Friday, October 24, 2008

Greenspan is Wrong

He is also wrong about how he is wrong.

He used to be right, as when he wrote “Gold and Economic Freedom” in 1966.* What changed his mind since then remains a mystery.

Now he says:
“I made a mistake in presuming that the self-interests o f organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.” Referring to his free-market ideology, Mr. Greenspan added: “I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.”

Mr. Waxman pressed the former Fed chair to clarify his words. “In other words, you found that your view of the world, your ideology, was not right, it was not working,” Mr. Waxman said.

“Absolutely, precisely,” Mr. Greenspan replied.

But, as economist, Dr. George Resiman points out, it is not the free market that is to blame.

The actual responsibility for our financial crisis lies precisely with massive government intervention, above all the intervention of the Federal Reserve System in attempting to create capital out of thin air, in the belief that the mere creation of money and its being made available in the loan market is a substitute for capital created by producing and saving. This is a policy it has pursued since its founding, but with exceptional vigor since 2001, in its efforts to over come the collapse of the stock market bubble whose creation it had previously inspired...

In doing this, the Federal Reserve’s ultimate purpose was to stimulate both investment and consumer spending. It wanted the cost of obtaining capital to be minimal so that it would be invested on the greatest possible scale and for people to regard the holding of money as a losing proposition, which would stimulate them to spend it faster. More spending, ever more spending was its concern, in the belief that that is what is required to avoid large scale unemployment.

All this additional money is actually fictitious capital, leading people to believe they have more resources than they do. This causes investments and spending in areas which would not have occurred if the availability of money reflected the true state of wealth. Over-investment in a market sector not supported by real demand (which in economics is defined as the willingness and the ability to pay for something) is what creates a bubble. It’s called a bubble because it pops.

Many factors went into making the housing market the sector which experienced the bubble (Fannie, Freddie and their securitization schemes, the CRA, desire for a “real” investment following the dot-com crash, and more) but what made the bubble possible to the scale in which it occurred can be directly traced back to 2 major things (1) the infinite manipulability of fiat money, and (2) the failed central planning of the central bank system. Not until we return to the honest money system of the gold standard and the market discipline found in a free banking system will we be able to avoid the huge boom-bust swings of the past century, and the financial destruction they bring with them.

Greenspan is right to admit his system doesn't work, but it's ridiculously wrong to equate his system with a free market.

(*) In Capitalism: The Unknown Ideal by Ayn Rand


Glenn said...

Greetings Beth - I had to check out your blog - thoughtfully researched, well written. I would take exception to this post in a key area related to the areas of regulation (lack of) and the gold standard. As to the latter, I believe that it's true that Greenspan mismanaged the money supply with unrealistically low prime rates, although I think that this was more an error of magnitude than of mechanism. I don't necessarily follow the connection with the gold standard...I'm thinking that you were espousing a monetarist macro-view of the economy that might have limited the amount of capital exposed to bad mortgage debt and investment in derivatives. Beyond that, though, I believe that (again, lack of regulation, to quote George Lux) - We had a group of Investors who assumed the Money creation power of fractional reserve banking without any controls, which slowly inflated the Price base throughout the Economy, without providing any greater security to Debt Risk or actual Investment expansion in the Economy. It was basically a creation of a new Middleman, who demanded a high rate of Return for a basic Paper mechanism, which did not instill any increased Value into the Investment. It was basically a Private Sector assumption of the Money Printing capacity of the Public Sector without Controls, and no organization for the assumption of real value to the Paper.

Beth said...

Hi Glenn,


I do think that inflation is the result of an increase in the money supply. I have not read enough Friedman to know if I would call my point of view "monetarist." Just a quick peak at Wikipedia on monetarism and I came up with:
1.Monetarism is a school of economic thought concerning the determination of national income and monetary economics. It focuses on the supply of money in an economy as the primary means by which the rate of inflation is determined. (This I would agree with.)
2. It argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability. (This I am less inclined to agree with because I don't know what is meant by "excessive" or "monetary authorities.")

I couldn't find George Lux on a web search, but I would agree that the money supply was being increased by both the private and public sectors....and both are problematic.

The connection to the gold standard is that it serves as an anchor to the money supply and can serve as a way to regulate without a(human)Regulator.

I listened to the NPR interviews with Greenberger that you recommended by email and can see that I need to delve further into understanding the role derivatives have played in the current mess.
Thanks again for being willing to join in a discussion.


Anonymous said...


I think the answer to your two questions about point #2 are:

- "excessive" probably refers to increasing the money supply beyond the rate the economy is growing. In order to keep prices stable, the money supply needs to increase at the same rate as the economy; if it lags, then you get deflation; if it gets ahead, you get inflation.

- "monetary authorities" are probably referring to central bankers (eg, the Federal Reserve)

Friedman famously advocated replacing the Fed with a simple accountant who just increased the money supply around 3%/year because that was the historical average growth of the US economy. There are more sophisticated rules for deciding on the percentage amount (eg, the Taylor Rule) but all fall on the side of eliminating the discretion of the Fed in favor of an automated system.

Friedman, btw, has a wonderful scene in his PBS "Free to Choose" series where he is sitting on a pile of gold in the NY Fed and explaining how people used to dig gold out of the ground so they could then bury it underground in vaults.

- cfc

Darin said...

"There are more sophisticated rules for deciding on the percentage amount (eg, the Taylor Rule) but all fall on the side of eliminating the discretion of the Fed in favor of an automated system."

I'm not so sure about stating the Taylor Rule and sophistication in the same sentence. We have seen that there is not such thing as a "government induced full employment" (i.e. Phillips Curve)....much of the opposition to this thinking is refuted by the Austrian School economist. I do, however, enjoy Friedman's economic thoughts (especially Free to Choose).

Beth said...


Thanks for the explanation of "excessive" and "monetary authority." I have come across some more on Friedman's point of view which I will put into a future post. So do you agree with him?