Posted with permission of the author.
Alan Greenspan finally tells the truth, but nobody believes him.
The CrisisMarch 2010
http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdfIt was an unexpected medium for a theoretical explanation from he who had been the most powerful economist in the world. In a short, quasi-academic paper titled The Crisis and published by Brookings, Alan Greenspan finally commented on the events to which his name will forever be attached. Neither ringing defense nor melodramatic mea culpa, the paper is instead a brief survey of the "geopolitical" events which led to the "Great Recession", and a series of reform suggestions which are strangely at odds with its analytical premises.
Greenspan's paper was met by a brief firestorm of criticism, and then, instant, contemptuous, dismissal. Greenspan was the monster whose policy suggestions had brought these events into the world. Greenspan was a cynical liar who was merely trying to save what was left of his reputation. Greenspan was a fool, trying to lend an objective skeleton to what was so obviously the result of greed and corruption...
In reality, these responses were mistimed. For perhaps the only time in his career, Greenspan wrote something worth reading. Greenspan's famous instant postmortem before Congress on the banking collapse, "I was wrong", and his simultaneous embrace of Keynesian regulation have been well documented. In The Crisis, Greenspan goes much, much farther... beyond Keynes, beyond Say, beyond Ricardo, to become a full-fledged Marxist. The Great Recession was a crisis of overproduction, pure and simple. They are words that could not be heard from the enfants terrible of the neo-Keynesians... not from Stiglitz nor Krugman nor Rubin. But, Greenspan goes there and without even a hint that any other interpretation is possible.
Of course, Greenspan doesn't remain a Marxist for long. By the time that reform proposals are required, Greenspan easily reverts to his comfort zone. Regulation? Certainly, with an eye to the capital requirements of the banks, a few monetary twists, and... And what? And nothing. There is such a very wide gap between what Greenspan explains as the genesis of the Great Recession and what he now proposes, that nothing whatever is resolved. Had his reforms been in place, could these events have been avoided? The answer is too obviously, "No". And lest the reader miss his point, Greenspan is strangely ambivalent in the last half of The Crisis, one moment talking about the Great Recession as a "once in a century crisis", and the next, implying that it may lend its character to all crises in the foreseeable future. One moment it is bailouts which will never be necessary again, and the next it is bailouts which were the only thing that prevented a truly titanic collapse and may be routinely required as the economy goes forward. The entire premise of the paper is based in the geopolitical "events" that created the Great Recession, but there is not a single mention of how those events have now been solved, reconciled or tamed.
This thing is worth reading. That Greenspan is a major, MAJOR tool, is a foregone conclusion. The Crisis is a reminder that even tools have their day... before quietly, inevitably, fading away.
*******
In a terse, no nonsense style, Greenspan lays out the crisis in the following terms: The fall of the Soviet Union and the collapse of the Socialist Bloc (and the dismantling of the protected Socialist trading zone which partially buffered the Chinese and Indian economies, among others) added hundreds of millions of highly productive workers to the world economy. While this massive addition was as productive as the workers in the advanced capitalist countries, it did not consume nearly as much. The result was a discontinuim between between production and markets, particularly domestic markets. The increase in productive capacity without markets meant an increase in the production of commodities for export. A massive overproduction of commodities was the inevitable result. Greenspan does not use this exact terminology, but makes his case in a way which defies any other conclusion.
From the overproduction of commodities, the next stage in the escalation of "the crisis" was the overproduction of Capital. Greenspan plots this as an unprecedented fall in the general rate of interest, in all major economies, regardless of their specific policies. With the fall in interest rates, a general rise in the price of fixed assets, particularly real estate, follows. It is here that the advent of derivative securities and the rest play their part. Greenspan does not deny that these instruments, and the rampant speculation they produced, were the immediate cause of the "bubble" and the following crisis. He does imply, however, that the great mass of Capital trapped by falling interest rates would have created a similar crisis through some other medium if real-estate derivatives had not been available. Once again, he points to the onset of the very same crisis in economies which, for one reason or another, did not participate in the real-estate securities bubble.
What Greenspan is describing, to the consternation of his critics, is not a crisis of greed, speculation, policy, deregulation, politics or institutional inertia. What he is describing is a fundamental crisis of capitalism. Worse, while he is very specific as to the cause of the "Crisis", he is anything but clear as to how it has in any way been resolved... even partially.
The bankruptcy of Lehman Brothers in September 2008 precipitated what, in retrospect, is likely to be judged the most virulent global financial crisis ever. To be sure, the contraction in economic activity that followed in its wake has fallen far short of the depression of the 1930s. But the virtual withdrawal, on so global a scale, of private short term credit, the leading edge of financial crisis, is not readily evident in our financial history.
