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Greenspan’s Follies

There’s just one problem with Alan Greenspan’s attempts to defend his record on the financial crisis: The former Fed chairman is guilty as charged.

NICOLAS ASFOURI/AFP/Getty ImagesOvershadowed: Greenspan will most likely be remembered as the man most responsible for the worst financial crisis since the Great Depression.

For prescient warnings about todays predicament, see Think Again: Alan Greenspan, also by Stephen S. Roach, from the January/February 2005 issue of Foreign Policy.

Alan Greenspans fingerprints are all over what is fast becoming the worst financial calamity since the Great Depression. Sensitive to mounting criticism that his stewardship of the Federal Reserve led to todays wrenching crisis, the former Fed chairman has launched a massive public relations campaign to set the record straight. Greenspan does make an inarguable point in stating his case for the defensethat it is critical to get the lessons of this crisis right. I couldn’t agree more.

But methinks the man doth protest too much. Unfortunately, Mr. Greenspan has been blinded by a dangerous combination of politics and ideology in his own search for those very lessons. It was much the same during the 18 years he spent at the helm of the Fed, guided by the belief that the U.S. public wants rapid, albeit noninflationary, economic growth. A politically compliant central banker, he has stated in his best-selling memoirs that he believes the independence of the Federal Reserve is not set in stoneimplying that there is always huge pressure to keep the growth machine humming. A market libertarian, he has long argued that regulatory intrusion slows the economy. Prestothe rest is historyand an increasingly painful one at that. Greenspans blend of politics and ideology led to bad economics and a succession of policy blunders whose severity is only now becoming clear.

Greenspans handling of the housing bubble is the smoking gun. The Greenspan mantra is that markets know bestthat central bankers should not attempt to override the verdict of millions of market participants by declaring that an asset bubble has formed. After all, there are the costs to economic growth to consider if monetary policy is used to deflate such bubbles. And why should any modern economy have to incur those costs? After all, goes the script, the authorities always have the wherewithal to clean up any post-bubble mess. Maybe not. This time, the mess is almost beyond the realm of comprehensionmost likely a good deal larger than any growth that might have been foregone had the U.S. housing bubble been handled more judiciously.

Yet the problem has never really been the bubble in the narrow sense of the word. One of the weakest links in the Greenspan defense is his fixation on whether a serious bubble was forming in Americas housing market. Never mind his earlier arguments that housing markets were local, not national, and that it was highly unlikely that home prices could ever fall nationwide. Whoops. Never mind also his equally irrelevant point that there were lots of housing bubbles in the world at the same time, and that Americas property market excesses didn’t look so bad by comparison. Everyones doing it, so its not the Feds fault. Right?

Wrong. The trouble with Americas housing bubble was never its comparison with Ireland. The core of the problem lies in the distortions that asset bubbles created on the real side of the U.S. economy. Courtesy of the most rapid rates of sustained U.S. house price appreciation in the modern post-World War II era, along with innovative financing techniques that allowed American homeowners to extract equity with ease from their humble abodes, the new age of the asset-dependent consumer was born. Net equity extraction from residential propertyironically, derived from a statistical framework developed by Alan Greenspan, himselfsurged from 3 to nearly 9 percent of disposable personal income in the first half of the current decade.

And so it went. Increasingly supported by the confluence of both property and credit bubbles, U.S. consumers spent well beyond their means. Personal consumption climbed to an unheard-of 72 percent of real GDP in 2007a record for the United States and, for that matter, for any leading economy in modern history. At the same time, household debt soared to a record 134 percent of disposable personal income. America certainly achieved the rapid growth that Greenspan felt the body politic wanted. But it was growth based increasingly on fumes.

Unfortunately, the distortions of a bubble-infected U.S. economy didn’t stop there. Consumers who saw their homes as a new piggy bank or ATM machine felt little pressure to save the old-fashioned wayout of their paychecks. Saving rates plunged to zero for the first time since the Great Depression. An increasingly asset-dependent U.S. economy then had to borrow surplus saving from places like China in order to keep growingand run massive current account and trade deficits in order to attract the foreign capital. Greenspan and his disciple Ben Bernanke saw this situation exactly backwards. America, they insisted, was simply doing the rest of the world a huge favor by absorbing its surplus saving. Serious dollar risks were characterized as a problem for a distant day. Suddenly, that day doesn’t seem so distant.

