator than the government, has now adopted a more expansive view of
the proper role of the state.

He argues that regulators should enforce collateral and capital
requirements, limit or ban certain kinds of concentrated bank lending,
and even compel financial companies to develop “living wills” that
specify how they are to be liquidated in an orderly way.

And he acknowledged shortcomings in regulation — an area on which the
central bank has placed far greater emphasis under Mr. Greenspan’s
successor, Ben S. Bernanke

“For years the Federal Reserve had been concerned about the ever-larger
size of our financial institutions,” Mr. Greenspan wrote. Fed research
has not been able to find economies of scale as banks grow beyond a
modest size, he said, and in a 1999 speech, Mr. Greenspan warned that
“megabanks” formed through mergers created the potential for “unusually
large systemic risks” should they fail.

Mr. Greenspan added: “Regrettably, we did little to address the problem.”

The former Fed chairman also acknowledged that the central bank failed
to grasp the magnitude of the housing bubble but argued, as he has
before, that its policy of low interest rates was not to blame. He stood
by his conviction that little could be done to identify a bubble before
it burst, much less to pop it.

“We had been lulled into a sense of complacency by the only modestly
negative economic aftermaths of the stock market crash of 1987 and the
dot-com boom,” Mr. Greenspan wrote. “Given history, we believed that any
declines in home prices would be gradual. Destabilizing debt problems
were not perceived to arise under those conditions.”

His new thoughts on regulation appeared to be a turnabout from Mr.
Greenspan’s past views on bank size. Sanford I. Weill the former
Citigroup chief executive, wrote in a 2006 memoir that when Citigroup
was formed in 1998 out of the merger of banking and insurance giants,
Mr. Greenspan told him, “I have nothing against size. It doesn’t bother
me at all.”

In a lengthy footnote, Mr. Greenspan wrote that it was “interesting
speculation” to ask whether investment banks would have avoided taking
on extraordinary leverage — as much as 20 to 30 times tangible capital —
had they remained partnerships instead of incorporating, as a 1970
ruling permitted broker-dealers to do.

“To be sure, the senior officers of Bear Stearns and Lehman Brothers
lost hundreds of millions of dollars from the collapse of their stocks,”
he wrote. “But none to my knowledge filed for personal bankruptcy
and their remaining wealth allowed them to maintain much of their
previous standards of living.”

The main policy prescription in Mr. Greenspan’s paper was higher capital
requirements and liquidity ratios, which he argued would be the most
effective way to blunt the impact of future crises. And he suggested
that discussions under way to designate regulators to detect systemic
financial risks would be of limited use.

“Unless there is a societal choice to abandon dynamic markets and
leverage for some form of central planning, I fear that preventing
bubbles will in the end turn out to be infeasible,” Mr. Greenspan wrote.
“Assuaging their aftermath seems the best we can hope for.”

Mr. Greenspan, who stepped down as Fed chairman in January 2006, has
defended his once-celebrated 18-year tenure previously. But the
Brookings paper is his most extensive examination to date of the
crisis’s origins.

The paper, titled “The Crisis,” argues that a global housing bubble was
primarily caused by a sharp drop in long-term interest rates from 2000
to 2005, brought about by export-oriented growth in developing
economies, especially China, after the end of the cold war. China,
saving the dollars it was earning, in effect made money available for
cheap loans.

“In short, geopolitical events ultimately led to a fall in long-term
mortgage interest rates that in turn led, with a lag, to the
unsustainable boom in house prices globally,” he wrote.

Mr. Greenspan also tried to refute, or at least deflect, the criticism
he has received for the Fed’s conduct of monetary policy in the years
after the burst of the dot-com bubble in 2001 and the subsequent
recession  John B. Taylor, a Stanford economist, has been the most
influential exponent of that criticism.

In response, Mr. Greenspan argued that the rise in home prices had
become unhinged from other measures of inflation. While conceding that
the low fed funds rate, the benchmark interest rate the Fed controls,
made it easier for borrowers to use adjustable-rate mortgages, he said
he suspected — “but cannot definitively prove” — most home purchasers
would have taken out 30-year fixed-rate mortgages had the
adjustable-rate ones not been available.

“The global house price bubble was a consequence of lower interest
rates, but it was long-term interest rates that galvanized home asset
prices, not the overnight rates of central banks, as has become the
seemingly conventional wisdom,” Mr. Greenspan wrote.

In addition to endorsing higher capital and liquidity requirements, Mr.
Greenspan said banks and possibly all financial intermediaries should be
required to hold bonds that automatically convert to equity when capital
falls below a certain threshold. That could help reduce the “moral
hazard” that exists because the banks that failed did not suffer the
full costs of their actions.

The Senate is contemplating a mechanism by which the government can
seize and dismantle a huge, interconnected financial company before
panic spreads.

For a big, interconnected company, regulators should initiate a special
bankruptcy process, he wrote. A bankruptcy judge would require creditors
to take a haircut before the company is reorganized. The company should
then be split up into separate units, “none of which should be of a size
that is too big to fail,” Mr. Greenspan wrote.

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