Friday, October 24, 2008

Irrational Without Exuberance

I cannot remember if I am the good twin or the evil one.

From The Joke File, Expressions for Stressful Days

Earlier this week the atmosphere in the hearing room of the Congressional Committee on Oversight and Government Reform was charged with electricity just like it was so many times before when Alan Greenspan came calling on Capital Hill. Except this time the current appeared to be rigged to the Maestro’s chair.

Instead of the accolades and praise that characterized his testimony before Congressional leaders in the past, Greenspan was treated to an old fashioned verbal tar and feathering. After all it was Greenspan who kept interest rates low and talked up the virtues of an economy fueled by a fast growing housing market. He also resisted regulatory reform and argued that market mechanisms would provide natural restraint.

Yet the Congressmen were only able to coax a lukewarm acknowledgement from Greenspan that he had “found a flaw” in his ideology.

Greenspan’s testimony this week sent me looking back at a previous Small Cap Copy post “Irrational Exuberance” in December 2006, on the anniversary of a long since forgotten speech by Alan Greenspan in December 1996. It was that notorious speech at the American Enterprise Institute during which Greenspan coined the phrase “irrational exuberance.” However, that was not what had caught my attention two years ago.

What stood out for me was his now twelve-year old comments about how low inflation leads to lower risk premiums and higher asset prices. What if asset prices have escalated to “irrational” levels? His conclusion was that central bankers, including himself, “need not be concerned” so long as “a collapsing financial asset bubble does not threaten to impair the real economy, it production, jobs….”

What Greenspan apparently had not considered was the possibility that an economic slow down and rising unemployment might trigger defaults on mortgage loans and then a collapse of housing prices. This would be especially acute if weak underwriting policies had created low quality loans. Some flaw!

Greenspan has long held the view that regulation is not the answer since “government regulators are no better than markets at imposing discipline.” Clearly that is true in Greenspan’s case since under his command the Federal Reserve failed to even take action against potentially fraudulent lending activity. The Federal Reserve board has had broad authority ever since the Home Ownership and Equity Protection Act (HOEPA) was passed in 1994, to at least prevent deceptive lending. Yet it was only this year that the Fed under Ben Bernanke finally tightened restrictions on sub-prime mortgages.

While I am tempted to vilify Greenspan for his arrogance and near-sightedness, there is plenty of blame for members of Congress who slavishly followed his recommendations and for complacent voters who have given inept politicians a pass. Our focus today should be on finding a better way out of this hole we are in than to simply continue digging.

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