What Greenspan missed repeatedly over the yearsand still misses todayare the corrosive impacts this bubble had in fostering the imbalances and excesses of an asset-dependent U.S. economy. Unprecedented consumer leverage is only part of the problem. So, too, is the failure of an aging U.S. population to save precisely when it needs to prepare for retirement. Global imbalances are also an outgrowth of this era of excessunderscored by Americas massive external deficit and, by the way, the protectionist fires it stokes. Alas, these fault lines were made all the deeper by the Feds regulatory laxity in an era of unprecedented financial innovationa laxity made all the more dangerous by the cheap borrowing costs of a Fed-induced credit bubble. This dangerous combination undoubtedly played a key role in fueling voracious investor demand for opaque and increasingly toxic financial products.

It didn’t have to be this way. Just saying no to asset bubbles was always an option. A variety of anti-bubble toolsthe bully pulpit of jawboning, more disciplined regulatory oversight, and, ultimately, a tighter monetary policycould have prevented disaster. Yes, economic growth would probably have been slower, but that shortfall likely pales in comparison to the post-bubble carnage now before us. Too bad Greenspan couldnt bring himself to follow the sage advice of one of his predecessors at the Fed and take away the punch bowl just when the party was getting good.

Of course, squabbling over Alan Greenspans place in history is not going to get us out of this crisis. But vigorous debate about the past is absolutely essential if we are to avoid such a quagmire in the future. As always, the search for scapegoats is on. Rating agencies, regulators, Wall Street, loan sharks, property speculators, and subprime homeowners will all pay a steep price. Some, of course, already have. In the end, I suspect the Federal Reserve will also pay a steep price, losing some autonomy when Congress adds financial stability to the Feds mandated charge of maintaining full employment and price stability. As well it should. The central banks stewardship of the U.S. economy is far too important to be left to politics and ideology.

Over the years, a few of us warned this was all unsustainable. The longer it went on, the more discredited we became. There is some satisfaction in knowing that the time-honored laws of economics have not been repealedthat the new paradigm rationales that typically get invoked at the end of bubbles have again been repudiated. But there is no satisfaction in peering into the abyss. The legacy of Alan Greenspan will be forever tarnished by this dangerous and painful reality check.

NICOLAS ASFOURI/AFP/Getty ImagesOvershadowed: Greenspan will most likely be remembered as the man most responsible for the worst financial crisis since the Great Depression.

For prescient warnings about todays predicament, see Think Again: Alan Greenspan, also by Stephen S. Roach, from the January/February 2005 issue of Foreign Policy.

Alan Greenspans fingerprints are all over what is fast becoming the worst financial calamity since the Great Depression. Sensitive to mounting criticism that his stewardship of the Federal Reserve led to todays wrenching crisis, the former Fed chairman has launched a massive public relations campaign to set the record straight. Greenspan does make an inarguable point in stating his case for the defensethat it is critical to get the lessons of this crisis right. I couldn’t agree more.

But methinks the man doth protest too much. Unfortunately, Mr. Greenspan has been blinded by a dangerous combination of politics and ideology in his own search for those very lessons. It was much the same during the 18 years he spent at the helm of the Fed, guided by the belief that the U.S. public wants rapid, albeit noninflationary, economic growth. A politically compliant central banker, he has stated in his best-selling memoirs that he believes the independence of the Federal Reserve is not set in stoneimplying that there is always huge pressure to keep the growth machine humming. A market libertarian, he has long argued that regulatory intrusion slows the economy. Prestothe rest is historyand an increasingly painful one at that. Greenspans blend of politics and ideology led to bad economics and a succession of policy blunders whose severity is only now becoming clear.

Greenspans handling of the housing bubble is the smoking gun. The Greenspan mantra is that markets know bestthat central bankers should not attempt to override the verdict of millions of market participants by declaring that an asset bubble has formed. After all, there are the costs to economic growth to consider if monetary policy is used to deflate such bubbles. And why should any modern economy have to incur those costs? After all, goes the script, the authorities always have the wherewithal to clean up any post-bubble mess. Maybe not. This time, the mess is almost beyond the realm of comprehensionmost likely a good deal larger than any growth that might have been foregone had the U.S. housing bubble been handled more judiciously.

