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02 Oct 2009 10:32 am

Greenspan: It's Not Easy Being Greenspan . . . or Any Other Central Banker

My favorite Alan Greenspan story comes from a friend in the investment banking industry, who heard him give a talk in New York shortly after he retired from the Chairmanship of the Fed. One of The Maestro's many critics, rather than asking a question, launched into a diatribe about the Fed's decision to increase liquidity in the run-up to Y2K, which many have credited with helping to over-inflate the tech bubble. Greenspan let him talk himself out, then said, "If you're asking whether we know how to pop an asset price bubble using the power of the Federal Reserve, the answer is yes." Then he sat back and savored the silence as a room full of Wall Street types contemplated what it would actually have meant for the Federal Reserve to spike up interest rates high enough to deflate the bubble.

It was a perhaps slightly more humble Alan Greenspan who sat down today with David Leonhardt at the New York Times. Right out of the gate, he admitted that "the general view of how the world works that we held in 2006 was significantly wrong." The Federal Reserve had not understood, he said, how quickly the liquidity washing around the global system could disappear--how far that system could be driven by fear.

In hindsight, this seems a little puzzling--financial crises are hardly new, or rare. But Alan Greenspan was hardly the only one to believe that in developed countries with strong institutions, they could be controlled. Entire PhD careers have been built--and now destroyed--on "The Great Moderation," over which Greenspan presided for so long.

Asked what he would have done differently, Greenspan emphasized capital requirements. In a crisis environment, he told the audience, "you cannot function with a system with capital as low as it was." Moreover, capital requirements are relatively easy to impose, as are limitations on certain kinds of loans. What's difficult, he said, is regulations that require a forecast of what is going to happen.

In the debate about financial regulation, there has been a split between those who want regulators to prevent crises, and those who want to make the system more robust to inevitable failures. Greenspan seemed to be throwing in his lot with the latter group. No regulator, he said, would ever have the wisdom to simply keep financial crises from happening.

"By definition a financial crisis is a discontinuous break in prices. Which of necessity means that it was unexpected, because were it expected, it would be arbitraged away."

Before the crisis, he pointed out, most observers--including those now being hailed as prescient--anticipated that the next big problems to come from America's gargantuan current account deficit, which they expected to bring on a crisis with the overvalued US dollar. As a result, they sold dollars, and the expectations of a future dollar crisis abated.

Greenspan drove home this point by touching on his (wrong) predictions of what would happen in the overvalued housing market. Greenspan acknowledged that he had known the housing market was overvalued in 2004-5, but said that he had expected to see what had already happened in England and Australia--prices falling, then stabilizing at a lower level.

So what should regulators do? And perhaps more importantly, how should they generate the political capital with which to do it? In response to this question from Leonhardt, Greenspan indicated that the problem is not in our political stars, but in ourselves. "People like Geithner and Bernanke and Larry Summers are all wholly cognizant of the economic problems that exist out there. If we were able to leave the decision making to them, I'd be confident that we'd get a good--not a perfect--outcome. But there is a populist strain in this country that has good aspects and bad aspects. The tendency is to make bad short term budget decisions. We've historically kept our level of debt way below our capacity to borrow, but if you take existing programs and project them out, we're eroding that cushion."

This is why even Greenspan, who supported the Bush tax cuts, has said that taxes need to rise, a point he and Leonhardt discussed at some length. Greenspan indicated that he favors a VAT to deal with America's large and growing budgetary imbalances--not, he said, because this is what he wants, but because our current spending commitments have made it a necessity. He also favors spending cuts, such as means-tested copays for Medicare services, but as he admits, he's no politician. It doesn't matter if all the wonks agree, if America rejects their "obvious" solution.

Greenspan's other major worry for the future is the same thing he spent years worrying about at the Fed (though some argue, worrying too little): inflation. This is not an urgent problem--but ironically, he said, this may make it harder to solve. The doubling of the Fed's balance sheet, he said, would eventually show up as an increase in the price level if that doubling were not reversed, though given economic conditions, and the time it takes for increases in the money supply to actually produce inflation, he didn't expect price indexes to start rising before late 2011 at the earliest. "What has to be reversed is the size of the Fed's balance sheet. There's no doubt that this is what has to be done, and the people at the Fed are aware of this. But the urgency to do it is not there. What you have to be aware of is that when things aren't urgent, there's a temptation to say, we don't need to do it right now, and suddenly it's a year later. We cannot allow this to happen."

Watch the full video of this session:


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