A “once-in-a-century credit tsunami” is what Alan Greenspan has called the economic crisis that the world is now facing. Greenspan was chairman of the Federal Reserve, America’s central bank, from 1987 to 2006. During this time, Greenspan was the maestro of America’s monetary policy through the 1987 stock market crash, the dot-com boom of the 1990s, and the resulting bust and recession of 2001.
Despite presiding over the longest boom in the country’s history, Greenspan’s unwavering support for free markets and deregulation was challenged by Congress last week. Although he denied fault for the current crisis, in his testimony he conceded, “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.” Greenspan’s lifetime of free market ideology has shown itself to be little more than wishful thinking.
It’s not altogether surprising that there would be conflict between the goals of a company’s managers and its shareholders. After all, managers are only human. It’s often difficult to focus on long term success when short term profits—and the bonuses that come with them—are within reach. The realization that managers will act upon self-interests is certainly nothing new; most business textbooks have some discussion of the “agency dilemma.” However, Greenspan’s testimony errs on the side of ignorance. “A critical pillar to market competition and free markets did break down,” he said. “I still do not fully understand why it happened.”
Although the ‘why’ eludes him, his acumen on the ‘how’ remains sharp. The unchecked growth and resulting collapse of Fannie Mae and Freddie Mac as well as their close ties to the Democratic party have led many Republican lawmakers to blame the meltdown on their opposition. Greenspan disagrees, and instead finds fault in gluttonous financial companies who packaged subprime mortgages into complex securities. “The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of the crisis) would have been far smaller and defaults accordingly far lower,” he said.
Moreover, the free market activist seems to be reforming. Although the additional regulation that Greenspan believes necessary has been limited, it is certainly progress from the staunch opposition to such regulation while he was Federal Reserve Chairman. He testified that securitizers should be required to keep a portion of the securities they’ve created. While this would certainly discourage firms from releasing toxic securities out on the market, other institutional factors exist that contributed in making this crisis global, such as the use of the derivative securities known as credit default swaps.
These act as insurance policies for the underlying security, but because they are labeled “swaps,” they are not held accountable to insurance regulations. These swaps were proliferated throughout the global banking community and created an interconnectedness that allowed the collapse of the domestic housing market to affect credit markets worldwide. Greenspan commented, “Excluding credit default swaps, derivatives are working well”, apparently sponsoring regulation of such swaps. However, leaving the derivative market still largely unregulated in the wake of this collapse seems too optimistic. Although free market beliefs have functioned well in times of great prosperity, its failures admit that we shouldn’t just have faith in the market. Transparency, even if it’s due to regulation, should be the hallmark of the new economic regime.
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