Alan Greenspan on Central Banks, Stagnation, and Gold

Wednesday, October 29, 2014

Event Description

Alan Greenspan, former chairman of the Board of Governors of the Federal Reserve System, joins Gillian Tett, U.S. managing editor at the Financial Times, to discuss current trends in the global economy and solutions for addressing the financial crisis. Greenspan weighs in on the Federal Reserve's quantitative easing and the effects on financial markets of exiting the program, and discusses stagnation, regulation, and gold reserves.

The C. Peter McColough Series on International Economics is presented by the Corporate Program and the Maurice R. Greenberg Center for Geoeconomic Studies.

Event Highlights

Alan Greenspan on quantitative easing:

"…there's been two aspects to quantitative easing. One is to galvanize effective demand by creating credit in the marketplace. That has not worked. But what has worked is the second prong of the issue that originated quantitative easing—getting the real rate of return on long-term assets down, and that will have a major effect on price to earnings ratios, on cap ratio in real estate, on all income-earning assets. And, indeed, in that respect, it's been a terrific success. But it hasn't been a success in the demand side for one fundamental reason, namely that as of now, if you look at the Federal Reserve, Bank of England, ECB, what you basically see is an explosion of assets, an explosion of reserve balances, and that's the only two statistics that are moving."

Alan Greenspan on entitlements:

"…the real problem that I find very disturbing is the fact that we are not touching entitlements when we're looking at our fiscal situation, and that's basically where the data show the problem is. …this is not a partisan issue. In fact, the actual rate of increase in entitlements under Republican administrations has been greater than under Democrat. So it's the so-called political third rail for everybody. Unless we get to grips with that thing, I don't see how we come to grips with this problem."

Alan Greenspan on Europe's financial situation:

"Today, what we really need is the ability of a lot of these countries to devalue. …where do we go from here? Well, the only place we go from here is to free the currencies to readjust…The only solution…is actually a full political integration of Europe, because if that occurs, then the currency problem disappears."

This is the corrected transcript of the meeting in its entirety.

TETT: OK, well, good morning, everybody, and welcome to this morning's breakfast debate with Chairman Greenspan. My name is Gillian Tett. I'm the U.S. managing editor of the Financial Times, so I hope you've all got your free copy of the FT out in the lobby.

And Chairman Greenspan is obviously a man who needs absolutely no introduction, least of all to this audience. I was looking at his new paperback version of his book, which again I hope you've all seen. It's called "The Map and the Territory 2.0." This is Chairman Greenspan getting into the digital age with 2.0. And at the back of it, it says, "After reading this book, you will understand why five American presidents turned to Chairman Greenspan and made him one of the great economic policymakers of our time," which I think is a very good explanation as to why so many of you have come to breakfast this morning for this sellout event to hear his thoughts about the global economy and where it's going.

And it is a terrific time to be talking about this, because quite apart from the fact that the book is out yesterday, I think, with the paperback version with updated chapters on very topical issues, like China and like gold—and we'll discuss that in a minute—we're also at a very interesting juncture for the global economy. Not only are we all sitting here with baited breath to see what the Federal Reserve does next, or rather doesn't do or stops doing, but we've also had a fascinating development overnight in Europe, not just in terms of the European bank stress tests, but the fact that Sweden's central bank has just cut interest rates in recognition of the deflation and stagnation that's very much gripping the Western world at the moment.

So we're going to talk for about half an hour, and then I'll open it up to questions. This is a session which is on the record.

But I'd like to start by asking you, Chairman Greenspan, when you look at the Western world today, do you agree with Christine Lagarde's assessment that today we're living in a time of the new mediocre, in terms of economic performance? Is the Western world currently doomed to secular stagnation, to use another phrase chaired by your former colleague, Larry Summers?

GREENSPAN: Well, I'm always, always in agreement with the famous member of the IMF. I think this is essentially what we've seen before. The best way I would put it is this. If you're looking at the stagnation, so to speak—incidentally, remember that Alvin Hansen coined that phrase back in 1938. And what they were looking at was an economy which, remember, during the Great Depression, the unemployment rate in the United States never got below double-digit numbers. And the system required somebody to come out and say, "There's something fundamental different here." And he did, in a very famous 1938 opus. I remember it well, because it was one of the very first books that I read when I was becoming an economist, and I was very impressed with it.

Essentially, we're looking at a period like 1940. This is very similar in many respects, because what is missing here is—or I should say what is (inaudible)—is a very high level of uncertainty. And the best way to measure that, the way I do, in fact, and I do it and describe it in some detail in the book, is I set up the gross domestic product not in the usual personal consumption expenditures and investment and that type. I look at it and taking the whole array of outlays in terms of what is their unit—what is their life expectancy? Software is three to five years. Nonresidential buildings may be thirty-five to forty years. Haircuts, one month. I invented that on the basis of a personal sample.


TETT: Male or female.

GREENSPAN: In any event, if you basically weight the GDP, what you find is that there's an extraordinary collapse in the average duration. Then if you look more deeply into the numbers, it's all in buildings and construction and things where the income flows from income-earning assets is to a very significant extent in far distant years.

So that when you array the numbers in that form, and then you look at, for example, the yield spread between the U.S. Treasury five-year note and the thirty-year bond, that spread a couple of years ago was the widest spread in American history, which is another way of saying, as you go farther and farther into the future, you're discounting those incomes more and more.

