Greenspan Explains What Went Wrong

Rarely has a public figure's reputation suffered a reversal as dramatic as Alan Greenspan's. When he left the Federal Reserve in early 2006 after nearly 19 years as chairman, he was hailed as the "maestro" and credited with steering the country through numerous economic shoals. Four years later, his policies are widely blamed for fostering the 2007–09 financial crisis. Now Greenspan is offering an elaborate "not guilty" defense.

The indictment of Greenspan is straightforward. Lax regulation by the Fed of financial markets encouraged dubious subprime mortgages. Easy credit engineered by the Fed further inflated the housing "bubble." Greenspan's rebuttal comes in a 14,000-word article for the Brookings Papers on Economic Activity, a journal from the think tank of the same name.

Greenspan is in part contrite. He admits to trusting private markets too much, as he already had in congressional testimony in late 2008. He concedes lapses in regulation. But mainly, he pleads innocent and makes three arguments.

First, the end of the Cold War inspired an economic euphoria that ultimately caused the housing boom. Capitalism had triumphed. China and other developing countries became major trading nations. From the fall of the Berlin Wall to 2005, the number of workers engaged in global trade rose by 500 million. Competition suppressed inflation. Interest rates around the world declined; as this occurred, housing prices rose in many countries (not just the United States) because borrowers could afford to pay more.

Second, the Fed's easy credit didn't cause the housing bubble because home prices are affected by long-term mortgage rates, not the short-term rates that the Fed influences. From early 2001 to June 2003, the Fed cut the overnight fed-funds rate from 6.5 percent to 1 percent. The idea was to prevent a brutal recession following the "tech bubble"—a policy Greenspan still supports. The trouble arose when the Fed started raising the funds rate in mid-2004 and mortgage rates didn't follow as they usually did. What unexpectedly kept rates down, Greenspan says, were huge flows of foreign money, generated partially by trade surpluses, into U.S. bonds and mortgages.

Third, regulators aren't superhuman. They can't anticipate most crises, and even miss some massive frauds when evidence is shoved in their face: Bernie Madoff is Exhibit A.

Given regulators' shortcomings, Greenspan favors tougher capital requirements for banks. These would provide a larger cushion to absorb losses and would bolster market confidence against serial financial failures. Before the crisis, banks' shareholder equity was about 10 percent: $1 in shareholders' money for every $10 of bank loans and investments. Greenspan would go as high as 14 percent.

Up to a point, Greenspan's defense is convincing. The Fed was a prisoner of large forces that it didn't completely understand or control. The anti-Greenspan backlash is heavily political. It satisfies the post-crisis clamor for scapegoats. But his explanation also misreads what happened.

It was not the end of the Cold War, as Greenspan asserts, that triggered the economic boom. It was the Fed's defeat of double-digit inflation in the early 1980s. For 15 years, high inflation had destabilized the economy. Once it fell—from 14 percent in 1980 to 3 percent in 1983—interest rates slowly dropped, and this minimized recessions and boosted stocks and housing prices. By 1988, a year before the fall of the Berlin Wall, mortgage rates had already dropped from 15 percent in 1982 to 9 percent. By 1991, the year the Soviet Union collapsed, the stock market had already tripled since 1982.

Greenspan's complicity in the financial crisis stemmed from succeeding too much. Recessions were infrequent and mild. The 1987 stock-market crash, the 1997–98 Asian financial crisis, and the burst "tech bubble" did not lead to deep slumps. The notion spread that the Fed could counteract almost any economic upset. The world had become less risky. The problem of "moral hazard"—meaning that if people think they're insulated from risk, they'll take more risks—applied not to individual banks but to all of society: bankers, regulators, economists, ordinary borrowers, and consumers.

"[W]e had been lulled into a state of complacency," Greenspan writes in passing, failing to draw the full implication. Which is: too much economic success creates the seeds of its undoing. Neither Greenspan nor any other major economist has wrestled with this daunting contradiction.

Robert Samuelson is also the author of The Great Inflation and Its Aftermath: The Past and Future of American Affluence and Untruth: Why the Conventional Wisdom Is (Almost Always) Wrong.