the greenspan legacy

The magnitude of the current financial crisis defies attempts to target any individual villain or villains for ultimate responsibility. (Certainly right wing attempts to lay the blame at the feet of Fannie Mae or the Community Reinvestment Act don’t even remotely hold up to scrutiny by any credible economist.) But the individual who bears by far the largest share of responsibility is former Fed chief Alan Greenspan.

John McCain’s economic guru, the former Republican chairman of the Senate Banking Committee, Phil Gramm, gushed to Greenspan when he appeared before that committee in 1999, “You will go down as the greatest chairman in the history of the Federal Reserve Bank.” It is becoming increasingly clear that history’s verdict will almost certainly be the opposite.

Today’s New York Times has a MUST-READ piece on the Greenspan legacy. Read the whole thing. It’s hard to excerpt just a few bits, but I’ll give it a try:

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives — exotic contracts that promised to protect investors from losses, thereby stimulating
riskier practices that led to the financial crisis. For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever
derivatives have come under scrutiny in Congress or on Wall Street. “What we
have found over the years in the marketplace is that derivatives have been an
extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. -Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added.

Today, with the world caught in an economic tempest that Mr. Greenspan recently
described as “the type of wrenching financial crisis that comes along only once
in a century,” his faith in derivatives remains unshaken.

The problem is not that the contracts failed, he says. Rather, the people using them
got greedy. ...

[Ed. note: Wall Street investors greedy??!? I'm SHOCKED, SHOCKED. Who knew they would betray Greenspan's trust in their better nature.]

The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them. ...

[Ed. note: Read that again. $531 TRILLION. That's over HALF A QUADRILLION. What could go wrong?]

Over the years, Mr. Greenspan helped enable an ambitious American experiment in letting market forces run free. Now, the nation is confronting the consequences. ...

Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable that they required federal oversight to protect the financial system. In meetings with -federal officials, celebrated appearances on Capitol Hill and heavily attended speeches, Mr. Greenspan banked on the good will of Wall Street to self-regulate as he fended off restrictions. ...

[Ed. note: So, there you go. Goodwill and self-regulation will prevail on Wall Street.]

A professed libertarian, he counted among his formative influences the novelist Ayn Rand, who portrayed collective power as an evil force set against the enlightened self-interest of individuals. In turn, he showed a resolute faith that those participating in financial markets would act responsibly. ...

“Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various people in the Treasury,” recalled Alan S. Blinder, a former Federal Reserve board member and an economist at Princeton University. “I think of him as consistently cheerleading on derivatives.” ...

Mr. Greenspan warned that derivatives could amplify crises because they tied together the fortunes of many seemingly independent institutions. “The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence,” he said.

But he called that possibility “extremely remote,” adding that “risk is part of life.”
...

As the stock market roared forward on the heels of a historic bull market, the dominant view was that the good times largely stemmed from Mr. Greenspan’s steady hand at the Fed.

“You will go down as the greatest chairman in the history of the Federal Reserve Bank,” declared Senator Phil Gramm, the Texas Republican who was chairman of the Senate Banking Committee when Mr. Greenspan appeared there in February 1999.
...

“Aren’t you concerned with such a growing concentration of wealth that if one of these huge institutions fails that it will have a horrendous impact on the national and global economy?” asked Representative Bernard Sanders, an independent from Vermont.

“No, I’m not,” Mr. Greenspan replied. “I believe that the general growth in large institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically — I should say, fully — hedged.”

The House overwhelmingly passed the bill that kept derivatives clear of C.F.T.C. oversight. Senator Gramm attached a rider limiting the C.F.T.C.’s authority to an 11,000-page appropriations bill. The Senate passed it. President Clinton signed it into law.

Still, savvy investors like [Obama advisor] Mr. Buffett continued to raise alarms about derivatives, as he did in 2003, in his annual letter to shareholders of his company, Berkshire Hathaway.

“Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers,” he wrote. “The troubles of one could quickly infect the others.”

And when Mr. Greenspan began to hear of a housing bubble, he dismissed the threat.
Wall Street was using derivatives, he said in a 2004 speech, to share risks with other firms.

Shared risk has since evolved from a source of comfort into a virus. As the housing crisis grew and mortgages went bad, derivatives actually magnified the downturn.

The Wall Street debacle that swallowed firms like Bear Stearns and Lehman Brothers, and imperiled the insurance giant American International Group, has been driven by the fact that they and their customers were linked to one another by
derivatives. ...

Last December, McCain confessed, "The issue of economics is not something I've understood as well as I should." Economics is not “an issue,” but at least McCain was committed to learning more about the subject: "I've got Greenspan's book," he said.

That’s reassuring.

Last October, McCain said that as president he would appoint Alan Greenspan to lead a review of the nation's tax code - even if the former Federal Reserve chairman was dead: "If he's alive or dead it doesn't matter. If he's dead, just prop him up and put some dark glasses on him like, like 'Weekend at Bernie's.’”

John McCain, Sarah Palin, Phil Gramm and a deceased Alan Greenspan. Now there is an economic team.