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Alan Greenspan still thinks he’s right

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Steven Pearlstein is a business and economics columnist for The Washington Post and a Robinson professor of political and international affairs at George Mason University.

Alan Greenspan’s last book, “The Age of Turbulence,” was published in the fall of 2007, more than a year after he stepped down as chairman of the Federal Reserve and months before the financial implosion that would badly tarnish his reputation as the “maestro” of the American economy.

His latest book, oddly named “The Map and the Territory,” is meant to be an account of his intellectual journey to discover why, as the nation’s top bank regulator and its most famous economic prognosticator, he failed to see it all coming. Why had the markets, which for centuries had been so adept at self-correction, failed this time? Why had bank executives, with every incentive to protect their fortunes and reputations, knowingly gambled it all away?

What we find, however, is that Greenspan’s journey of discovery brings him right back to where he began — to an unshakable faith in free markets, an antipathy toward market regulation, and a conviction that progressive taxes and social spending are to blame for slow growth, stagnant wages and exploding deficits.

Those who have followed his career know that it was Greenspan who gave the green light to bank consolidation, Greenspan who pushed financial deregulation, Greenspan who advocated new global rules that would have reduced bank capital reserves and Greenspan who blocked efforts to crack down on abusive subprime lending. But if you are looking for him to accept any responsibility for the crisis that ensued, you will be sorely disappointed.

Instead, he shifts the blame to subsequent policymakers for bailing out the financial system and imposing “massive” new regulation that, he asserts without proof, has cast “a pall of uncertainty” over the economy and ushered in an era of “crony capitalism.”

“Unless we reverse the inexorable increase in the role of government,” he warns ominously, in language he could have lifted from the Romney-Ryan campaign site, “we will surely lose our pre-eminence as the undisputed global leader.”

To take him at his word, Greenspan began to have doubts about his understanding of how the economy works after the financial collapse, which he characterized as an “existential crisis” for economic forecasters such as himself. He set out to “understand how we got it so wrong and what we can learn from the fact that we did.”

His journey begins with a reconsideration of the great British economist John Maynard Keynes, who famously rejected the neoclassical model of an economy based solely on rational self-interest in favor of one driven by “animal spirits” that often lead to irrational herd behavior.

Greenspan also comes to a new appreciation of the danger posed by extended periods of economic stability, which lull people to take undue risks and sow the seeds of the next crisis. That hypothesis was advanced decades ago by the left-wing economist Hyman Minsky, whom Greenspan curiously fails to mention.

Noting the failure of the bond market to distinguish the risk between lending to the productive German savers and the spendthrift Greek slackers, Greenspan comes to understand the importance of “culture” long after it became central to development economics.

Finally, Greenspan stops to drink the waters of behavioral economics, a lively new area of research that has demonstrated that irrational economic behavior is not only widespread but so predictable that it can be incorporated into economic models.

“I have come around to the view that there is something more systematic about the way people behave irrationally, especially during periods of economic stress, than I had previously contemplated,” he declares with the wonderment of someone who has just discovered the existence of Costco or the iPhone.

From these new insights, Greenspan moves on to a straightforward review of major factors in the financial crisis: Excessive bank consolidation that led to the creation of institutions that were over-leveraged and undercapitalized. Growth of a giant, unregulated shadow banking system. Risk-management systems that ignored the possibility of a “hundred-year flood.”

Like Fred Astaire on the dance floor, Greenspan glides through the list without the slightest sign he might have had something to do with those developments. What he does remember is that during his watch, the markets and the economy quickly recovered after asset bubbles burst — in 1987 (junk bonds) and again in 2001 (dot-com). Based on those happy outcomes, Greenspan confidently reprises his now widely discredited view that, in the long run, the economy is better off if the government restricts itself to cleaning up after bubbles rather than trying to prevent them from growing too large.

A good deal of “The Map and the Territory” is given over to attacking the Dodd-Frank reform of financial regulation — specifically a provision that mandates greater oversight for firms so large and interconnected that they could pose a risk to the system. Greenspan interprets that to mean that the government has officially conferred on them the status of “too big to fail,” which in his view will lead inevitably to more rounds of excessive risk-taking and government bailouts. The better approach, he argues, would be to put any failing bank through an orderly, government-managed liquidation in which shareholders would be wiped out, executives fired, assets sold and creditors forced to accept serious losses.

Reading this critique, you’d have no idea that it was Greenspan, back in the 1990s, who first revived the “too big to fail” doctrine when the Fed arranged a bailout for an unregulated hedge fund known as Long-Term Capital Management, which he judged to be too heavily in debt to too many banks to be allowed to default.

More significantly, if he’d looked more closely at Dodd-Frank, he would have discovered that his preferred method for dealing with failing banks is precisely the one set out in the new law. In fact, it is because the law reduces the chance of future bailouts that the credit ratings of the big banks have been downgraded and their cost of funding, relative to that of smaller banks, has increased.

Much of “The Map and the Territory” is taken up with rambling and disjointed observations, full of straw men and non sequiturs. The flow of logic between the chapters and within them is hard to discern.

One reader who surely won’t be too happy with the book is Ben Bernanke, Greenspan’s successor and onetime colleague at the Fed. Bernanke was an architect of the bank bailout that Greenspan now says was misguided, as well as a key behind-the-scenes player in crafting the Dodd-Frank law that, by Greenspan’s account, is leading us to socialist ruin.

Careful readers — including Janet Yellen, who’s been nominated by President Obama to replace Bernanke — will also note a paragraph near the end of the book in which Greenspan questions whether the Fed will have the political will to unwind the trillions of dollars in monetary stimulus it has pumped into the financial system since the crisis — a bout of money-printing that he warns could lead to double-digit inflation if not fully reversed. Among central bankers, that’s trash talk.

A theme running through “The Map and the Territory” is that, since the mid-1960s, the rise of spending on entitlement programs — Social Security, Medicare, Medicaid, food stamps — has diverted so much income from long-term business investment to immediate consumption that the country, by his calculation, has on average knocked precisely 0.21 percentage points off GDP growth each year, with the result that our collective income is now 10 percent smaller than it otherwise could have been.

But the regression analysis he relies on for his conclusion does not, and cannot, prove that it was specifically the government’s entitlement spending that was responsible for the overall fall in national savings or that the decline in savings caused the decline in business investment. It is equally plausible that it was the cost of waging unnecessary wars, or the dramatic rise in executive compensation and Wall Street bonuses, or an ill-advised (and Greenspan-supported) tax cut in 2001 that led to the drop in national savings.

And even if it could be proved that the growth in social spending led to less savings, in a global economy that doesn’t lead inevitably to less business investment. In fact, we know that the rest of the world was anxious to supply U.S. firms with cheap capital for worthwhile investments — and some not so worthwhile. We also know that many of those companies chose to invest that capital not here at home but in foreign subsidiaries — one of a number of inconvenient facts that Greenspan overlooks in concluding that slower productivity growth is all the fault of excessive social spending.

The irony is that it was precisely such reliance on facile conclusions based on statistical regularities that led so many economists to “get it so wrong” in the years leading up to the crisis. Rather than learning from such mistakes, however, Greenspan seems determined to repeat them.

Steven Pearlstein is a business and economics columnist for The Washington Post and a Robinson professor of political and international affairs at George Mason University.

THE MAP AND THE TERRITORY Risk, Human Nature, and the Future of Forecasting By Alan Greenspan Penguin Press. 388pp. $36

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