Alan Greenspan: The Boy in the Bubble

In the spirit of never accepting responsibility
for anything — find someone to blame

‘This is the work of a true master’

By Dean Baker

Dean Baker is co-director of the Center for Economic and Policy Research.

You don't get to top positions in Washington unless you're very good at blaming others for your mistakes. And when it comes to economic policy, Alan Greenspan has long held some of the very top positions.

Therefore, we should expect some pretty good excuses for the housing crash that is now threatening to engulf the US economy.

However, even long-time Greenspan watchers had to be impressed by his latest effort at self-vindication. In a Wall Street Journal column last week, Mr. Greenspan placed the blame for the housing bubble on the end of the Cold War. There's no point in going through the argument, let's just acknowledge this is the work of a true master.

The issue for most of us is not Greenspan's personal culpability. The real policy question is what the Fed can and should do in response to financial bubbles like the housing bubble and the 90s stock bubble that preceded it. The Greenspan doctrine on this topic (adjusted as needed for political circumstances) appears to be: 1) bubbles cannot be recognized before they burst; 2) there is nothing that the Fed could do even if it did recognize a bubble; and 3) collapsing bubbles are no big deal anyhow.

Taking these points in turn, for some of us, it just does not seem to be very hard to recognize financial bubbles. The basic methodology is to note when prices of assets like stocks or houses have diverged from long-term trends. When there is such a divergence, you go to step two, which is to see whether there is a plausible explanation in the fundamentals of the economy.

Third grade arithmetic

In the case of the stock market bubble, we saw the average price-to-earnings ratio for the stock market, which had historically been around 14 to 1, rise above 20 to 1 in the mid-nineties. Returns on stock are directly related to price-to-earnings ratios (this is third grade arithmetic, not complex economics).

This meant, unless investors had hugely more optimistic views about the future growth of profits than the overwhelming majority of economic forecasters or they were prepared to accept really low returns on the stock they held, then the market was being driven by an irrational bubble.

Since neither of these explanations seemed plausible, some of us (including, on certain days, Alan Greenspan) recognized the stock bubble for what it was. Similarly, in the years from 1995 to 2006, when house prices rose by 70 percent after adjusting for inflation, some of us were prepared to call the run-up a bubble, since house prices had just kept even with the overall rate of inflation for the prior hundred years. These bubbles were recognizable and some of us did recognize them at the time.

Greenspan's next line of defense is that there is nothing the Fed can do about a bubble even if it did recognize it. The story of the powerless Fed is really hard to accept. First, it has enormous regulatory powers. For starters, it could have tightened up the rules on the predatory subprime mortgages. More importantly, Alan Greenspan could have used his enormous megaphone as Federal Reserve Board chair to lay out the evidence for the existence of a stock or housing bubble.

This does not mean mumbling "irrational exuberance" on rare occasions. The point is to use Congressional testimonies and other public appearances to carefully explain how stock or housing prices are unsustainable.

Why not try?

If Alan Greenspan had followed this route, every financial manager would have been forced to carefully assess his arguments. All the bankers and fund managers who now must own up to multi-billion dollar losses for their companies and clients would be forced to explain why they ignored Alan Greenspan's analysis. Anyone who said they paid no attention to the Fed chairman's words would be sued for the full value of their personal wealth, their 401ks, and their homes.

Would this Fed talk have been sufficient to deflate the bubbles? My guess is it would, but talk is cheap. Why not try?

Finally, Greenspan would have us believe it is easy to repair the damage from a burst bubble. This is a ridiculous claim in light of recent experience. In the wake of the stock crash in 2002 and 2003, Greenspan and others were worried about the threat of deflation and mass unemployment for the first time since the Great Depression. The fallout from the housing crash is likely to be even more severe.

The upshot is the Fed must try to combat asset bubbles before they do serious damage to the economy. Greenspan's tenure was a disastrous failure because he was AWOL when it came to the most important dangers the economy faced on his watch. No silly excuses will get around this fact.