October 25, 2013 10:41 am
An interview with Alan Greenspan
Six years on from the start of the credit crisis, the former US Federal Reserve chairman is prepared to admit that he got it wrong – at least in part
A couple of years ago I bumped into Alan Greenspan, the former chairman of the US Federal Reserve, in the lofty surroundings of the Aspen Institute Ideas Festival. As we chatted, the sprightly octogenarian declared that he was becoming interested in social anthropology – and wanted to know what books to read.
Greenspan, after all, was somebody who had trained as an ultraorthodox, free-market economist and was close to Ayn Rand, the radical libertarian novelist. He was (in) famous for his belief that the best way to run an economy was to rely on rational actors competing in open markets. As Fed chair, he seemed to worship mathematical models and disdain “soft” issues such as human culture.
But Greenspan was serious; he wanted to venture into new intellectual territory, he explained. And that reflected a far bigger personal quest. Between 1987 and 2006, when he led the Fed, Greenspan was highly respected. Such was his apparent mastery over markets – and success in delivering stable growth and low inflation – that Bob Woodward, the Washington pundit, famously described him as a “maestro”. Then the credit crisis erupted in 2007 and his reputation crumbled, with critics blaming him for the bubble. Greenspan denied any culpability. But in late 2008, he admitted to Congress that the crisis had exposed a “flaw” in his world view. He had always assumed that bankers would act in ways that would protect shareholders – in accordance with free-market capitalist theory – but this resumption turned out to be wrong.
In the months that followed, Greenspan started to question and explore many things – including the unfamiliar world of anthropology and psychology. Hence our encounter in Aspen.
Was this just a brief intellectual wobble, I wondered? A bid for sympathy from a man who had gone from hero to zero in investors’ eyes? Or was it possible that a former “maestro” of free markets could change his mind about how the world worked? And if so, what does that imply for the discipline of economics, let alone Greenspan’s successors in the policy making world – such as Janet Yellen, nominated as the new head of the Fed?Earlier this month I finally got a chance to seek some answers when I stepped into a set of bland, wood-panelled offices in the heart of Washington. Ever since Greenspan left the imposing, marble-pillared Fed, this suite has been his nerve centre. He works out of a room dubbed the “Oval Office” due to its shape. It is surprisingly soulless: piles of paper sit on the windowsill next to a bust of Abraham Lincoln. One flash of colour comes from a lurid tropical beach scene that he has – somewhat surprisingly – installed as a screen saver.
“If you are not going to have numbers on your screen, you might as well have something nice to look at,” he laughs, spreading his large hands expansively in the air. Then, just in case I might think that he is tempted to slack off at the age of 87, he stresses that “I do play tennis twice a week – but my golf game is in the soup. I haven’t had time to get out.” Or, it seems, daydream on a beach. “I get so engaged when I have a problem you cannot solve, that I just cannot break away from what I am doing – I keep thinking and thinking and cannot stop.”
The task that has kept him so busy is his new book, The Map and the Territory, published this month and a successor to an earlier memoir, The Age of Turbulence. To the untrained eye, this title might seem baffling. But to Greenspan, the phrase is highly significant. For what his new manuscript essentially does is explain his intellectual journey since 2007. Most notably it shows why he now thinks that the “map” that he (and many others) once used to analyse finance is incomplete – and what this means for anyone wanting to navigate today’s economic “territory”.
This is not quite the mea culpa that some people who are angry about the credit bubble would like to see. Greenspan is a man who built his career by convincing people that he was correct. Born in New York to a family of east European Jewish ancestry, he trained as an economist and, before he was appointed by Ronald Reagan to run the Fed, was an economic consultant on Wall Street (interspersed with a brief spell working for the Nixon administration). This background once made him lauded; today it seems more of a liability, at least in the eyes of the political left. “Before  I was embarrassed by the adulation – they made me a rock star,” he says. “But I knew then that I was being praised for something I didn’t really do. So after, when I got hammered, it kind of balanced out, since I don’t think I deserved the criticism either … I am a human so I feel it but not as much as some.”
Yet in one respect, at least, Greenspan has had a change of heart: he no longer thinks that classic orthodox economics and mathematical models can explain everything. During the first six decades of his career, he thought – or hoped – that Homo economicus was a rational being and that algorithms could forecast behaviour. When he worked on Wall Street he loved creating models and when he subsequently joined the Fed he believed the US central bank was brilliantly good at this.
“The Fed model was as advanced as you could possibly get it,” he recalls. “All the new concepts with every theoretical advance was embodied in that model – rational expectations, monetarism, all sorts of sophisticated means of thinking about how the economy worked. The Fed has 250 [economic] PhDs in that division and they are all very smart.”
And yet in September 2008, this pride was shattered when those venerated models suddenly stopped working. “The whole period upset my view of how the world worked – the models failed at a time when we needed them most … and the failure was uniform,” he recalls, shaking his head. “JPMorgan had the American economy accelerating three days before [the collapse of Lehman Brothers] – their model failed. The Fed model failed. The IMF model failed. I am sure the Goldman model also missed it too.
