clip_image002

Popular Economics Weekly

One thing was clear from last week’s Financial Crisis Inquiry Commission hearings. Though extremely sorry, the main players—such as former Fed Chairman Alan Greenspan, as well as Robert Rubin and Charles Prince of Citibank—wouldn’t take responsibility, or return their rich payouts for helping to cause the financial market crash in 2008 that almost precipitated a second Great Depression.

Why the difficulty in pinning down who was responsible? Firstly, it hasn’t yet seemed to occur to them, or anyone, that they committed a crime. That in looking out for their short term profits, without considering the longer term consequences, what they did was indefensible. “The buck stopped there,” said one New York Times cartoon, implying some kind of group think caused the collapse and loss of more than $11 trillion in wealth, in spite of repeated warnings from underlings that much of Citibank’s mortgages were junk. “We all bear responsibility” was Rubin’s paean to the commission, as if he didn’t consider himself one of those responsible, even though he was Chairman of Citibank’s executive committee.

Secondly, no one seemed to even understand the consequences. A string of unprecedented financial innovations created institutions that “don’t take into account the kind of communities we want to build”, said economist Robert Shiller in a recent New York Times Op-ed. Yet as leaders of their respective institutions it was certainly their job to foresee any downside consequences. There were certainly precedents, such as the creation of extreme asset bubbles in Japan. In fact, the Federal Reserve had worried about Japanese-style deflation in the early 2000s, the result of Japan’s own busted real estate and stock bubbles.

On the contrary, the biggest players only saw the upside. Greenspan in fact trumpeted the advantages of exotic (and unregulated) derivatives that spread the risk more widely, that he thought lessened the dangers of default. Yet Greenspan of all people should have foreseen the crash.

I remember well that he encouraged risky mortgages by recommending adjustable rate mortgages as preferable to fixed rates because their interest rates were lower, even though he admitted at hearings he only borrowed at fixed rates! A housing bubble was most unlikely, he said, because home owners couldn’t buy and sell their homes like stocks. Their transaction costs were higher, the housing market was less liquid—and moving costs were considerable.

This was when the Fed had been holding down short-term interest rates in 2003-4 almost as low as today in a bid to fight Japanese-style deflationary fears, and boost a recovery that hadn’t yet added one net job from the end of the 2001 recession. Because inflation was so low then—below 1 percent—the cost of money was in fact less than zero, which made it advantageous to mortgage with little or no down payment.

Why could some of the “smartest guys in the room” so miscall the worst downturn since the Great Depression? Greenspan for one, a disciple of Ayn Rand, believed that free markets embodied the highest moral order (his words). What made it moral? Greenspan, as Ayn Rand, et. al., believed that free market forces were the most efficient and impartial allocator of resources. So when crises did occur, they functioned as a market clearing device, and any attempt to mitigate their effects only prolonged the adjustment to new circumstances. Such crises embodied the forces of ‘creative destruction’ and shouldn’t be tampered with, in other words.

This is why many conservative economists who decried the stimulus spending said “let the banks fail”, so that bad debt can be wiped out. Creative destruction—the replacement of failing businesses with more vibrant ones—happened in nature, so why shouldn’t it be allowed to happen in the urban jungle?

The problem was that Greenspan’s ideology was outdated, and had become group think. The invisible hand of Adam Smith was no longer sufficient to control market forces that had become complex beyond understanding. Bubbles were caused by ignorance of fundamentals, including fundamental market forces that could go easily out of control when greater risk taking was encouraged, with no limits on borrowing.

Household incomes had been steadily shrinking in real (after inflation) terms since the 1970s, except for a short while in the 1990s, so the housing bubble and easy credit encouraged many households to spend borrowed money to keep up their standard of living, a standard that was now beyond their means.

There was too much room for greed, in a word, or as Alan Greenspan once famously said,

“It is not that humans have become any greedier than in generations past. It is that the avenues to express greed had grown so enormously.”

A sustainable economic system has to take more than individual self-interest into account. It must also include the interest of future generations, which means the Captains of Industry-and government-have to be held accountable for those generations as well.

Harlan Green © 2010