It was the global proliferation of securitized, toxic U.S. subprime mortgages that was the immediate trigger of the current crisis. But the roots of the crisis reach back, as best I can judge, to the aftermath of the Cold War. The fall of the Berlin Wall exposed the economic ruin produced by the Soviet bloc’s economic system. In response, competitive markets quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Soviet bloc and the then Third World.
A large segment of the erstwhile Third World nations, especially China, replicated the successful economic export-oriented model of the so-called Asian Tigers: fairly well educated low-cost workforces joined with developed-world technology, protected by an increasing rule of law, unleashed explosive economic growth. The IMF estimated that in 2005 more than 800 million members of the world’s labor force were engaged in export-oriented and therefore competitive markets, an increase of 500 million since the fall of the Berlin Wall. Additional hundreds of millions of workers became subject to domestic competitive forces, especially in the former Soviet Union. As a consequence, between 2000 and 2007, the real GDP growth of the developing world was more than double that of the developed world.
The red-bashing is minimal by Greenspanian standards and largely ironic considering the near instant cataclysm following on the elimination of "discredited central planning" (the "erstwhile Third World nations" described by Greenspan are all socialist or formerly socialist economies). Much more important is the sheer magnitude of the number Greenspan quotes: the number of workers producing for export went to 300 million between 1750 and 1989. Between 1989 and 2005, that number nearly tripled, from 300 to over 800 million. A vast increase in the production of commodities for export was the result.
A secondary point worth noticing is that everywhere in the paper, the former Socialist world and the "Developing World" are one and the same for Greenspan - no doubt a disappointment for those who thought that globalization meant a vast new middle-class market for Nike and Starbucks developing in Paraguay.
The consequence was a pronounced fall from 2000 to 2005 in both global real long-term interest rates and nominal long-term rates (exhibit 1) which indicated that global saving intentions, of necessity, had chronically exceeded global intentions to invest. In the developing world, consumption restrained by culture and inadequate consumer finance could not keep up with the surge of income and, as a consequence, the savings rate of the developing world soared from 24% of nominal GDP in 1999 to 34% by 2007, far outstripping its investment rate.
The capitalism-ation of the former-socialist world unleashed its productive capacity in the form of the production of commodities for export, but not in the markets to consume them. The result translated into an over-production of commodities which became an overproduction of Capital.
Yet the ex post global saving – investment rate in 2007, overall, was only modestly higher than in 1999, suggesting that the uptrend in the saving intentions of developing economies tempered declining investment intentions in the developed world. That weakened global investment was the major determinant in the decline of global real long-term interest rates was also the conclusion of the March 2007 Bank of Canada study. Of course, whether it was a glut of excess intended saving or a shortfall of investment intentions, the conclusion is the same: lower real long-term interest rates.
The capital accumulated by this process added to a "glut" already evident in the capitalist countries, leading to a fall of worldwide interest rates - the best indication of a fall in the rate of profit and the overproduction of capital.
The reader should also note the phrase: "whether it was a glut of excess intended saving or a shortfall of investment intentions, the conclusion is the same: lower real long-term interest rates". In this short fragment, the Marxist Greenspan, dismisses the entire supply-side/demand-side "debate" of the Libertarian Greenspan and the complete host of Austrians and Randians and assorted ninnies.
Inflation and long-term rates in all developed economies and major developing economies by 2006 had converged to single digits, I believe for the first time ever. The path of the convergence is evident in the unweighted variance of interest rates on ten-year sovereign debt of 15 countries that declined markedly from 2000 to 2005 (exhibit 2). Equity and real-estate capitalization rates were inevitably arbitraged lower by the fall in global long-term real interest rates. Asset prices, particularly house prices, accordingly moved dramatically higher.
The Economist's surveys document the remarkable convergence of nearly 20 individual nations' house price rises during the past decade. Japan, Germany, and Switzerland (for differing reasons) being the only important exceptions. U.S. price gains, at their peak, were no more than the global peak average. In short, geo-political 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.
Various critics interpreted these passages as a defense by Greenspan of his own policies: "It happened everywhere, even where my policies were not in effect, so it couldn't have been me."
In truth, Greenspan is saying something much more transcendent: that the crisis was fundamental, far exceeding the impacts of any "policy". A glut of capital plus a reduction of investment opportunities produces a fall in the rate of interest. The inevitable deflation/devaluation begins, expressed as an inflation in the prices of fixed assets, real-estate foremost among them. This is the virtual "bubble" looking for an outlet.