“So that left me asking myself what has happened? Are we living in an unreal world which has a model which is supposed to replicate the economy but gets caught out by one of the most extraordinary events in history?”
Shocked, Greenspan spent the subsequent months trying to answer his own question. He crunched and re-crunched his beloved algorithms, scoured the data and tested his ideas. It was not the first time he had engaged in intellectual soul-searching: in his youth he had once ascribed to intellectual positivism, until Rand, the libertarian, persuaded him those ideas were wrong.
However, this was more radical. Greenspan was losing faith in “the presumption of neoclassical economics that people act in rational self-interest”. “To me it suddenly seemed that the whole idea of taking the maths as the basis of pricing that system failed. The whole structure of risk evaluation – what they call the ‘Harry Markowitz approach’ – failed,” he observes, referring to the influential US economist who is the father of modern portfolio management. “The rating agency failed completely and financial services regulation failed too.”
But if classic models were no longer infallible, were there alternative ways to forecast an economy? Greenspan delved into behavioural economics, anthropology and psychology, and the work of academics such as Daniel Kahneman. But those fields did not offer a magic wand.
“Behavioural economics by itself gets you nowhere and the reason is that you cannot create a macro model based on just [that]. To their credit, behavioural economists don’t [even] claim they can,” he points out.
But as the months turned into years, Greenspan slowly developed a new intellectual framework. This essentially has two parts. The first half asserts that economic models still work in terms of predicting behaviour in the “real” economy: his reading of past data leaves him convinced that algorithms can capture trends in tangible items like inventories.
“In the non-financial part of the system [rational economic theory] works very well,” he says. But money is another matter: “Finance is wholly different from the rest the economy.” More specifically, while markets sometimes behave in ways that models might predict, they can also become “irrational”, driven by animal spirits that defy maths.
Greenspan partly blames that on the human propensity to panic. “Fear is a far more dominant force in human behaviour than euphoria – I would never have expected that or given it a moment’s thought before but it shows up in the data in so many ways,” he says. “Once you get that skewing in [statistics from panic] it creates the fat tail.” The other crucial issue is what economists call “leverage” (more commonly dubbed “debt”). When debt in an economy is low, then finance is “neutral” in economic terms and can be explained by models, Greenspan believes. But when debt explodes, this creates fragility – and that panic. “The very nature of finance is that it cannot be profitable unless it is significantly leveraged … and as long as there is debt there can be failure and contagion.”
A cynic might complain that it is a pity Greenspan did not spot that “flaw” when he was running the Fed and leverage was exploding. He admits that he first saw how irrational finance could become as long ago as the 1950s and 1960s when he briefly tried, as a young New York economist, to trade commodity markets. Back then he thought he could predict cotton values “from the outside, looking at supply-demand forces”. But when he actually “bought a seat in the market and did a lot of trading” he discovered that rational logic did not always rule. “There were a couple of guys in that exchange who couldn’t tell a hide from copper sheeting but they made a lot of money. Why? They weren’t trading a commodity but human nature … and there is something about human nature which is not rational.”
Half-a-century later, when Greenspan was running the Fed, he had seemingly come to assume that markets would always “self-correct”, in a logical manner. Thus he did not see any reason to prick bubbles or control excessive exuberance by government fiat. “If bubbles are not leveraged, they can be highly disruptive to the wealth of people who own assets but there are not really any secondary consequences,” he explains, pointing out that the stock market bubble of the late 1980s and tech bubble of the late 1990s both deflated – without real economic damage. “It is only when you have leverage that a collapse in values becomes so contagious.”
Of course, the tragedy of the noughties credit bubble was that this bout of exuberance – unlike 1987 or 2001 – did involve leverage on a massive scale. Greenspan, for his part, denies any direct culpability for this. Though critics have carped that he cut rates in 2001, and thus created easy money, he points out that from 2003 onwards the Fed, and other central banks, were diligently raising interest rates.
But even “when we raised [official] rates, long-term rates went down – bond prices were very high”, he argues, blaming this “conundrum” on the fact that countries such as China were experiencing “a huge increase in savings, all of which spilled into the developed world and the global bond market at that time”. But whatever the source of this leverage, one thing is clear: Greenspan, like his critics, now agrees that this tidal wave of debt meant that classic economic theory became impotent to forecast how finance would behave. “We have a system of finance which is far too leveraged – [the models] cannot work in this context.”
So what does that mean for institutions such as the Fed? When I arrived to interview Greenspan, the television screens were filled with the face of Yellen. What advice would he give her? Should she rip up all the Fed’s sophisticated models? Hire psychologists or anthropologists instead?
For the first time during our two-hour conversation, Greenspan looks nonplussed. “It never entered my mind – it’s almost too presumptuous of me to say. I haven’t thought about it.” Really? I press him. He shakes his head vigorously. And then he slides into diplomatic niceties. One unspoken, albeit binding, rule of central banking is that the current and former incumbents of the top jobs never criticise each other in public. “Yellen is a great economist, a wonderful person,” he insists.
