"Chairman Greenspan’s Legacy"

Harvard Professor of Political Economy has penned a prototypic New York Review of Books essay on Alan Greenspan’s The Age of Turbulence. That means no snarkiness.

What would likely disappoint readers of this blog is that Friedman thinks that Greenspan acquitted himself well in managing monetary policy; he argues that growth was weak after 2001 and the Fed’s super-low interest rates did not produce inflation. He amazingly fails to see that negative real interest rates discourage savings (which were already low in the US) and supercharge speculation.

Nevertheless, Friedman makes an observation I haven’t seen elsewhere, that despite Greenspan’s claim to be a loyal defender of free markets, he was intervened frequently, at least as far as monetary and fiscal policy were concerned:

Greenspan continually reiterates his belief in the power of private economic activity organized in free, competitive markets. Government interference, therefore, is for him mostly a bad idea. It was, he writes, “the embrace of free-market capitalism,” not monetary policy, that “helped bring inflation to quiescence.” Further, in his view, free markets are not only efficient but robust. In the face of disturbances—higher oil prices, say, or a decline in either consumer or business confidence—they tend to correct themselves. “If the story of the past quarter of a century has a one-line plot summary,” he writes, “it is the rediscovery of the power of market capitalism.”

This mantra is strikingly at odds with Greenspan’s account of what he and his colleagues did during his years at the Federal Reserve. They took corrective action, gave advice and even instructions, and took the initiative in anticipating the difficulties markets might face. They did so not just in the immediate aftermath of the September 11 atrocities, which anyone would recognize as out of the ordinary, but in one episode after another throughout his years at the Federal Reserve. Familiar examples include the 1987 stock market crash; the wave of financial problems in many Asian and Latin American countries beginning in 1997; the near collapse of the LTCM hedge fund in 1998; the passage of the millennium from 1999 to 2000 (which many people feared would trigger widespread “Y2K” computer glitches); and many others.

In dealing with such events Greenspan and his colleagues treated financial markets more as delicate flowers requiring careful attention and nursing. Similarly, although he frequently makes clear in what he writes that he rejects Keynesian economics, both at the Federal Reserve and during his time in the Ford White House he consistently advocated a Keynesian stimulus (through tax rebates or lower tax rates) whenever he thought the economy needed a boost.

Friedman gives a good overview of the regulatory lapses, gaps, and missed opportunities that made the subprime mess possible:

Central banking involves more than just making monetary policy, however, and in these broader respects the Federal Reserve, and Greenspan’s leadership of it, do bear part of the blame for the subprime collapse and the wider damage to which it has led. As is becoming ever more apparent, many of the lending practices in the mortgage market during these years, especially in the subprime market, involved carelessness, deception, or both. Many people borrowed who had no prospect of servicing the loans they took out; they were hoping either to resell the house at a higher price, or to refinance it and draw on the appreciated value to make their payments. Some borrowers were apparently induced to buy houses they could not afford, or to take out loans they should not have been granted, by irresponsible brokers and other agents keen to make commissions on transactions despite knowing they were inappropriate.

Many of the banks that packaged these loans into securities also put them into complex investment “vehicles” that they did not understand, and sold them to investors who understood even less about them. The credit rating agencies, on which investors normally rely to inform them of such risks, were at best useless. Today the wreckage, consisting of abandoned houses, defaulted loans, displaced homeowners, banks making good on the billions of dollars of losses they had guaranteed, and uninsured investors marking down their portfolios, can be seen everywhere. The damage will surely get worse before it begins to abate.

Regulation of financial markets in the United States is both spotty and fragmented among numerous agencies. One problem, from which many individual homebuyers suffered, is a straightforward gap in existing regulation. For years, a stock broker who recommended that a client buy a security that was grossly unsuited for that person had been subject to regulatory sanction, or even redress by private litigation, under the suitability requirements of the National Association of Securities Dealers as well as the New York Stock Exchange’s “know your customer” rule. Both sets of rules operate under the aegis of the Securities and Exchange Commission. While they are far from being rigorously enforced, for real estate agents and independent mortgage brokers there are no such rules at all. In addition, poorly disclosed compensation arrangements for brokers, which would be illegal in the securities markets, have persisted in the mortgage market and give mortgage brokers substantial incentives to steer customers into loans that are excessively expensive or risky or both.

