Greenspan Concedes That the Fed Failed to Gauge the Bubble
By SEWELL CHAN
nytimes.com, March 18, 2010
WASHINGTON — Is Alan Greenspan, famous for his libertarian leanings and hands-off approach to Wall Street, having some second thoughts?
Many Calls for Avoiding a Repeat of Bank Bailouts (March 19, 2010)
After more than six decades as a skeptic of big government, the former Federal Reserve chairman, now 84, is gingerly suggesting that perhaps regulators should help rein in giant financial institutions by requiring them to hold more capital.
Mr. Greenspan, once celebrated as the “maestro” of economic policy, has seen his reputation dim after failing to avert the credit bubble that nearly brought down the financial system. Now, in a 48-page paper that is by turns analytical and apologetic, he is calling for a degree of greater banking regulation in several areas.
The report, which he is to present Friday to the Brookings Institution, is by no means a mea culpa. But in his customarily sober language, Mr. Greenspan, who has long argued that the market is often a more effective regulator than the government, has now adopted a more expansive view of the proper role of the state.
He argues that regulators should enforce collateral and capital requirements, limit or ban certain kinds of concentrated bank lending, and even compel financial companies to develop “living wills” that specify how they are to be liquidated in an orderly way.
And he acknowledged shortcomings in regulation — an area on which the central bank has placed far greater emphasis under Mr. Greenspan’s successor, Ben S. Bernanke.
“For years the Federal Reserve had been concerned about the ever-larger size of our financial institutions,” Mr. Greenspan wrote. Fed research has not been able to find economies of scale as banks grow beyond a modest size, he said, and in a 1999 speech, Mr. Greenspan warned that “megabanks” formed through mergers created the potential for “unusually large systemic risks” should they fail.
Mr. Greenspan added: “Regrettably, we did little to address the problem.”
The former Fed chairman also acknowledged that the central bank failed to grasp the magnitude of the housing bubble but argued, as he has before, that its policy of low interest rates was not to blame. He stood by his conviction that little could be done to identify a bubble before it burst, much less to pop it.
“We had been lulled into a sense of complacency by the only modestly negative economic aftermaths of the stock market crash of 1987 and the dot-com boom,” Mr. Greenspan wrote. “Given history, we believed that any declines in home prices would be gradual. Destabilizing debt problems were not perceived to arise under those conditions.”
His new thoughts on regulation appeared to be a turnabout from Mr. Greenspan’s past views on bank size. Sanford I. Weill, the former Citigroup chief executive, wrote in a 2006 memoir that when Citigroup was formed in 1998 out of the merger of banking and insurance giants, Mr. Greenspan told him, “I have nothing against size. It doesn’t bother me at all.”
In a lengthy footnote, Mr. Greenspan wrote that it was “interesting speculation” to ask whether investment banks would have avoided taking on extraordinary leverage — as much as 20 to 30 times tangible capital — had they remained partnerships instead of incorporating, as a 1970 ruling permitted broker-dealers to do.
“To be sure, the senior officers of Bear Stearns and Lehman Brothers lost hundreds of millions of dollars from the collapse of their stocks,” he wrote. “But none to my knowledge filed for personal bankruptcy and their remaining wealth allowed them to maintain much of their previous standards of living.”
The main policy prescription in Mr. Greenspan’s paper was higher capital requirements and liquidity ratios, which he argued would be the most effective way to blunt the impact of future crises. And he suggested that discussions under way to designate regulators to detect systemic financial risks would be of limited use.
“Unless there is a societal choice to abandon dynamic markets and leverage for some form of central planning, I fear that preventing bubbles will in the end turn out to be infeasible,” Mr. Greenspan wrote. “Assuaging their aftermath seems the best we can hope for.”
Mr. Greenspan, who stepped down as Fed chairman in January 2006, has defended his once-celebrated 18-year tenure previously. But the Brookings paper is his most extensive examination to date of the crisis’s origins.
The paper, titled “The Crisis,” argues that a global housing bubble was primarily caused by a sharp drop in long-term interest rates from 2000 to 2005, brought about by export-oriented growth in developing economies, especially China, after the end of the cold war. China, saving the dollars it was earning, in effect made money available for cheap loans.
“In short, geopolitical events ultimately led to a fall in long-term mortgage interest rates that in turn led, with a lag, to the unsustainable boom in house prices globally,” he wrote.
Mr. Greenspan also tried to refute, or at least deflect, the criticism he has received for the Fed’s conduct of monetary policy in the years after the burst of the dot-com bubble in 2001 and the subsequent recession. John B. Taylor, a Stanford economist, has been the most influential exponent of that criticism.
In response, Mr. Greenspan argued that the rise in home prices had become unhinged from other measures of inflation. While conceding that the low fed funds rate, the benchmark interest rate the Fed controls, made it easier for borrowers to use adjustable-rate mortgages, he said he suspected — “but cannot definitively prove” — most home purchasers would have taken out 30-year fixed-rate mortgages had the adjustable-rate ones not been available.
“The global house price bubble was a consequence of lower interest rates, but it was long-term interest rates that galvanized home asset prices, not the overnight rates of central banks, as has become the seemingly conventional wisdom,” Mr. Greenspan wrote.
In addition to endorsing higher capital and liquidity requirements, Mr. Greenspan said banks and possibly all financial intermediaries should be required to hold bonds that automatically convert to equity when capital falls below a certain threshold. That could help reduce the “moral hazard” that exists because the banks that failed did not suffer the full costs of their actions.
The Senate is contemplating a mechanism by which the government can seize and dismantle a huge, interconnected financial company before panic spreads.
For a big, interconnected company, regulators should initiate a special bankruptcy process, he wrote. A bankruptcy judge would require creditors to take a haircut before the company is reorganized. The company should then be split up into separate units, “none of which should be of a size that is too big to fail,” Mr. Greenspan wrote.