Alan Greenspan’s bubble deflated

"Alan Greenspan was a good Fed chairman, but his reputation was grossly over-inflated"

Tim Congdon

Alan Greenspan’s enthusiasm for the capitalist system began in the early 1950s, when he was in his late twenties. Crucially, he belonged to a small circle of Ayn Rand admirers and was married — although for only ten months — to one of Rand’s closest friends. Rand espoused a robust pro-capitalist individualism with an intellectual rigour and forensic panache that overwhelmed the young Greenspan. His philosophical leanings were for a time towards a rather gauche and nihilistic logical positivism. This took an extreme form when, on more than one occasion, he wondered aloud in the private Rand group whether he really existed. According to Jennifer Burns’s 2009 biography The Goddess of the Market, Rand “pounced” at such nonsense by asking, “And by the way, who is making that statement?”

The reality of Alan Greenspan is today very much a matter of public record. Since Rand’s pouncing, his existence has continued for almost seven decades of ever-increasing distinction and diminishing philosophic doubt. When his years as chairman of the Federal Reserve, from 1987 to 2006, were characterised by virtually continuous prosperity, he became fêted as the “maestro” of central banking. He has now teamed up with the 59-year-old Adrian Wooldridge, who has an alter ego as the Bagehot columnist on the Economist, to write a book on Capitalism in America: a History.

Despite his fame as an economic guru (or perhaps because of it), Greenspan has a penchant for making Delphic remarks. A quote often attributed to him is, “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.” Happily, Capitalism in America is not obscure at all. Unhappily, it goes along with the current fashion to denigrate the American banking system and endorses misguided, if widely-held proposals for banks to hold much more capital relative to the risks they take. Later, this review will argue that the proposals are not only “un-American” (to recall a word used by Jamie Dimon, chief executive of JP Morgan Chase), but are also developed with such incoherence as to undermine their authors’ credibility.

Let it be said that the book has many good points. A fair conjecture is that most of the words were typed out by Wooldridge, even if the ideas and narrative reflect a huge input from Greenspan. As might be expected from a book written by someone with decades of journalistic experience, Capitalism in America is an easy and enjoyable read. Obviously intended for the trade market, it has been shortlisted for the 2018 Financial Times and McKinsey Business Book of the Year Award.

It contains several well-presented, consistent and important themes. One of these is that “creative destruction”, a notion advanced by Joseph Schumpeter in his 1942 classic Capitalism, Socialism and Democracy, has been vital for American dynamism. Innovative and better technologies have created new and growing industries. At the same time old and inferior industries with obsolete technologies have been destroyed. Technical and managerial advances have improved living standards overall, but their impact has been untidy and far from painless. As Greenspan and Wooldridge explain with a charming selection of words, “The central mechanism of . . . progress has been creative destruction: the restless force that disequilibrates every equilibrium and discombobulates every combobulation.” Automobiles are an example. They may be a blessing of modern life, but they ended the horse-and-buggy era. The authors note that in 1900 there were 109,000 carriage and harness makers in America, whereas nowadays there are “only a handful”.

The downside of creative destruction is evident; it hurts those who suffer the destruction. The losers may become politically active, agitating against the changes which injure a few even if they benefit the majority. As Greenspan and Wooldridge remark: “The ‘perennial gale’ of creative destruction thus encounters the ‘perennial gale’ of political opposition.” The risk is that official restrictions are introduced which reduce efficiency and lower productivity. An instructive item of evidence is a chart in chapter 12 (entitled “America’s Fading Dynamism”), which shows the number of pages in the Code of Federal Regulations. The upward line is remorseless, from about 70,000 in 1975 to almost 200,000 in 2016. The “mountains of legislation” have increased the demand not just for regulators, but also for the private sector professionals who advise business clients on how to comply (and sometimes how to evade). All too often, regulations have led to much extra employment and no genuine added output. Is it any wonder that productivity growth over the last decade has been disappointing?

The Great Recession of 2008 and 2009, like the Great Depression of the early 1930s, has a chapter of its own. In the American public debate, both episodes were attributed largely to the misdeeds of the financial sector and provided yet another rationale for rules and restrictions. The 2010 Dodd-Frank Act, the principal legislative response to the later crisis, is described as trying “to micromanage the financial services industry with thousands of pages of detailed regulations”. Perhaps big banks can afford to hire experts to mitigate the damage, but the burden for small financial institutions is heavy and painful. Greenspan and Wooldridge remark that Dodd-Frank was “quickly dubbed the ‘Lawyers’ and Consultants’ Full Employment Act’”.

However, this hostility to Dodd-Frank sits oddly with their main recommendation for the financial system. Dodd-Frank aims partly to prevent the harms to American society that come from misconduct by bankers and others and to some extent these harms are distinct from banking system capital. But also central to its purpose are Dodd-Frank’s restrictions on the amount and type of risk that banks can put on their balance sheets. Such restrictions make sense only if risk is relative to their equity capital, since equity capital measures banks’ ability to absorb losses that are due to excessive risk. Yet Greenspan and Wooldridge both denounce Dodd-Frank (which therefore forces banks to hold more equity capital) and urge that “the best way” to stop another Great Recession is “to force banks to hold substantially more equity capital”. This looks a bit strange.

