Greenspan on Financial Crisis: "I Made a Mistake"

At the end of the day economic theory is like any other discipline when overlaid with the human factor - it is more art than science. People operating in the real world often make common sense observations about the way 'markets behave' that defy and in fact are 'disproven' by certain economic theories. In the end, as with the colossal financial crisis cresting its very first wave over the US and world economies, the lesson well learned is never to allow theory itself to regulate market behavior.

To his very great credit, former Federal Reserve Chairman Alan Greenspan, the guru of finance for generations of business school students, admitted before a Congressional committee today that he made a mistake in assuming that alllowing banks to operate absent conflict of interest regulation or oversight would work because of the misapprehension that operating in their self interest would be enough to assure the banks would preserve shareholder interests (AP. 4/23/08). Greenspan told the House Oversight Committee and its chair, Rep. Henry Waxman (D., CA) , that it was "a flaw in the model that I perceived is the critical functioning structure that defines how the world works" (AP, 10/23/08) that banks would fail to protect their equity or their shareholders and would engage in risky practices that would deplete their revenues. Greenspan's admission is a bold one and one that is necessary to truly examine the banking collapse (that so many mislabel as simply an offshoot of the mortgage crisis). He admits there was a basic flaw in the model of how this country manages its banking industry, in how it views the functioning of the free market in this aspect. Greenspan admitted to being shocked by what he called "the collapse of a critical pillar to market competition and the free market". (AP 10/23/08, committee transcript)

While Greenspan did lay some blame on soaring foreclosures and over-eager investors, the admission that the banks lending habits presented a risk at counter purposes to preserving assets and protecting shareholders is critical to reframing regulation over our banking industry that acknowledges the human element that econommic theory on free markets could never capture - 'greed'. The panel sought to lay quite a bit of blame at Greenspan's feet, much of which he deflected or denied, but it is a major step forward in establishing reasonable economic and banking policies in this country to acknowledge flaws in our basic thinking about how markets function since in this case they did not function this way at all.

Greenspan has also been criticized for not seeing the housing bubble for what it was, for keeping interest rates too low for too long and in that way continuing to encourage risky investment in the housing market - but the separate issues were clear. On the one hand the housing market had never previously collapsed in the violent fashion that it did in 2006 and subsequently. So,some risk should have been forecast and keeping interest rates low did encourage continued activity and investment in a volatile and risky market. But, on the other, better oversight of banking industry conflicts of interest would have prevented banks from continuing to make risky loans or assume huge chunks of unbacked debt even after market prices went into freefall. Buyers can be lured into a market by low rates, but they cannot purchase when the downside risk of a loan is against the interest of a bank's shareholders and poses a risk to the bank's assets. The credit begins to dry up in that instance and the sellers have to lower prices, reduce risk. Interest rates should also climb in that scenario to better reflect the risk involved, and that would discourage market speculation of the sort that played the most destructive role in the foreclosure mess. The phony and 'paper' loans would not have occured because on the one side, even fraudulent buyers won't speculate where there is no reasonable profit guarantee, and on the other side the verifiction process would have been strict in order to protect assets and shareholder dollars.

Understanding the limits of free market thinking and the perhaps previously unacknowledged frailty of the banking sector, will allow regulators to move forward with a more cohesive and realistic framework to forestall these harmful lending practices in the future. Greenspan's admission of his shock at the way the market did not behave the way theory has told us it should, explains some of the slowness to respond, but also the limits of going out on limbs with widely accepted monetary and economic theories without exercising regulatory restraint to prevent market failure and/or collapse.

Good news that came up during the Oversight Committee hearing came in the form of testimony from FDIC chariman Sheila Bair, who assured the panel her group is hard at work with the government to set reasonable loan guarantees and to allow more and more homewoners to modify their mortgages and stay in their homes - to forestall further freefall in market prices and prevent further financial harm to banks and the overall economy. Bair said the FDIC is working "closely and creatively" (AP 10/23/08) with the Treasury department to develop loan guarantees and present affordable mortgage options to current homeowners at risk.

Greenspan's admissions about flaws in free market theory and his acceptance of the reality that banks cannot be allowed to pursue self interest in an unregulated environment, coupled with Bair's testimony purporting to develop work out plans for hundreds of thousands of existing mortgages to rpevent further foreclosures, should help stem the pricing freefall in the housing sector and correct inadequacies in the oversight framework governing the banking industry. The clearest picture of what went wrong and how to fix it is what the Oversight Committee and federal regulators and decision makers will need to lead the country our of what by all accounts will be a sustained recession. Acknowledging mistakes, identifying areas of redirection and developing a path for individual homeowners to pay their mortgages and contribute to bank solvency and health is really the only clear way out.