Friday, March 27, 2009

A Wizard of Oz?

Alan Greenspan, whose public esteem has suffered the most dramatic reversal of anyone in recent history (Dubya not excluded), has a reflective but unapologetic commentary in today's Financial Times (27 March 2009)

He is an unrepentant free-marketeer but he cannot explain the recent collapse. He says the market is good at calculating risk but it has failed to foresee the current crisis. He calls for better regulation of the financial intermediaries but he warns against over-regulation at a time when the goal must be to get credit flowing, so take your pick.

I think the problem for Greespan and other free-marketeers is that they think of financial services as being part of the service industry, like restaurants or dry-cleaners, i.e. they offer an economically useful service and the economy will tend to benefit from an expansion of the financial services.

Greenspan is forced to accept now that some regulation is required (he was a very reluctant bailiff at the Fed), but he thinks the problems are on the margins i.e. that free market forces will normally keep banks etc. from behaving irresponsibly.

I think that the system of credit is inherently volatile and, left to their own devices, banks etc. will always tend to behave irresponsibly. This tendency was exacerbated in recent years by factors such as (a) distorted incentive systems, (b) US trade imbalance creating vast pools of dollars abroad (c) almost zero returns on T-bills leaving investment funds seeking any home that offered a decent return, (d) unregulated hedge funds, (e) .

These and other factors increased the opportunities for bad debts developing to catastrophic levels but, absent all exacerbating factors, a credit crisis would still develop over time. Those who are trying to restore the system of credit should realise that it is not just a matter of clearing out bad debts (and bad management), there needs to be a fundamental change which would restore our faith in the financial system.

Greenspan's spiritual home, the Ayn Rand Center, is blaming it all on government and especially on the Fed!

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