Despite the apparent inconsistency, Greenspan and Wooldridge are uncompromising on the subject. At one point they advocate capital/asset ratios of 25 per cent “or, even better, 30 per cent”, compared with current figures typically in the five to 15 per cent area. They seem to be confident that thick capital buffers would reduce “the probability of contagious default” which they assert was “the root of the [last] financial crisis”. Moreover, as the quote above says, the state is to have powers “to force” (my italics) banks to behave properly. Evidently, in their view the move to much higher levels of banking system capital should be mandatory, presumably, indeed, with statutory backing.

Greenspan and Wooldridge are not alone in wanting further bank recapitalisation. They may be at an extreme end of a spectrum of opinion, but enthusiasm for higher bank capital requirements is shared by a large number of movers and shakers in the American economics establishment. But movers and shakers are not always right. Bluntly, the reasoning for extra bank capital in Capitalism in America is weak and unconvincing. Given the prestige that attaches to the “Greenspan” brand and the tendency for that prestige to decide the argument without further ado, the case against must be spelt out and heard.

The first problem is that, in the paragraphs surrounding their recommendations on bank capital, Greenspan and Wooldridge make false statements about the behaviour of the American economy. They declare in their introduction to the book (on page 27) that all — yes, all — financial crises are “set off by financial intermediaries’ having too little capital in reserve and fostering modern versions of a contagious run” on the banking system. This is simply untrue, unless the authors are using an idiosyncratic notion of “financial crisis”. A recent and readily available counter-example is the bursting of the dotcom bubble in 2000. Many tech stocks lost more than 80 per cent of their value in less than a year. The whole American economy weakened in late 2000 and early 2001 at least partly because of this shock, obliging the Federal Reserve to lower its funds rate from 6 per cent to 1 per cent to revive economic activity. At no point in the crisis was the capital position of the United States’ banking system regarded as difficult or threatened. No major banks went bust and no speculative run on them occurred. (The Federal Deposit Insurance Corporation website says that four banks failed in 2001, but they were all minor and depositors lost no money. By contrast, in the USA’s Great Depression almost 10,000 banks went under.)

Even worse, Greenspan and Wooldridge contradict themselves on this crucial question in successive chapters. Whereas on page 27 all financial crises — in American history, implicitly — are to be blamed on inadequate bank capital, on page 43 (in chapter one, on ‘A Commercial Republic: 1776-1860’) an alternative theory is favoured. The US suffered financial panics in 1837, 1857, 1873, 1884, 1893, 1896 and 1907. The panics varied in their symptoms, but Greenspan and Wooldridge judge that “the underlying pattern” was “always the same”. Specifically, “Expansions gathered pace until they were finally constrained by a ‘gold ceiling’ that limited the supply of credit and forced businesses to retrench.”

Greenspan and Wooldridge are not thinking straight. As far as 19th-century banks were concerned, a “gold ceiling” was something quite different from a lack of capital. Gold was a liquid item on the assets side of the balance sheet, intended to meet loss of trust by depositors who might withdraw their cash; capital was an accounting entry on the liabilities side of the balance sheet, measuring the value of the business to its owners after other claims had been met. Sloppy non-specialist writers sometimes confuse the two, because capital is often called “capital and reserves”, a phrase which looks and sounds like “gold and cash reserves”. But Greenspan and Wooldridge are specialists who have no excuse for such misunderstanding.

To reiterate, in the 19th century capital and gold were not at all the same thing, just as today a bank’s shareholders’ funds must be distinguished sharply from its cash holdings (that is, the sum of vault cash and reserves at the central bank). It was possible then — just as it is possible now — for a bank to be liquid (to have ample cash to meet normal settlement obligations) and yet insolvent (with the assets worth so much less than claims from depositors and other creditors that shareholders are wiped out). Conversely, a bank can be illiquid (with scarcely any cash left for depositors) and fully solvent (with assets worth something to shareholders, after all other creditors have been paid off). Indeed, a key function of any central bank is to ensure that banks of the second type (solvent and with good assets, but short of cash) can borrow from it and survive a run. That thesis was the heart of the 1873 classic Lombard Street, written by the real Walter Bagehot.

Acknowledged experts such as Green-span and Wooldridge ought not to be in a muddle about the plumbing and wiring of banking organisations. But this is not the end of their troubles. Greenspan was a good friend of Milton Friedman (1912–2006), who — like Rand — was an icon of the American intellectual Right. Friedman co-authored with Anna Schwartz a much-praised 1963 book A Monetary History of the United States, 1867-1960, which argued that a collapse in the quantity of money was the main cause of the Great Depression. The Friedman and Schwartz analysis is mentioned on page 236 and applauded as “monumental”. But the theory that financial crises stem from declines in the quantity of money is separate from either the theory that they are caused by banks’ shortage of cash or that they arise from banks’ lack of capital.

It would be understandable if — in his nineties — Greenspan left much of the actual writing of Capitalism in America to the much younger Wooldridge. Their book is, then, unsurprisingly journalistic in form: it does not pretend to be an academic treatise over-burdened with footnotes and equations. All the same, the authors must want its arguments taken seriously. For Greenspan, in particular, Capitalism in America must matter as it may be a final testament to his passion for America and its economic system.

But the book’s policy conclusions are not justified by a tangle of superficial and inconsistent reasoning. And, in a true free-market capitalism, would Ayn Rand have pounced on the notion that banks must be “forced” to behave themselves by regulatory bureaucrats? Would she not agree with Jamie Dimon that highly prescriptive state intervention in shareholder-owned organisations is “un-American”? Is not the point of America that people and companies are free to choose? There are bubbles and busts in financial markets; there are also bubbles and busts in reputations. Alan Greenspan was a good Fed chairman, but his reputation was grossly over-inflated.

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