Greenspan: Financial Crises Are, By Definition, Unforeseeable

The other day, I watched former Fed Chairman, Alan Greenspan, talk on C-SPAN to the Economic Club of New York, and it was absolutely fascinating. It gave me a new lens to look at the economic downturn. Unfortunately, C-SPAN doesn't let me edit to the interesting parts, but the most enlightening part for me was during the question and answer period in the last 30-minutes:

http://www.c-span.org/Watch/watch.aspx?MediaId=HP-A-15576

Here were my five highlights from the speech:

1) Financial Crises Are, By Definition, Unforeseeable. A financial crisis only happens when there is a swift discontinuity in the prices of assets over a short period of time. If the markets had foreseen the discontinuity in price, it would not have become a crisis because the opportunity would have been arbitraged away.

For instance, with large deficits, people expected the collapse of the dollar and took defensive positions against the possibility. As a result, the dollar steadily declined, but there was no crisis because a collapse was foreseen. On the other hand, when people were holding subprime mortgages which they believed to be triple-A rated, which they subsequently found out out to be toxic, the economic crisis hit from the discontinuity in pricing.

A financial crisis must come from a shock to the system. And Greenspan argues that if that's the case, regulation should spend more time and effort ensuring the economy is flexible and can absorb these shocks, rather than trying to predict them.

2) We Have No Policy Against Asset Bubbles. Asset bubbles, as Greenspan explains it, is the result of a long stretch of economic growth, low interest rates, and low inflation. This period creates a sense of euphoria, and the belief that value will forever rise, which (of course) leads to financial crisis. Greenspan states that there is no policy that he knows of to suppress these bubbles that lead to crisis, but if there were, he would be a strong supporter.

3) With Risk Management, Long Tails of Failure Still Exist. Modern risk management means that banks keep enough of a capital buffer to prevent something like 99.5% of default risk. And banks make the deliberate decision to take that once-in-a-decade chance of default because the capital necessary to protect against 100% of default risks would be exorbitant. Greenspan goes on to suggest that we should reexamine how much capital banks store because a 10% capital to assets ratio may not be the right amount.

4) Humans aren't built to be afraid forever. Fear stems from an increase in uncertainty and people tend to withdraw when they're in a state of fear. This fear grinds the economy to a halt - but not forever. History has shown that people and markets are adaptable, and people won't be afraid forever. The question is when.

5) Enlightened Self-Interest Is Our First Line of Defense. Greenspan believed that enlightened self-interest would lead to effective self-regulation. Banks would manage their own risk appropriately to stave off insolvency. But, he said, euphoria infected even the most sophisticated player, which lead to a breakdown in risk management. Regulation needed to breakdown as well for the banks to be able to take on such a high risk profile. Any regulation system needs to rely on a measure of self-regulation to be effective.


My paraphrasing doesn't do Greenspan justice. I would watch Greenspan himself if you're interested.


Links:
Recession will be worst since 1930s: Greenspan