But tact cannot entirely mask Greenspan’s deep concern that six years after the leverage-fuelled crisis, there is even more debt in the global financial system and even easier money due to quantitative easing. And later he admits that the Fed faces a “brutal” challenge in finding a smooth exit path. “I have preferences for rates which are significantly above where they are,” he observes, admitting that he would “hardly” be tempted to buy long-term bonds at their current rates. “I run my own portfolio and I am not long [ie holding] 30-year bonds.”
But even if Greenspan is wary of criticising quantitative easing, he is more articulate about banking. Most notably, he is increasingly alarmed about the monstrous size of the debt-fuelled western money machine. “There is a very tricky problem we don’t know how to solve or even talk about, which is an inexorable rise in the ratio of finance and financial insurance as a ratio of gross domestic income,” he says. “In the 1940s it was 2 per cent of GDP – now it is up to 8 per cent. But it is a phenomenon not indigenous to the US – it is everywhere.
“You would expect that with the 2008 crisis, the share of finance in the economy would go down – and it did go down for a while. But then it bounced back despite the fact that finance was held in such terrible repute! So you have to ask: why are the non-financial parts of the economy buying these services? Honestly, I don’t know the answer.”
What also worries Greenspan is that this swelling size has gone hand in hand with rising complexity – and opacity. He now admits that even (or especially) when he was Fed chairman, he struggled to track the development of complex instruments during the credit bubble. “I am not a neophyte – I have been trading derivatives and things and I am a fairly good mathematician,” he observes. “But when I was sitting there at the Fed, I would say, ‘Does anyone know what is going on?’ And the answer was, ‘Only in part’. I would ask someone about synthetic derivatives, say, and I would get detailed analysis. But I couldn’t tell what was really happening.”
This last admission will undoubtedly infuriate critics. Back in 2005 and 2006, Greenspan never acknowledged this uncertainty. On the contrary, he kept insisting that financial innovation was beneficial and fought efforts by other regulators to rein in the more creative credit products emerging from Wall Street. Even today he remains wary of government control; he does not want to impose excessive controls on derivatives, for example.
But what has changed is that he now believes banks should be forced to hold much thicker capital cushions. More surprising, he has come to the conclusion that banks need to be smaller. “I am not in favour of breaking up the banks but if we now have such trouble liquidating them I would very reluctantly say we would be better off breaking up the banks.”
He also thinks that finance as a whole needs to be cut down in size. “Is it essential that the division of labour [in our economy] requires an ever increasing amount of financial insight? We need to make sure that the services that non-financial services buy are not just ersatz or waste,” he observes with a wry chuckle.
There is a profound irony here. In some senses, Greenspan remains an orthodox pillar of ultraconservative American thought: The Map and the Territory rails against fiscal irresponsibility, the swelling social security budget and the entitlement culture. And yet he, like his leftwing critics, now seems utterly disenchanted with Wall Street and the extremities of free-market finance – never mind that he championed them for so many years.
Perhaps this just reflects an 87-year-old man who is trying to make sense of the extreme swings in his reputation. I prefer to think, though, that it reflects a mind that – to his credit – remains profoundly curious, even after suffering this rollercoaster ride. When I say to him that I greatly admire his spirit of inquiry – even though I disagree with some conclusions – he immediately peppers me with questions. “Tell me what you disagree with – please. I really want to hear,” he insists, with a smile that creases his craggy face. As someone who never had children, his books now appear to be his real babies; the only other subject which inspires as much passion is when I mention his adored second wife, Andrea Mitchell, the television journalist.
But later, after I have left, it occurs to me that the real key to explaining the ironies and contradictions that hang over Greenspan is that he has – once again – unwittingly become a potent symbol of an age. Back in the days of the “Great Moderation” – the period of reduced economic volatility starting in the 1980s – most policy makers shared his sunny confidence in 20th-century progress. There was a widespread assumption that a mixture of free market capitalism, innovation and globalisation had made the world a better place. Indeed, it was this very confidence that laid the seeds of disaster. Today, however, that certainty has crumbled; the modern political and economic ecosystem is marked by a culture of doubt and cynicism. Nobody would dare call Yellen “maestro” today; not when the Fed (and others) are tipping into such uncharted territory. This delivers some benefits: Greenspan himself now admits this pre-2007 confidence was an Achilles heel. “Beware of success in policy,” he observes, laughing. “A stable, moderately growing, non-inflationary environment will create a bubble 100 per cent of the time.”
But a world marked by profound uncertainty is also a deeply disconcerting and humbling place. Today there are no easy answers or straightforward heroes or villains, be that among economists, anthropologists or anyone else. Perhaps the biggest moral of The Map and the Territory is that in a shifting landscape, we all need to keep challenging our assumptions and prejudices. And not just at the age of 87.
‘The Map and the Territory: Risk, Human Nature, and the Future of Forecasting‘ by Alan Greenspan is published by Penguin.
Copyright The Financial Times Limited 2013.