The Maestro of the Free Market
Alan Greenspan’s reputation has suffered but The Map and the Territory is a reminder of his vast contribution to American public life
Alan Greenspan: A force for good If old soldiers never die, retired generals never stop refighting their old battles. All the same there is something wholly admirable in Alan Greenspan’s publication of another volume on economics and public policy. Greenspan may be approaching his 88th birthday, but he still has fresh things to say. The title of his new book, The Map and the Territory, may baffle at first, but it refers to Greenspan’s more than 60 years of analysing the peaks and troughs, the hills and valleys, of the American business cycle. His two decades as chairman of the Federal Reserve, which ended in 2006 before the onset of the Great Financial Crisis, were widely regarded as a great success at the time. Bob Woodward, one of the two journalists behind the Watergate scoop, wrote a book on the period called Maestro. Everyone knew to whom that referred. But Greenspan’s reputation is not what it was. The severe economic downturn of late 2008 and early 2009 occurred under his successor, Ben Bernanke, but the instability is alleged to have originated in the financial excesses of the Greenspan era. The 20 years to 2006 have been condemned as a period in which the American people took on too much debt, making inevitable a phase of retrenchment and recession. In congressional testimony in 2008 Greenspan confessed to error. He acknowledged to a committee of the House of Representatives that “those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included”, were “in a state of shocked disbelief”.
A former acolyte of the libertarian philosopher Ayn Rand, Greenspan has always been an articulate supporter of free-market capitalism. In the heyday of President Reagan and Prime Minister Thatcher, he was a prominent advocate of deregulation, including deregulation of the financial system. His 2008 congressional testimony was therefore seen as a remarkable about-turn. But was his recantation sincere? The Map and the Territory has given Greenspan an opportunity to present and defend his true beliefs.
But the result is a muddle and, frankly, a disappointment. Greenspan suffers from the besetting sin of all economists except the one-armed variety, that they can say “on the one hand this” and “on the other hand that”. On the one hand, Greenspan reiterates his conviction that government meddling harms private enterprise. Chapter seven, “Uncertainty undermines investment”, identifies “the threat of arbitrary intervention” arising from undue policy activism as a major block to the current American economic recovery. He is particularly critical of “the vast and troubled financial regulations mandated by the Dodd-Frank Act”.
On the other hand, he repeats and endorses his 2008 congressional testimony, and on several occasions concedes that something went horribly wrong in the closing months of that year. He makes unembarrassed statements that in his view the breakdown in financial markets necessitated government intervention as an initial response and justified extra regulation as the longer-term remedy. He dislikes the Dodd-Frank Act, but he approves of the big increases in banks’ capital requirements that have been orchestrated since 2008 by the Bank for International Settlements in Basle.
What, exactly, does Greenspan want? A theme is that excessive leverage and risky banking were causes of the crisis, in line with the consensus of international financial officialdom. But the argument is not well-presented and, bluntly, Greenspan cannot make up his mind about the desirable level of regulation. As with far too many accounts of the years in question, the impression is given that the American banking system operated in 2007 with unusually low levels of capital and incurred losses that wiped out much of banks’ equity. The point is of huge importance, since officialdom’s justification for the capital-raising agenda over the last five years is that many banks did have losses similar to or larger than their equity. Let us check the facts. In the decades before 2007 the Federal Reserve did not supervise all of the American financial system, since the main business of the investment banks (Goldman Sachs, Morgan Stanley and so on) was to trade and underwrite securities. This business is not “banking” as usually understood, and Goldman Sachs and its immediate rivals were answerable not to the Fed, but to the Securities and Exchange Commission. The Federal Reserve has long compiled detailed numbers on the capital position and profitability of the US commercial banking system as such. For these banks Greenspan’s (and international officialdom’s) accusations of excessive leverage before the crisis are plain wrong. Moreover, the losses seen in the crisis were tiny relative to capital and at no point endangered the solvency of the commercial banking system. (The investment banks are different.)
Concern about US banks’ capital adequacy long predates the Great Recession and in fact goes back to the early years of independence. It became urgent in the 1980s as a result of the Third World debt crisis. Although it may seem incredible relative to the situation today, the New York money centre banks had equity-capital-to-assets ratios under 5 per cent in the early 1980s. They were told to more than double their equity capital buffers. In the ten years to end-1997 the ratio of US commercial banks’ equity to assets averaged 7.3 per cent and in the following ten it averaged 9.3 per cent. Just before the Lehman Brothers debacle itself the ratio was 10.1 per cent.
In other words, the American banking system was less leveraged when the Great Financial Crisis intensified in autumn 2008 than it had been typically in the previous 20 years and much less leveraged that at the onset of the Third World debt crisis of the 1980s. Moreover, the losses suffered by the commercial banking system as a whole were minuscule relative to its capital. In fact, the official Fed data show only one quarter in the recent crisis period with a negative return on bank equity. It was in the third quarter of 2009 when the loss amounted to 1.01 per cent of equity. (Readers may blink, given the media hullabaloo about these events. But, yes, in the worst quarter of the supposed greatest setback to free-market capitalism since the 1930s, 99 per cent of the mainstream American banking system’s capital was untouched.) Now let the reviewer immediately acknowledge that in 2008 and 2009 the investment banks were in a right old pickle. They had been incompetent and greedy in fomenting a bubble in securitised housing finance, and had losses running into tens of billions of dollars. At the worst moments the scale of the losses was uncertain, and these organisations — including Goldman Sachs — had lost much of their creditworthiness and could not fund their assets from market sources. In the event Goldman Sachs and Morgan Stanley had to have themselves re-classified as commercial banks, so that they could borrow from the Fed, while the three other big investment banks (Bear Sterns, Lehman and Merrill Lynch) had either to be taken over by other banks or, in the egregious case of Lehman, go “belly up”.
