Monday, March 22, 2010

Greenspan setting the record straight? Not really

"Partially I made the mistake in presuming that the self interests of organizations, specifically banks and others were such that they were best capable of protecting their own shareholders and their equity in the firms.... The problem here is something which looked to be the very edifice, and indeed, a critical pillar to market competition and free markets, did break down."

- Alan Greenspan during crisis hearings last year

In a new paper for the Brookings Institute, "The Crisis", Alan Greenspan lays out his case for an increase in regulatory capital and an increase of collateral requirements for all financial institutions. Seems a little late. His argument rests on the fact that if there is a high degree of uncertainty, that is, there will be regulatory mistakes, the burden should be on the banks to protect themselves from risks. Again, this could have happened before and this is not an argument against regulation. Banks did not do enough to protect themselves. Hence here is a need for better regulatory oversight.

Greenspan also provides a spirited defense of his Fed leadership based on three arguments. First, the end of the Cold War lead to a huge savings glut and change in global economics which created the bubble. Second, monetary policy was working fine even based on his interpretation of the Taylor Rule. Monetary policy was not excessively loose. Third, even if rates were low, there is not a strong link between short-term rates and housing prices; consequently, monetary policy could not have been the culprit.

Each of these arguments are interesting but miss the point. First, the savings glut was well known and identified by the Fed. The Fed could have run monetary policy to offset some of the global imbalances to eliminate market distortions. Yes , there were fears of deflation after the Tech bubble, but the Fed did not have to drop rates inside 1 percent.

The Taylor rule argument is a little more convincing. Taylor rules in real time may give different signals so there would have been some confusion in determining whether monetary policy. as loose or tight. Nevertheless, the housing bubble was going in full force even before the rates were lowered. Monetary policy only further added to the problem.

The link of between housing prices and long-rates does not address the rationing in credit for poor borrowers which was offset through the sub-prime market. The link also does not address the issue of home equity lines which further changes the loan to value ratios for many homeowners.

Greenspan wants to resurrect his legacy s the Maestro but it will continue to take a beating. The bubbles happened on his watch and the view of the Fed has been that bubbles could not occur in the first place. The Fed also did nothing to stop the mortgage market growth and asked for no powers to better monitor the shadow banking system.

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