Subprime mortgages in the United States for years had been a small appendage to the broader U.S. home mortgage market, comprising only 7% of total originations as recently as 2002. Most such loans were fixed-rate mortgages, and only a modest amount had been securitized. With the price of homes having risen at a quickening pace since 1997 (exhibit 3), such subprime lending was seen as increasingly profitable to investors.
Belatedly drawn to this market, financial firms, starting in late 2003, began to accelerate the pooling and packaging of subprime home mortgages into securities (exhibit 4). The firms clearly had found receptive buyers. Both domestic and foreign investors, largely European, were drawn to the above average yield on these securities and a foreclosure rate on the underlying mortgages that had been in decline for two years.
It is not greed, speculation and corruption which causes a crisis of capitalism but a fundamental crisis of capitalism which causes the inevitable increase in greed, speculation and corruption. The only unresolved issue is where it will all come to a head.
But, don't the participants see it coming? On the contrary...
Clearly with such experiences in mind, financial firms were fearful that should they retrench too soon, they would almost surely lose market share, perhaps irretrievably. Their fears were formalized by Citigroup’s Charles Prince’s now famous remark in 2007, just prior to the onset of the crisis, that “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
From this clear-headed description of the crisis, Greenspan's paper becomes more and more muddled. It is now time to propose "reforms" and it is in this mode that the analysis becomes increasingly tentative and ambiguous. From Greenspan the monetarist, no obvious monetary prescriptions are forthcoming. From Greenspan, the libertarian, a change of heart is evident. Greater government requirements for increased capital reserves are proposed, while all testimonials to the "self-correcting" nature of "free capital markets" are entirely dispensed with. Still, what Greenspan proposes would have had little or no effect on the crisis he himself describes. Greenspan senses this in a series of standalone commentaries on the failures of economic forecasting, regulation, and the banking system as a whole.
It is in such circumstances that we depend on our highly sophisticated global system of financial risk management to contain market breakdowns. How could it have failed on so broad a scale? The paradigm that spawned Nobel Prize winners in economics22 was so thoroughly embraced by academia, central banks, and regulators that by 2006 it became the core of global regulatory standards (Basel II). Many quantitative firms whose number crunching sought to expose profitable market trading principles were successful so long as risk aversion moved incrementally (which it did much of the time). But crunching data that covered only the last 2 or 3 decades prior to the current crisis did not yield a model that could anticipate a crisis.
U.S. commercial and savings banks are extensively regulated, and even though for years our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still were able to take on toxic assets that brought them to their knees. The heavily praised U.K. Financial Services Authority was unable to anticipate, and prevent, the bank run that threatened Northern Rock. The venerated credit rating agencies bestowed ratings that implied AAA smooth-sailing for many a highly toxic derivative product. The Basel Committee on Banking Supervision, representing regulatory authorities from the world’s major financial systems, promulgated a set of capital rules that failed to foresee the need that arose at the height of the crisis for much larger capital and liquidity buffers.
The ultimate goal of financial structure and regulation in a market economy is to direct a nation’s saving, plus any saving borrowed from abroad (the current account deficit), towards investments in plant, equipment and human capital that offer the greatest increases in a nation’s output per hour. Nonfinancial output per hour, on average, rises when obsolescent facilities (with low output per hour) are replaced with facilities that embody cutting-edge technologies (with high output per hour). This process improves (average) overall standards of living for a nation as a whole. The evident success of finance for decades prior to the onset of this crisis in directing our scarce savings into real productive capital investments appears to explain the extent nonfinancial market participants had been compensating U.S. financial services.
The share of U.S. gross domestic income accruing to finance and insurance, according to the Bureau of Economic Analysis, had risen fairly steadily from 2.3% in 1947 to 7.9% in 2006 (exhibit 8). Only a small part of the rise was the result of an increase in net foreign demand for U.S. financial and insurance services. The decline in the share to 7.4% in 2008 reflects write-offs of previously presumed productively employed saving.
In the end, it is left entirely unclear as to whether Greenspan believes that the larger crisis is over. At one turn Greenspan calls his crisis, "a once in a hundred year" event while at the next he wonders whether each succeeding crisis will not be similar... a once in a hundred year crisis occurring every 10 to 15 years. So too with massive government intervention. While Greenspan clearly attributes the forestalling of another Great Depression to that immediate governmental bailout, he offers no hope that it won't be required each time that the crisis reasserts itself.
It is this last point that should concern Greenspan's critics. While there are debatable proposals for moderating the breakdown of credit in future crises, there is no proposal whatever for resolving the underlying dynamic that Greenspan himself lays out. What is it that prevents Greenspan's crisis from immediately reasserting itself once the immediate impacts of this recession pass?
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