But in the buildup to today’s mortgage market mess, numerous potentially helpful government agencies also either dropped the ball or looked the other way. As early as 2001 the Treasury Department tried to get subprime lenders to adopt a code of “best practices” and to submit to monitoring, but the large lenders objected and the Treasury did not press the matter. The Department of Housing and Urban Development likewise proposed a set of rules for real estate transactions but then failed to follow through. As recently as 2006 there was an interagency initiative to regulate nontraditional mortgage products such as packaged subprime mortgages, but again nothing came of it. The Office of the Comptroller of the Currency, a bureau of the Treasury Department that is always solicitous of the desire of banks to escape supervision and regulation if they can, has actively thwarted state-level action.

And the Federal Reserve Board, which under the 1968 Truth in Lending Act and other legislation is also responsible for regulating interest rate disclosures (and especially high-cost mortgages), likewise failed to act. This neglect by the Federal Reserve was hardly the result of lack of awareness. Both at the staff level and higher, numerous eyes were squarely on the problem. Edward Gramlich, a member of the Board of Governors from 1997 to 2005, frequently testified before Congress on problems in home finance and called within the Federal Reserve for action to halt abuses and make lending in this market more rational. But Greenspan was consistently unsympathetic, and the Federal Reserve neither took action on its own nor supported action by other agencies. In his book, Greenspan writes:

I was aware that the loosening of mortgage credit terms for subprime borrowers increased financial risk, and that subsidized home ownership initiatives distort market outcomes. But I believed then, as now, that the benefits of broadened home ownership are worth the risk.

Gramlich died last September. His final book, Subprime Mortgages: America’s Latest Boom and Bust,[*] published shortly before his death, likewise welcomed the increase in home ownership that subprime mortgages have made possible—especially among low-income households, and especially among racial minorities. But Gramlich also called for a number of corrective measures. Most important, he argued, was to bring under federal regulation the state-chartered lending institutions that account for half of the subprime lending (but very little in the prime mortgage market). He also called for expanding existing legislation so that more borrowers could prepay their mortgages without penalties. A frequent problem today is that families who cannot meet their higher payments after the initially low two-year “teaser” rate is reset cannot afford to get out of the mortgage either. A third suggestion was to have the federal government fund many of the foreclosure prevention programs that already operate at the local level.

Today both Gramlich’s analysis and his proposals look even more incisive. Indeed, some policymakers have taken notice. Last summer the Federal Reserve Board and the Office of Thrift Supervision, a bureau within the Treasury Department, launched a limited program to coordinate state-level and federal regulation of mortgage lending. More recently the Bush administration has proposed a moratorium on foreclosures.

Greenspan’s opposition to such proposals was consistent with the admiration that he expresses for unfettered markets and the sanctity with which he regards property rights (which in this context really means private rights of contract) throughout his memoir. Both give rise to a systematic aversion to government regulation of private economic activity. For Greenspan, recognition that the workings of such markets sometimes destroy asset values, jobs, or even entire industries is still not ground for interference in the economy in the aggregate, or with individual transactions to which two or more private parties voluntarily agree.

Greenspan frequently appeals to the views of Joseph Schumpeter, the Austrian-émigré Harvard economist of the 1930s and 1940s, who labeled such economic developments “creative destruction.” In contrast to Greenspan’s careful nursing of the economy and the financial markets in his conduct of monetary policy, his rejection of regulation of the subprime mortgage market and of intervention in the built-up chain of financing that distributed the ownership of these securities (and the consequent risks) throughout the US economy and abroad was of a piece with the economic philosophy he espouses.

Alas, Schumpeter to the contrary, not all destruction is creative. And although Adam Smith (whom Greenspan also admires) explained that the desire to make money is mostly what leads people to undertake economically useful activity, not everyone who is making money is doing something economically useful. Just how much damage the widening ripples of the subprime collapse will inflict, on either the US financial markets or the American economy, is still unclear. But in hindsight one wishes that Alan Greenspan, as Federal Reserve chairman, had clung to his economic philosophy in regulatory matters no more closely than he did in his hands-on conduct of monetary policy. Or that in fulfilling this particular responsibility of the Federal Reserve he had simply listened to Ned Gramlich.