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No Flaw in His Model ... Old Time Religion Was Right After All

Now Greenspan Wants to Take It All Back

by MICHAEL HUDSON

It all seems so long ago! On October 23, 2008, Alan Greenspan issued a mea culpa for his deregulatory policy as Federal Reserve Chairman. “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform. “The whole intellectual edifice, however, collapsed in the summer of last year.”

For a moment he seemed to be rethinking his lifelong assumption that the financial sector would seek to protect its reputation by behaving so honestly that its customers would gain from dealing with it. For years he had claimed that regulation was not needed because bankers would seek to protect their reputations and their “counter-parties” would look to their own interest.

 “Were you wrong?” Congressman Henry Waxman prompted him to elaborate.

 “Partially,” the Maestro replied. “I made a mistake in presuming that the self-interest of organizations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms.” However, he admitted, “I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works. I had been going for 40 years with considerable evidence that it was working exceptionally well.”

But the past two or three years have evidently given Greenspan enough time for a re-think. In yesterday’s Financial Times (March 30, 2011) he returns to his old well-paying job, proselytizing for deregulation. His op-ed, “Dodd-Frank fails to meet test of our times,” is a Mea Culpa The Sequel to his co-religionists for his 2008 apostate Mea Culpa. “The US regulatory agencies will in the coming months be bedevilled by unanticipated adverse outcomes,” he warns, “as they translate the Dodd-Frank Act’s broad set of principles into a couple of hundred detailed regulations.” The Act “may create … regulatory-induced market distortion,” because neither lawmakers nor “most regulators” understand how “complex” the financial system is.

But if Wall Street’s collateralized debt obligations (CDOs) and other derivatives are too complex for regulators to understand, they must be too complex for buyers and other counterparties to evaluate. This would seem to negate a key logical assumption of free market theory. Without “full knowledge of the market,” and of the consequences of one’s action, one cannot make an informed choice. So on logical grounds, regulators would seem to be following orthodox free market theory in rejecting derivatives and other such “complex” products.

Not so in Greenspan’s world. He does not acknowledge that Wall Street has been so adept at translating its wealth into political power that it only approves regulators who do not understand complexity. That is a precondition for deregulators such as Greenspan.

It all depends on what the word “complex” means. His argument sounds like priests or nuns answering a parochial school pupil’s question about how God can let so many bad things happen here on earth by simply saying, “God is too large for you to understand. Just believe.” Greenspan claims that nobody has sufficient skills to be “entrusted with forecasting, and presumably preventing, all undesirable repercussions that might happen to a market when its regulatory conditions are importantly altered.” Just look at the Bush Administration’s happy-face appointees at the FDIC and IMF who expressed faith that risks were declining in 2007-08. “Regulators were caught ‘flat-footed’ by a breakdown we had erroneously thought was more than adequately reserved against.”

 When Greenspan says “we,” he means the useful idiots that Wall Street insists on, while blackballing whomever is not a suitably true believer in the deregulatory kool-aid being doled out by Greenspan’s co-religionists on behalf of their financial god too complex for mortals to know. “The problem is that regulators, and for that matter everyone else, can never get more than a glimpse at the internal workings of the simplest of modern financial systems.” But the “regulators who never got more than glimpse” were headed by Bubblemeister Greenspan himself. He bears his failure to “more than glimpse” like a badge of honor.

So it seems that only the bankers know what they’re selling, not their customers or the regulators. But you must trust Wall Street to do the right thing. If bankers do not make money for their customers, they will lose their trust. Why would bankers and financial institutions act in such a way as to profiteer at their customers’ expense (and that of the overall economy for that matter)?

The reason, of course, is that the financial sector notoriously lives in the short run. Countrywide Financial, Lehman Brothers, WaMu, Bear Stearns, A.I.G. et al. gave their managers enormous salaries and even more enormous bonuses to turn themselves into a new power elite, creating fortunes that will endow their heirs for a century.

Someone is winning from all this complexity. The Federal Reserve Bank of Minneapolis has just published statistics showing that the wealthiest 1 per cent of America’s population doubled its share of wealth over the decade ending in 2007, when the bubble reached its peak. No doubt this polarization has widened as the economy shrinks under the weight of its debt overhead. But with regard to criticisms of the fact that bankers have used TARP and other bailout money simply to maintain “the outsized (to some, egregious) bankers’ pay packages,” Greenspan points out that “small differences in the skill level of senior bankers tend to translate into large differences in the bank’s bottom line.” Skill is expensive, and they are only being paid for their talents and expertise.

What amazes me about mismanagers like Countrywide’s chairman Mozilo and his counterparts is that when the S.E.C., F.B.I. and state attorneys general open a investigation to see whether to charge them with criminal felonies, they all insist that they were out of the loop, had no idea of what was going on, and profess to be “shocked, shocked, to find out that there’s gambling going on in this place.”

If they are so unknowledgeable to be even more stupid than the regulators and economist who warned about what was happening, how can they insist that they are worth whatever they can grab? For that matter, how did they manage to swap jail terms for getting to keep their tens of millions of dollars in salaries and bonuses? This is the real question that “free market” economists should be asking. Most Wall Street firms have paid substantial settlements, and Mozilo recently paid the Securities and Exchange Commission $67.5 million to avoid going to trial for civil fraud and insider dealing.

