How the World Works

Stephen Holmes

  • BuyThe Map and the Territory: Risk, Human Nature and the Future of Forecasting by Alan Greenspan
    Allen Lane, 388 pp, £25.00, October 2013, ISBN 978 0 241 00359 6

Among the once celebrated triumphs of Alan Greenspan’s eighteen and a half years as chairman of the Federal Reserve, three stand out. First, he responded nimbly and forcefully to a series of dangerous crashes (from Black Monday in October 1987 to the bursting of the dot-com bubble in 2000), injecting liquidity to calm the markets and arguably fending off recession. Second, along with the Clinton-era Treasury secretaries Robert Rubin and Larry Summers, he successfully lobbied for deregulation of the credit industry, including the repeal of the Glass-Steagall Act, which had separated investment banks from commercial banks. At the same time he blocked attempts to subject over the counter derivatives to government regulation – to require that their risks be made clear, for example. New financial instruments, including credit-default swaps, were making markets more stable than ever before, he argued, and any attempt at regulation would subject investors to potentially calamitous levels of uncertainty. Third, Greenspan kept interest rates at record lows, stimulating economic activity while miraculously avoiding any significant rise in the consumer price index, which would normally have been expected to balloon as a result of the inflationary pressures produced by cheap money.

Then came what Greenspan now acknowledges to be ‘the greatest financial crisis ever’, followed by the worst economic slump since the Great Depression. The bursting of the housing bubble led to an unprecedented worldwide banking crisis and ended Greenspan’s reputation as clairvoyant forecaster-in-chief of the US economy. What had once seemed his greatest triumphs were now seen as his worst failures. He had disregarded warnings that deregulation would open the way to massively risky lending and borrowing practices. Price stability in consumer goods was judged, in retrospect, to have been largely a result of technological advances and low-cost imports from China and elsewhere, with the inflationary pressures produced by his cheap-money policy channelled into asset-price bubbles in the housing and stock markets. And he stuck to a subsequently discredited theory that monetary loosening (lowering interest rates) will always be enough, in the aftermath of an unforeseen crash, to stave off a deflationary spiral. His once towering reputation now looked as unearned as those vertiginous profits on securitised subprime mortgages.

In the wake of the financial crisis, Greenspan issued a series of op-eds and papers in economics journals making excuses for his actions and swatting away his critics. The closest he came to a mea culpa was his testimony before a sceptical Congress in October 2008. His unexpected discovery that major lending institutions had been engaged in reckless gambling and had failed to protect shareholders’ equity had left him, he said, in a state of ‘shocked disbelief’.

The Map and the Territory recounts his convalescence and recovery from that shock. In his testimony he reported, lapsing into his usual mangled syntax, that he had found a ‘flaw in the model that I perceived is the critical functioning structure that defines how the world works’. He has written this book to repair that flaw or to redraw his map so that it describes more accurately the topography of the real economy. It’s an important document because of what it tells us about the challenge presented by the financial crisis to a still powerful and widely held free-market ideology.

The central tenets of that ideology are well known and easy to state. Social welfare can best be achieved if individual participants in the market, motivated by rational self-interest, are allowed to engage in economic activity unhampered by government, which should restrict itself to ‘setting the legal conditions of political freedom’. If markets are perfect, it follows that any interference by government will introduce imperfections, especially the ‘fog’ of uncertainty through which investors must haplessly peer.

That Greenspan remains in thrall to free-market ideology is demonstrated by his unrepentant insistence here that ‘we need to lift the burden of massive new financial regulation that is becoming increasingly counterproductive.’ His current proposals for reversing what he sees as the otherwise unavoidable eclipse of America’s global economic dominance show no departure from his pre-crisis views: cut state benefits, allow housing repossessions, repeal many of the Dodd-Frank reforms of the banking system, eliminate or reduce deficit spending, and ensure that labour markets remain open to wage-lowering competition from foreign workers.

Political pressures to reverse deregulation, it seems to Greenspan, can best be fended off by token concessions: it’s fine to raise the level of cash reserves that commercial banks have to hold – even though the banks’ profitability will be reduced – so long as other financial institutions, such as investment banks, are left to speculate more or less freely with borrowed funds. Greenspan’s ‘fondest hope for this book’ is therefore nothing new. He wants to encourage Congress and other policymakers to recognise the ‘recuperative powers of deregulating markets’, which ‘is in our long-term collective self-interest despite the unavoidable short-term pain it will bring’.

So, the take-home message of The Map and the Territory is that Greenspan’s pre-crisis model of how the world works was essentially correct. But his reasoning on the way to this reassuring conclusion is convoluted and sometimes difficult to follow. Above all, he has to give some plausible account of the ‘flaw’ he was so shocked to discover in 2008. Doing so allows him to answer the charge that the libertarian ideology to which he is devoted bears some responsibility for the crisis. Unfortunately, his attempt to refute this allegation draws him into an impenetrable mesh of contradictions.

Greenspan begins by saying that his crystal ball failed him so miserably only because of a glitch in his highly conventional assumptions about the micro-foundations of self-correcting markets. ‘A basic assumption of classical and neoclassical economics, that people behave in their rational long-term self-interest’, turns out to be ‘not wholly accurate’. Human beings aren’t consistently rational maximisers of their own net worth. He has reluctantly come to this conclusion partly by peering into what he weirdly calls the ‘impenetrable black box’ of his own mind. He has also benefited from behavioural economics, the purpose of which is to introduce greater realism into theories of human decision-making.

Behavioural economics is concerned with cognitive biases, especially the unintended and often unwelcome consequences of a reflexive and self-defeating reliance on various common short cuts for making decisions in uncertain conditions. Greenspan knows this, but his ruminations on the ‘vagaries of human nature’ seem more a matter of what used to be called mass psychology. He’s interested in the way non-rational compulsions trip otherwise rational people into making fatally irrational decisions, and focuses on three main culprits: ‘fear, euphoria and herd behaviour’. Contrary to the parsimonious economics textbooks of Greenspan’s youth, the rational self-interest of buyers and sellers in a free market is repeatedly derailed by panic, irrational exuberance and copycat behaviour, especially in stressful circumstances.

To exonerate his fellow regulators and forecasters, Greenspan initially blames the crisis on the tempestuous animal spirits of investors and financiers. He sees himself as guilty only of having accepted ‘the neoclassical approach to economics based on utility maximisation’, which meant he was left dazed and incredulous by the self-destructive behaviour of major lending institutions. In other words, he failed to foresee the crisis because people disappointed his expectations of the way rational economic agents are supposed to behave. He has adapted to reality by lowering his opinion of human nature, and has concluded that booms and busts are ‘psychology-driven’.

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