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Greenspan: Not My Fault

Former Fed Chairman Alan Greenspan acknowledges that the Fed did little to rein in the systemic risks banks were taking, but also said that the Fed couldn't have prevented the recession even it had acted. Most forecasting models are broken, he said.

March 19: This post has been updated.

Alan Greenspan, former chairman of the Federal Reserve, will be presenting a 48-page paper to the Brookings Institution tomorrow. For years considered "The Maestro" of our economic system, Greenspan acknowledges in his paper that the Fed "did little" to address the systemic risks of banks that were growing increasingly complex, but he doubts that the recession could have been prevented.

I've pulled out a few choice excerpts. (If you want to read the full paper, we've put it in our handy document viewer.) 

On why the Fed and other regulators didn't pop the credit bubble:

Why did the 2007 bubble reach century-rare euphoria? The answer, I believe, lies with the dot-com bubble that burst with very little footprint on global GDP, and in the U.S., the mildest recession in the post-World War II period. And indeed the previous U.S. recession (1990-1991) was the second most shallow. Coupled with the fact that the 1987 stock market crash left no visible impact on GDP, it led the Federal Reserve and many a sophisticated investor to believe that future contractions would also prove no worse than a typical post-war recession.

Did they know what was coming? He says no -- they could "identify" bubbles, but they could not "effectively time the onset of crisis."

The current crisis has demonstrated that neither bank regulators, nor anyone else, can consistently and accurately forecast whether, for example, subprime mortgages will turn toxic, or to what degree, or whether a particular tranche of a collateralized debt obligation will default, or even if the financial system as a whole will seize up. A large fraction of such difficult forecasts will invariably be proved wrong. Regulators can readily identify underpriced risk and the existence of bubbles, but most importantly they cannot, except by happenstance, effectively time the onset of crisis. This should not come as a surprise.

And then he says that the Fed had the capacity to crack down on the bubble, but it would've compromised economic growth:

To be sure, central banks have the capacity to break the back of any prospective cash flow that supports bubbly asset prices, but almost surely at the cost of a severe contraction of economic output, with indeterminate consequences.

Could the crisis have been prevented? Greenspan says he doubts it.

Could the breakdown that so devastated global financial markets have been prevented? Given inappropriately low financial intermediary capital (i.e. excessive leverage) and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.

And his suggested regulatory solutions?

(1) increased regulatory capital and liquidity requirements on banks and
(2) significant increases in collateral requirements for globally traded financial products, irrespective of the financial institutions making the trades.

Greenspan also mentions a number of "less important" reforms. They include preventing financial institutions from forming complex structures for the purpose of avoiding higher taxes, as well as requiring "living wills" from financial institutions indicating how they can be liquidated with minimal economic impact. He warns, however, that "the notion of an effective 'systemic regulator' as part of a regulatory reform package is ill-advised. The current sad state of economic forecasting should give governments pause on the issue. Standard models, other than those that are heavily add-factored, could not anticipate the current crisis, let alone its depth."

It's particularly interesting reading this now, because on my morning commute to work, I've been making my way through economist Dean Baker's book, False Profits, in which he basically argues against many of these same points. Baker is co-director of the liberal Center for Economic and Policy Research. 

"In this financial crisis story, the crisis is talked about as if it were a rare and highly unlikely event -- a black swan -- rather than one that could be predicted with absolute certainty, even if the timing and exact course of events could not be known," writes Baker. Compare that to Greenspan's "standard models ... could not anticipate the current crisis," and I believe you have what is called a contradiction.

One thing Baker and Greenspan do agree on is this -- we don't need more "systemic regulators." The irony is that they agree on this for completely different reasons. Greenspan suggests that a systemic regulator wouldn't have been able to forecast the crisis either. And Baker writes that we don't need one because we already have one: "The problem was not that we lacked a systemic risk regulator but that we had one that failed catastrophically at its job," and that regulator, according to Baker, was the Federal Reserve Board.

Greenspan chaired the Fed from 1987 to 2006. While in 2008, he acknowledged he had been wrong about the self-correcting power of free markets, he has maintained that the Fed did not cause the housing bubble. His presentation tomorrow will continue in that vein, arguing that regulators knew of the bubble and had the power to rein it in, but could not have predicted the timing of the crisis, and ultimately could not have prevented the crisis.

I'm sure Baker will have a field day with that.

Update: This post has been updated to include a few of Greenspan's more minor reform suggestions.

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