So in all this mess that has led to a $13 trillion government bailout, only Martha Stewart became an insider jailbird. For Wall Street, paying a civil fine “without acknowledging wrongdoing” blocks victims from recovering civil damages in the event that they try to sue to get their money back. Evidently the Obama Administration believes that to make the banks pay would simply require yet further bailouts of “taxpayer money.” So by refraining from prosecuting, Geithner at the Treasury and other regulators can claim to be saving taxpayers – by permitting the large banks to have grown 20 per cent larger today than they were when the bailouts began!

But Greenspan argues that the economy would be even poorer under financial regulation. “One of the [Dodd-Frank] law’s provisions,” he criticizes, “made credit-rating organizations legally liable for their opinions about risks.” But to avoid killing business with such regulation, “the Securities and Exchange Commission in effect suspended the need for a credit rating.” To make the ratings agencies responsible for the tens of billions of dollars lost as a result of their pasting AAA ratings on junk mortgages would cut down their business.

 It is as if fraud is simply part of the free market. In this respect, I find his Financial Times article even more damning than his October 2008 Congressional testimony.

To show how thoroughly he has been cured from his temporary apostasy from free market religion, Greenspan belittles the fact that: “In December, the Federal Reserve … proposed to reduce banks’ share of debit card fees associated with retail transactions, leading many lenders to contend they would no longer be able to afford to issue debit cards.”

 Can there be a better logic to promote the “public option” and have the Treasury issue credit cards as well as debt cards? The rake-off charged by banks from sellers and buyers alike (not to mention late fees that yield the card companies even more than their interest charges these days) has been a major factor eating into retail profits and personal incomes.

The banks are arguing, in effect: “If we can’t earn back enough profits to cover the losses we’ve made on our junk loans, we’ll organize our own lockout of customers – to force you to pay whatever we demand to cover our costs, pay our salaries and bonuses.”

So why not let the government say, “OK, we’ll provide a public-option alternative. And if this works, we’ll use it as a model for our public health insurance option.”

 Greenspan responds that if banks are regulated to reduce the risk they pose to the economy, they may simply pack up and take their dealings to London: “concerns are growing that without immediate exemption from Dodd-Frank, a significant proportion of the foreign exchange derivatives market would leave the US.” My own response is to say fine, let them leave. Let Britain’s Serious Fraud Office and bank regulators pick up the pieces from their next opaque gamble “too complex” to understand.

  Most slippery in Greenspan’s op-ed is his attempt to divert attention away from the instability that financial deregulation has caused – the vast polarization of wealth, the enormous mushrooming of debt beyond the ability to pay, the massive impoverishment of the economy as a result of its debt overhead, as if all this were stability? Don’t look there, he says; look at how “the global ‘invisible hand’ has created relatively stable exchange rates, interest rates, prices, and wage rates.” But real estate prices have not been stable – they have been inflated with debt, and then crashed the net worth of hapless borrowers. Commodity prices are not stable, especially not that of Greenspan’s beloved gold bullion.

Nevertheless, Greenspan concludes, there can be no such thing as a science of regulation. “Financial market behavior is subject to so wide a variety of ‘explanations,’ especially in contrast to the physical sciences where cause and effect is much more soundly grounded.” But what sets the physical sciences apart from junk economics is the fact that it is not directly self-interested. There are no huge financial rewards for having a blind spot (except of course for scientists denying that nuclear power might be dangerous or deep-water oil drilling a risky proposition). There is method in the madness of today’s free market orthodoxy opting for GIGO (garbage in, garbage out) financial models that sing along with maestro Greenspan that Wall Street wealth will all trickle down.

“Is the answer to complex modern-day finance that we return to the simpler banking practices of a half century ago?” he asks rhetorically “By “simpler” banking practices of days of yore, he really means more honest practices, subject to knowledgeable public regulation. It was a world where banks held onto the mortgages they made rather than flipping them to third parties without any responsibility for truth in lending – or in selling, for that matter. “That may not be possible if we wish to maintain today’s levels of productivity and standards of living.”

“In moving forward with regulatory repair, we may have to address the as yet unproved tie between the degree of financial complexity and higher standards of living,” Greenspan suggests. But his response is that wealth at the top is the price to be paid for rising living standards. But they are not rising – they are falling! Bankers have not turned out to be job creators. They are debt creators, and debt deflation is what is pushing the economy into depression, raising unemployment and driving housing prices further and further down.

So it sounds like Greenspan today would do just what he did years ago, and reject the warning by Fed governor Ed Gramlich urging the Fed to regulate the soaring financial fraud. His mantra is still that the invisible hand is too complex to regulate.

For further commentary on his remarkable “I take it all back” op-ed, I recommend the excellent column of Yves Smith, “OMG, Greenspan Claims Financial Rent Seeking Promotes Prosperity!” Naked Capitalism, March 30, 2011.

MICHAEL HUDSON is a former Wall Street economist. A Distinguished Research Professor at University of Missouri, Kansas City (UMKC), he is the author of many books, including Super Imperialism: The Economic Strategy of American Empire (new ed., Pluto Press, 2002) and Trade, Development and Foreign Debt: A History of Theories of Polarization v. Convergence in the World Economy. He can be reached via his website, mh@michael-hudson.com