Friday, October 24, 2008

The Mistakes of Alan Greenspan

Alan Greenspan admitted today, many mistakes were made during his period as Chairman of the Federal Reserve. Greenspan was once hailed as an economic genius who presided over a long period of economic stability. But, now many blame him for fostering an asset boom and bust.

In a remarkable admission, he states how much he underestimated the capacity for banks to take reckless decisions.
"Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity – myself especially – are in a state of shocked disbelief."
In particular Greenspan is criticised for making two mistakes.
  1. Keeping interest rates too low in the early 2000s. This caused a boom in demand for houses and encouraged people to take out a mortgage who wouldn't have been able to afford it at normal interest rates. When Greenspan finally had to increase interest rates in 2005, the shock caused many to default.
  2. Not Have greater Regulation of Subprime Mortgages and Financial sector. Arguably, Greenspan had the authority to insist on greater regulation of subprime mortgages and financial derivatives. This would have prevented the series of bad loans and unacceptable risks taken by banks.
Greenspan admitted that they had poor information about the standards of mortgage lending.
"We didn't know that a deterioration in standards was occurring until 2005. The real toxic mortgages occurred with the increase in securitisation and the huge demand from abroad, and to the extent that Fannie and Freddie were involved, from them as well."
Of course, it is easy to be wise after the event. Greenspan was hardly alone in rejecting calls for greater financial regulation. He was not alone in wanting to keep interest rates low to boost economic growth.

Part of the problem is that policy makers are often making decisions based on past economic and financial trends. For example:
  • A Housing market boom and bust has never effected the real economy so much before. Policy makers used to feel targeting inflation was enough.
  • There was a widespread ignorance or willingness to turn a blind eye to the shocking practises of subprime mortgage lending.
  • Part of the problem was also that the government regulated, Freddie Mac and Fannie Mae were told to make mortgage lending as widely available as possible.

No comments: