Alan Greenspan has produced a paper explaining the Great Crash and his proposals for new regulations to prevent another crash. To reform the system, he recommends that banks be required to maintain more capital. This minimal step won’t change the deregulation movement’s emphasis on financial market efficiency at the expense of economic stability.
Greenspan explains that there is a tradeoff between growth and stability.
I strongly doubt that stability is achievable in capitalist economies, given the always turbulent competitive markets continuously being drawn towards, but never quite achieving, equilibrium (that is the process leading to economic growth).
P. 19. This quote is from the section titled “Principles of Reform”, but it should have been in the section on risk management. In her book, ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, Yves Smith explains that the economic models in wide use today spring from the ideas of Paul Samuelson. She singles out one of Samuelson’s assumptions:
In simple terms, “ergodicity” means that no matter what happens in the world, everything will reach a point where things stop changing, which, in economics, is the prized equilibrium. It also means that a system acts consistently over time.
P. 42. Smith points out the serious consequence of this assumption: it means that stability is the natural state of the economy. It means that in designing the regulatory framework, policymakers should favor efficiency over stability. Despite the quote above, this is Greenspan’s guiding principle. He must think that the constant back and forth around the “equilibrium” is close enough for risk management and other economic models to work. P.11.
Banks and other finance companies are relying on the assumption that stability is the natural state of the economy when they argue against regulation of financial markets. They argue that such rules create inefficiencies, by which they mean they make less money. Congress bought in, and gave us financial deregulation.
Smith thinks this is foolish.
…[A]ny systems designer will tell you that stability is a first order design consideration and efficiency is second.
P. 44. Buildings should stand up, even if it means using extra materials. Concrete and rebar are expensive, but worth it. Chemical plants start with making sure that reactions take place in a safe environment. Any change must first be safe and only then is cost a consideration.
In the real world, as opposed to the imaginary economic model world, top executives are indifferent to the success or failure of the businesses they operate, because they have private wealth. The law won’t touch them, either civilly or criminally. On top of that, many businesses are now too large to fail, and the government will bail them out. Greenspan says it as if it were perfectly obvious:
I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks.
P. 17. Treasury Secretary Timothy Geithner agrees.
Greenspan acknowledges that risk management failed, because managers underestimated the size and scope of the tail risk that is a part of all risk management models. He doesn’t even address the conflict between Samuelson’s principle of ergodicity and his own view that there is not really an equilibrium point. But even if failure of risk management caused the problems of large banks, it doesn’t explain what happened to regulation.
The most important point of bank regulation is to create greater stability. Stability was not a consideration to Greenspan, or any of the other people responsible for financial deregulation. Enraptured by the pseudo-proofs of mathematicized economics, they sacrificed stability, which benefits the nation, for efficiency, which, as it turns out, only benefits the rich. Even now, Greenspan ignores stability. He thinks the only role for regulation is “inhibiting irrational behavior, when it can be identified”. P. 20.
Efficiency in financial markets is a great benefit to the rich. Even in the aftermath of the Great Crash, the richest 1% has grabbed a greater share of the nation’s wealth. They are winning this battle in the class war. The rest of us are losing. We will continue to lose as long as the likes of Geithner and Greenspan design the regulatory framework.
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I discuss Greenspan’s explanation that the Great Crash was not his fault, it was the fault of the liberals, and there was nothing he could have done about it here.
