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Blaming Greenspan

The Times Peter Goodman has a very good piece today about Alan Greenspan's role in the financial meltdown--particularly his efforts to beat back derivatives regulation. The most striking thing about the piece is how blinded Greenspan was by either a simple-minded or deeply ideological faith in markets.

His various attempts at self-defense all have a stranglely circular logic. On the one hand, he strenuously opposed regulation because, in his view, people always obey their self-interest, and it's not in their interest to take excessive risks:

A professed libertarian, he counted among his formative influences the novelist Ayn Rand, who portrayed collective power as an evil force set against the enlightened self-interest of individuals. In turn, he showed a resolute faith that those participating in financial markets would act responsibly.

An examination of more than two decades of Mr. Greenspan’s record on financial regulation and derivatives in particular reveals the degree to which he tethered the health of the nation’s economy to that faith. ...

Time and again, Mr. Greenspan — a revered figure affectionately nicknamed the Oracle — proclaimed that risks could be handled by the markets themselves. ...

In his testimony at the time, Mr. Greenspan was reassuring. “Risks in financial markets, including derivatives markets, are being regulated by private parties,” he said.

“There is nothing involved in federal regulation per se which makes it superior to market regulation.”

On the other hand, when pressed for an explanation of what caused the crisis, Greenspan cites, in effect, self-interest:

The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack of integrity spawned the crisis, he argued in a speech a week ago at Georgetown University, intimating that those peddling derivatives were not as reliable as “the pharmacist who fills the prescription ordered by our physician.” ...

 “Risk management can never achieve perfection,” he wrote. The villains, he wrote, were the bankers whose self-interest he had once bet upon.

“They gambled that they could keep adding to their risky positions and still sell them out before the deluge,” he wrote. “Most were wrong.”

I guess the idea is that self-interest will keep the markets in line, except when it doesn't, in which case we're screwed.

Okay, that's a little cute. But you get the point. Embracing self-interest as the be-all and end-all of market-governing principles is just incredibly facile. You've got to take into account the difference between short-term self-interest and long-term self-interest; between individual and collective self-interest; between self-interest under under incomplete information and self-interest under perfect information. Etc., etc. 

Since what we usually have in financial markets is short-term, individual self-interest under highly incomplete information, it rarely leads to stable outcomes on its own. On the other hand, while regulation is far from perfect, it does move us closer to long-term, collective self-interest under more complete information, which is about the best we can hope for.

--Noam Scheiber