Alan Greenspan: The Financial Crisis Was Not My Fault

Despite leading the Fed's Board of Governors from 1987 to 2006, where he was ultimately responsible for setting U.S. monetary policy, including the critical years leading up to the worst financial crisis in history, the buck did not stop with Greenspan.

In fact, Greenspan spent much of his time before the Financial Crisis Inquiry Commission on April 7 blaming nearly everyone but the Fed for the financial meltdown that occurred 18 months ago. The "global proliferation of securitized, toxic U.S. subprime mortgages" was the immediate trigger of the crisis, but the roots of the crisis reach to the fall of the Berlin Wall, he explained. Greenspan seems to be saying that if only communism had not collapsed in 1989, then capitalism never would have taken hold around the world and the financial crisis would never have happened. Greenspan is likely to find it difficult to sell this argument.

The former chairman did not even admit that the policy instrument that he controlled, the interest rate, was a factor in the crisis. No, for Greenspan, the real fault lies with the Chinese and citizens in other mostly East Asian countries who save too much. As he said, the "savings glut" in the developing world, especially in East Asia, pushed down global long-term interest rates, which, with a dearth of investment opportunities in their home countries, forced them to send their savings to the United States, which the investment bankers channeled into toxic securities.

Greenspan failed to mention that it was his Fed that drove U.S. short-term interest rates down to just 1 percent in 2003 and kept them there for more than a year. Despite the consequences those low interest rates had in the inflating the housing bubble, Greenspan still thinks that keeping interest rates at historic lows for years was the right thing to do. (For details, click here.)

Greenspan had plenty of blame to spread around. When Phil Angelides, the former California state treasurer who chairs the commission, asked, "Why did you allow subprime lending to become such an infection in the market place?" Greenspan said it wasn't his fault. In Greenspan's view, the government-sponsored mortgage financing entities, Fannie Mae and Freddie Mac, are to blame for implementing a plan to increase home ownership in low-income communities that every president from Jimmy Carter through George W. Bush has advocated.

True, Fannie and Freddie securitized millions of dollars worth of subprime mortgage securities. But it was the Fed's support of reduced bank lending standards that led to mortgages requiring no down payment, no documentation of income, and loans that exceeded the value of the home that fueled the securitization demand.

Moreover, after about 2004, private sector banks had largely taken over the subprime mortgage securitization market from Fannie and Freddie. Greenspan, however, does not blame the investment community for the crisis. Perhaps that omission is intentional, since he is now a consultant at Pacific Investment Management Co., the $1 trillion asset management fund led by William H. Gross whose bond fund made $1.7 billion when he correctly bet that the federal government would not let Fannie and Freddie fail.

For good measure, he also blamed the credit-rating agencies for giving gold-plated ratings to toxic mortgage backed securities. In Greenspan's words, the investment community turned to these agencies "in despair" since they couldn't decipher the content of the securities they were selling.

Commissioner Brooksley Born, who headed the Commodity Futures and Trading Commission in the late 1990s, was not convinced. She said that although Greenspan has said that "the role of the regulator is prevention," in her opinion, the Fed "utterly failed to prevent the financial crisis." Born didn't buy Greenspan's claim that the financial system had become too complex for the regulators to understand.

Greenspan stood his ground, arguing that there were "flaws in the system" that prevented him and other analysts from understanding the extent of the risk created through securitization. Many smart people at investment banks and in the regulatory agencies, including but not limited to the Fed, misread the risk that was ballooning inside the growing housing bubble. As Greenspan argued, the "sense of euphoria" in the financial markets led "to more than a half century of significantly and chronically undercapitalized financial intermediaries, arguably the major failure of the private risk management system."

Greenspan sort of admits that he was over his head in terms of the mathematics at work in the financial world. He attributes a great deal of the financial crisis on the "indecipherable complexity of a broad spectrum of financial products and markets that developed with the advent of advanced mathematical models to evaluate risk."

This argument is not very compelling. Greenspan has one of the best economics departments in the country, where any number of his PhD economists could have explained the models to him.

Although Greenspan said he "fundamentally disagrees" with Born's characterization of his time at the Fed, he did admit to being fallible. He said that during his 21 years of government service, "I was right 70 percent of the time and wrong 30 percent of the time." Unfortunately, he did not tell us which decisions fall in the 30 percent category and which fall in the 70 percent category.

Born was particularly critical of Greenspan's actions in the late 1990s, when he actively worked to keep certain derivatives trading away from public scrutiny and regulation to avoid stifling the burgeoning credit default swap market. Congress adopted that recommendation and carved certain derivatives out of the Commodity Futures Modernization Act in December 2000.

Greenspan countered that even though it grew to a $60 trillion market, at the time Born was arguing for greater regulation of credit default swaps, they made up just one percent of the market. Moreover, he added, even if American International Group had been prevented from selling these insurance-like swaps, they would have "gotten into just as much trouble selling insurance." Born firmly disagreed. She countered that AIG could not have gotten into such trouble with a true insurance product because insurance is a heavily regulated market.

Ironically, given his strong anti-regulatory stance, Greenspan agrees that lack of effective regulation was at the heart of the crisis. If we wish to avoid another crisis, he said, regulators should require banks to increase their capital and their liquidity.

In the end, Greenspan indicated that there was no way to prevent "the breakdown that so devastated global financial markets" without taking steps that most Americans would choose to avoid like the plague. As Greenspan said, it will be impossible to prevent bubbles from forming unless society chooses to "abandon dynamic markets and leverage for some form of central planning."

And, with that comment, Greenspan came full circle. As mentioned above, he places the roots of the financial crisis at the collapse of the Berlin Wall and the freedom that event brought to millions of people. To quote Greenspan, ". . . its roots reach back, as best I can judge, to1989, when the fall of the Berlin Wall exposed the economic ruin produced by the Soviet system. Central planning, in one form or another, was discredited and widely displaced by competitive markets."

For a central banker who recently admitted that he followed an ultimately flawed philosophy, yet still (justly) relies on the superiority of free markets over central planning, this attempt to blame communism for capitalism's flaws is just too much. He is still trying to pass the buck.