Keen on Greenspan

When he ran the US Federal Reserve, Alan Greenspan received almost reverential treatment from Congress. Last week, he went from oracle to toast, as the House Committee on Oversight and Government Reform took him to task over the current crisis.


Greenspan not only conceded that he had made mistakes, but even ventured that his entire worldview may be wrong. In reply to Committee Chairman Waxman's proposition that his ideology "was not working", Greenspan replied:


That's precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.


The wellsprings of Greenspan's ideology were the Austrian economist Friedrich Hayek, and the Libertarian philosopher Ayn Rand-both of whom were champions of free market capitalism. Greenspan applied that ideology throughout his tenure as Chairman of the Fed, by opposing regulation, and by rejecting the claim that markets could make mistakes in pricing capital assets.


Greenspan is famous for parroting Robert Shiller's statement that the market was subject to "irrational exuberance". But he went on to deny that claim, and in fact to actively work against it. As Committee Chairman Waxman put it last week, "Over and over again, ideology trumped governance".


In fact, Greenspan's belief that markets couldn't misprice assets led to a conflict with his ideology. The man who believed that market always get it right, spent much of his tenure rescuing the stock market from its bouts of irrationality. In October 1987, just two months after he took over from Paul Volcker, the Market dropped 20 percent in one day. Greenspan's Fed did everything possible to prevent the crash going any further-with reassuring words, reductions in the reserve interest rate, easy provision of credit, and large scale purchases of commercial bonds.


Similar interventions occurred with the Savings and Loans crisis, the collapse of Long Term Capital Management, the Dotcom bust of 2000, and Enron's failure. Greenspan then retired from the Fed in February 2007-just under 20 years after he first sat in the chair, and six months before this Daddy of all financial crises began.


Greenspan's history of activist intervention, when his ideology should have led him to leave the markets to themselves, has clouded our capacity to judge just what went wrong. Was it really his free market ideology that failed, or did his faith in markets lead him to intervene-with all the powers of The State-when he should really have left the market to sort out its own woes?


My answer to both those questions is yes.


The ideology that the free market always works out the right price for everything-including assets-is manifestly false, as any reasoned appraisal of the 19th century trade cycle will attest. There was a major financial crisis every 20 or so years, when speculative excess led to overborrowing, a crisis, and ultimately a recovery. Hayek's ideology of markets that price everything with approximate accuracy is no match for Hyman Minsky's empirically-derived hypothesis that finance markets destabilise the real economy.


But the levels of overborrowing that were reached prior to Greenspan's activist Federal Reserve were nothing, compared to the level of debt that has run up on Greenspan's watch. The irrational exuberance of the Roaring Twenties was financed by private borrowing that peaked at 150 percent of GDP in 1930-and then blew out to 215 percent, as output and prices collapsed during the Great Depression.


Coincidentally, the US reached that same debt to GDP ratio in 1987-the year Greenspan first tried his interventionist hand at a rescue. But all that rescue really did was encourage the private sector to keep on borrowing. By the time Greenspan retired, that debt ratio was 280 percent, and it is now 290 percent.


We have now reached such an excessive level of indebtedness that there is no prospect for another debt surge to restore the illusion of prosperity. Instead now we have to de-lever: to reduce the excessive debt that was run up, not only under Greenspan but before him-ever since the mid-1960s, it has not been free market ingenuity that has driven America's economic performance, but rising debt.


As that painful process unfolds, Greenspan and his intellectual heroes-Hayek, Rand, and Friedman-should be tossed into the dustbin of history. We need to replace ideology-whether of the right or the left-with an empirically grounded understanding of the workings of a market economy, warts and all.


The new, realistic economics, will be built on the shoulders of Schumpeter, Keynes, and Hyman Minsky.