But what does the phrase “belly up” mean? Much of the trouble in this crisis has stemmed from the sloppy journalese in headlines, the morphing of headlines into factoids (“the banks were bust”), and the tendency of key players to go along with the factoids. The concept of bankruptcy is actually very complex. According to its balance sheet on Friday September 12, 2008, Lehman Brothers had positive equity of over $15 billion and hence could pay all its creditors in full. On the morning of Monday September 15, 2008, Lehman Brothers ran out of cash and sought protection from its creditors in the world’s largest-ever bankruptcy, with over $600 billion at stake. How can that make sense? How can an organisation with positive equity above $15 billion “go belly up”?
The answer is that over 95 per cent of the $600 billion of Lehman assets were financed by borrowing. As a result, when some of Lehman’s lenders stopped providing it with credit facilities, it could no longer repay its other creditors with cash. But was the balance sheet on September 12 lying? Well, yes and no, but not entirely. It is now over five years since the Lehman default, and the accountants and lawyers in charge of the debt work-out can begin to see daylight. The outcome is that unsecured creditors may well achieve a full 100 per cent return on their money. Major disputes between Lehman affiliates scattered all over the world are being settled on much better terms than expected. In autumn 2008 the value of Lehman’s assets was indeed above that of its total liabilities minus equity, just as the balance sheet said. Throughout the crisis the big quarrel between the bankers and the regulators was about the nature of the underlying problem. The bankers claimed that they were in difficulties because they could not finance their assets readily, even though most assets were of good quality and their businesses had positive equity. They did not need more capital. By contrast, the regulators insisted that banks’ financing strains were attributable to market distrust of banks’ capital adequacy. The immediate remedy was therefore for the banks to raise more capital, while over the long run they would have to operate with stronger capital shock-absorbers than in the past.
As the affairs of the failed institutions of 2008 come closer to final resolution, the truth is being clarified. In the US at least the bankers were substantially right. Their organisations may have found it difficult to finance their assets during the most testing months, but this was a problem of liquidity, not of solvency. In mid-2008 the overwhelming majority of the American banking system did have enough capital to cover such losses as were to be reported over the next two or three years. (Ireland, Iceland and Cyprus were different, or at any rate they became so as the crisis evolved.)
Not only did American banks at that time have much higher capital:asset ratios than ten or 20 years earlier, but they also had enough ammunition set aside to deal with losses arising from the most traumatic macroeconomic conditions since the 1930s. By extension, the case for a large further increase in capital ratios was and remains questionable. Given his well-known ideological positions, Greenspan might have been expected in The Map and the Territory to rubbish the critics of American capitalism. But instead he equivocates and gives far too much comfort to academics, regulators and politicians who are determined to denounce the market economy.
It cannot be emphasised too strongly that the failure of Lehman Brothers was not to blame for the Great Recession. But then who or what was responsible? There is a deep and unsettling paradox here. The regulatory response to the Lehman bankruptcy was to demand that banks raise more capital quickly, and to impose additional capital relative to balance-sheet totals in a more onerous regulatory regime. But that move towards higher capital:asset ratios caused banks in 2009 and 2010 to shed assets and shrink their balance sheets, with the further result that the quantity of money (such as the M2 measure, dominated by banks’ deposit liabilities) stopped growing. An argument can be made that the plunge in money growth was the cause of the Great Recession. Official bungling as well as investment bankers’ greed and folly must then be highlighted in any even-handed analysis of the Great Recession. (I argued that abrupt bank recapitalisation and regulatory tightening of late 2008 aggravated the downturn in my March 2011 Standpoint article, “Gordon Brown’s Recessional”.)
Talking of M2 (which was Milton Friedman’s favourite money aggregate), Greenspan is unusual among contemporary American economists in still seeing a connection between money and inflation. Fair enough, but he fails totally to understand that the regulatory onslaught from 2008 was the main reason for the crash in money growth from double-digit rates in 2007 to zero in 2009 and 2010. He therefore overlooks the possibility that the Great Recession, like the Great Depression of the early 1930s, can be attributed to a boom-bust in money growth. Has he forgotten the thesis of Friedman and Schwartz’s celebrated 1963 work, A Monetary History of the USA, which said that the Great Depression was caused by a collapse in the quantity of money, and was not due to the inefficiency of capitalism’s financial institutions? Can he not see that the Great Depression and the Great Recession may be analysed in similar cause-and-effect terms?
Alan Greenspan has been a force for good in American public life for 50 years, and he deserves yet another medal for writing an interesting and challenging book in his late eighties. But The Map and the Territory is not the last word, and we eagerly await its successor.