Yet the problem has never really been the bubble in the narrow sense of the word. One of the weakest links in the Greenspan defense is his fixation on whether a serious bubble was forming in Americas housing market. Never mind his earlier arguments that housing markets were local, not national, and that it was highly unlikely that home prices could ever fall nationwide. Whoops. Never mind also his equally irrelevant point that there were lots of housing bubbles in the world at the same time, and that Americas property market excesses didn’t look so bad by comparison. Everyones doing it, so its not the Feds fault. Right?

Wrong. The trouble with Americas housing bubble was never its comparison with Ireland. The core of the problem lies in the distortions that asset bubbles created on the real side of the U.S. economy. Courtesy of the most rapid rates of sustained U.S. house price appreciation in the modern post-World War II era, along with innovative financing techniques that allowed American homeowners to extract equity with ease from their humble abodes, the new age of the asset-dependent consumer was born. Net equity extraction from residential propertyironically, derived from a statistical framework developed by Alan Greenspan, himselfsurged from 3 to nearly 9 percent of disposable personal income in the first half of the current decade.

And so it went. Increasingly supported by the confluence of both property and credit bubbles, U.S. consumers spent well beyond their means. Personal consumption climbed to an unheard-of 72 percent of real GDP in 2007a record for the United States and, for that matter, for any leading economy in modern history. At the same time, household debt soared to a record 134 percent of disposable personal income. America certainly achieved the rapid growth that Greenspan felt the body politic wanted. But it was growth based increasingly on fumes.

Unfortunately, the distortions of a bubble-infected U.S. economy didn’t stop there. Consumers who saw their homes as a new piggy bank or ATM machine felt little pressure to save the old-fashioned wayout of their paychecks. Saving rates plunged to zero for the first time since the Great Depression. An increasingly asset-dependent U.S. economy then had to borrow surplus saving from places like China in order to keep growingand run massive current account and trade deficits in order to attract the foreign capital. Greenspan and his disciple Ben Bernanke saw this situation exactly backwards. America, they insisted, was simply doing the rest of the world a huge favor by absorbing its surplus saving. Serious dollar risks were characterized as a problem for a distant day. Suddenly, that day doesn’t seem so distant.

What Greenspan missed repeatedly over the yearsand still misses todayare the corrosive impacts this bubble had in fostering the imbalances and excesses of an asset-dependent U.S. economy. Unprecedented consumer leverage is only part of the problem. So, too, is the failure of an aging U.S. population to save precisely when it needs to prepare for retirement. Global imbalances are also an outgrowth of this era of excessunderscored by Americas massive external deficit and, by the way, the protectionist fires it stokes. Alas, these fault lines were made all the deeper by the Feds regulatory laxity in an era of unprecedented financial innovationa laxity made all the more dangerous by the cheap borrowing costs of a Fed-induced credit bubble. This dangerous combination undoubtedly played a key role in fueling voracious investor demand for opaque and increasingly toxic financial products.

It didn’t have to be this way. Just saying no to asset bubbles was always an option. A variety of anti-bubble toolsthe bully pulpit of jawboning, more disciplined regulatory oversight, and, ultimately, a tighter monetary policycould have prevented disaster. Yes, economic growth would probably have been slower, but that shortfall likely pales in comparison to the post-bubble carnage now before us. Too bad Greenspan couldnt bring himself to follow the sage advice of one of his predecessors at the Fed and take away the punch bowl just when the party was getting good.

Of course, squabbling over Alan Greenspans place in history is not going to get us out of this crisis. But vigorous debate about the past is absolutely essential if we are to avoid such a quagmire in the future. As always, the search for scapegoats is on. Rating agencies, regulators, Wall Street, loan sharks, property speculators, and subprime homeowners will all pay a steep price. Some, of course, already have. In the end, I suspect the Federal Reserve will also pay a steep price, losing some autonomy when Congress adds financial stability to the Feds mandated charge of maintaining full employment and price stability. As well it should. The central banks stewardship of the U.S. economy is far too important to be left to politics and ideology.

Over the years, a few of us warned this was all unsustainable. The longer it went on, the more discredited we became. There is some satisfaction in knowing that the time-honored laws of economics have not been repealedthat the new paradigm rationales that typically get invoked at the end of bubbles have again been repudiated. But there is no satisfaction in peering into the abyss. The legacy of Alan Greenspan will be forever tarnished by this dangerous and painful reality check.

<p> Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of The Next Asia. His forthcoming book, Unbalanced: The Codependency of America and China, will be published Jan. 2014. </p>

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