European Affairs

He was testifying to the Congressional Committee for Oversight and Government Reform on October 23, 2008, in a hearing chaired by California Democrat Henry Waxman. Chairman Waxman led the hearing as a direct inquisition into Greenspan’s decisions during his time as the Fed chairman and the degree to which they set the stage for the American (and the global) financial catastrophe. Greenspan from the discovery of bad mortgages, over-leveraged derivatives and other uncalculated financial risks that ultimately collapsed like a house of cards. Waxman pressed Greenspan through many questions before finally getting the beginning of an answer. “I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works,” Greenspan explained. The model, Waxman replied, seems to have reflected ideology shunning steps to regulate markets and ignoring actual evidence about the perilous behavior of the financial practitioners that were supposed to be under the scrutiny of the Fed and other U.S. regulatory authorities – but which went largely undetected until the sudden crash in 2007.

Chairman Waxman: Dr. Greenspan, you were the longest-serving chairman of the Federal Reserve in history and during this period of time you were perhaps the leading proponent of deregulation of our financial markets. Certainly you were the most influential voice for deregulation. You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements.

In 1994, you testified in a congressional hearing on regulation of financial derivatives. You said “there is nothing involved in Federal regulation which makes it superior to market regulation.” In 1997, you said, “There appears to be no need for government regulation of off- exchanged derivative transactions.” In 2002 when the collapse of Enron led to renewed congressional efforts to regulate derivatives, you wrote the Senate, “We do not believe a public policy case exists to justify this government intervention.” Earlier this year, you wrote in the Financial Times, “Bank loan officers, in my experience, know far more about the risks and workings of their counter parties than do bank regulators.” My question for you is simple: Were you wrong?

Alan Greenspan: Partially, but let’s separate this problem into its component parts. I took a very strong position on the issue of derivatives and the efficacy of what they were doing for the economy as a whole – which is essentially to transfer risk from those who have great difficulty in absorbing it to those who have the capital to absorb losses if and when they occur. These derivatives are working well.

Waxman: So you don’t you think you were wrong in not wanting to regulate the derivatives?

Greenspan: It depends which derivatives we are talking about. Credit default swaps, I think, have serious problems associated with them. But the bulk of derivatives – indeed the only derivatives that existed when major discussions started in 1999 – were those for interest-rate risks and foreign-exchange risk.

Waxman: You said in your statement that “…the whole intellectual edifice of modern risk-management collapsed” [in 2007]. You also said that “those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself especially, are in a ‘state of shock, disbelief.’” Now that sounds to me like you are saying that those who trusted the market to regulate itself – yourself included – made a serious mistake.

Greenspan: Well, I think that’s true of some products, but not all. I think that’s the reason why it’s important to distinguish the size of this problem and its nature. What I wanted to point out was that – excluding credit default swaps – derivatives markets are working well.

Waxman: Well, where do you think you made a mistake then?

Greenspan: I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.

And it’s been my experience, having worked both as a regulator for 18 years and similar quantities in the private sector, especially 10 years at a major international bank, that the loan officers of those institutions knew far more about the risks involved in the people to whom they lent money, than I saw even our best regulators at the Fed capable of doing.

So the problem here is something which looked to be a very solid edifice, and, indeed a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened, and, obviously to the extent that I figure out where it happened and why, I will change my views. If the facts change, I will change.

* * *

Waxman: Dr. Greenspan, you had an ideology…shown in your statement: “I do have an ideology. My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We’ve tried regulation, none meaningfully worked.” That was your quote. You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Now our whole economy is paying its price. Do you feel that your ideology pushed you to make decisions that you wished you had not made?

Greenspan: Well, remember what an ideology is: it is a conceptual framework about the way people deal with reality; everyone has one; you have to; to exist you need an ideology. The question is, whether it is accurate or not. What I’m saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.

Waxman: You found a flaw?

Greenspan: I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works.

Waxman: In other words, you found that your view of the world, your ideology, was not right, was not working.

Greenspan: Precisely. That’s precisely the reason I was shocked because I had been going for 40 years or more [on this model] with very considerable evidence that it was working exceptionally well…

Elaborating further on that point later, Greenspan added:

“The housing bubble became clear to me sometime in early 2006 in retrospect. I did not forecast a significant decline because we had never had a significant decline in prices, and it’s only as the process began to emerge that it became clear that we were about to have what essentially was a global decline in home prices.”


This article was published in European Affairs: Volume number 10, Issue number 1-2 in the Winter/Spring of 2009.