Now, the reason I raise this issue is when you look at the rest of the world, this is exactly the same problem that exists everywhere. You—I have—in the book, I show charts which show this significant decline that's measured in a number of different ways. The easiest way, when you don't have the data, is just construction or capital investment as a percent of GDP.

You look at the euro area, you look at the United States, you look at Great Britain, they all look the same. In fact, I've done it for pretty much every country in the world, and I even took a fling at Ukraine, and lo and behold, same pattern. In other words, the discounting of far-distant assets is extraordinary, in the sense unprecedented since the 1930s, and that statistically explains all of the stagnation.

TETT: Right.

GREENSPAN: So it is not some new conceptual framework. It's the same, old thing, just not been properly measured.

TETT: But I think telling people we're basically back to the future and back to 1938 or 1940 is not exactly reassuring, because what's got the world...

GREENSPAN: It didn't reassure me, I'll tell you.

TETT: But what got the world out of that funk last time, that stagnation, of course, was World War II and a lot of government spending.


TETT: When you look across five to ten years, how do you see the Western economy evolving now? Do you think that this stagnation, this sense of...

GREENSPAN: Well, there needn't be, in the sense that we can restore the same sort of average level of discounting for the very distant future that we had before. Those discount rates are derivative of human nature. And I go into it in some detail in which when I talk about time preference and some of the stabilities in human nature, you know, I go back to 5th Century B.C. Greece, where interest rates were very similar to where they are today. Ancient Rome, the same thing. In other words, there's something about how human species discounts the future which is unchanged, as best we can judge, and we're looking at the same thing today.

I think what we've got to do is to recognize where the uncertainty is coming from and get rid of it. I mean, obviously, when you're looking at very distant investments, which have gotten shoved aside, you've got basically very uncertain tax rates out there. Tax rates are a very critical factor in the estimation of discounted rate of return on the new investments.

And I don't know how we're going to get around this, but the real problem that I find very disturbing is the fact that we are not touching entitlements when we're looking at our fiscal situation, and that's basically where the data show the problem is. And as I point out in the book, this is not a partisan issue. In fact, the actual rate of increase in entitlements under Republican administrations has been greater than under Democrat. So it's the so-called political third rail for everybody.

Unless we get to grips with that thing, I don't see how we come to grips with this problem.

TETT: So if you were sitting in the White House today trying to draw up a plan to revitalize America, what would be your top three or four campaigning points? I mean, reform entitlements, change the tax code. Would you change the tax code? Would you...

GREENSPAN: All I have to say about tax rates is the lower, the better, but if you're going to have commitments of entitlements, pay for them. In other words, you cannot expect just to print money or do what we're doing now. We're not printing money; we're just expanding the federal bank's balance sheet. But eventually, that will turn into printed money. It hasn't yet, and that's what the real fascinating issue of the current period is. It's always easier to take a larger deficit, because inflation is dead in the water, and the reason for that is, effective demand is dead in the water.

If you have a situation where you've got very significant potential liquidity or actual liquidity, and prices are falling, the only explanation for that is that there's a huge deficiency of demand, and this where we're seeing a long-lived assets. You take—you can knock out—say, construction takes—is about historically was about 8 percent of the GDP. You knock out half of that, that's four percentage points. That's all of the increase—major increase in the unemployment rate.

So you don't have to look in a lot of different places. It's right there, and it's right in the very long-lived assets, which we know are a function of how people discount the future.

TETT: Right. If any of you in the room haven't seen the book, I would urge you to have a look at it, because quite apart from being a fascinating recognition of the limitations of models and the problems of using purely orthodox economic approaches to look at financial markets, which I as an anthropologist love, because I love the recognition that human nature matters, has also got a plethora of fascinating and verily quite alarming charts about where we are.

But just to come back to the issue that if you think the current sense of gloom, stagnation, call it what you will, is due to a lack of demand in the Western economy, do you think that actually engaging in quantitative easing or all these other unprecedented monetary experiments has been the right path? Has that just be a distraction and red herring, because it takes away from any need to address the fundamental lack of demand?

GREENSPAN: Well, let's look—there's been two aspects to quantitative easing. One is to galvanize effective demand by creating credit in the marketplace. That has not worked. But what has worked is the second prong of the issue that originated, quantitative easing—getting the real rate of return on long-term assets down, and that will have a major effect on price-to-earnings ratios, on cap ratio in real estate, on all income-earning assets.

And, indeed, in that respect, it's been a terrific success. But it hasn't been a success in the demand side for one fundamental reason, namely that as of now, if you look at the Federal Reserve, Bank of England, ECB, what you basically see is an explosion of assets, an explosion of reserve balances, and that's the only two statistics that are moving.

And what that essentially is, is the fact that the Federal Reserve, it is paying twenty-five basis points to the—say, Wells Fargo, which we'll say holds deposits at the San Francisco Fed, it has got a sovereign guarantee, virtually no capital requirements, and a reasonably good rate of return for that type of security. So what do they do? They just sit there and let it sit.

And the result is they get a nice return, but they do not relend it into the markets. In other words, you don't get Wells Fargo, say, relending it to, say, IBM or to U.S. Steel or the usual borrowers of funds, and unless and until that happens, you don't galvanize the level of economic activity. And if you just look at countries or central bank after central bank, it is not really pushed beyond the levels of just the two major accounts.

When that starts—and it will eventually start—all things can happen.

TETT: And what is going to happen?

GREENSPAN: Not all of them are good. But, for example, we are seeing the first sign—commercial and industrial loans is not a big category, but it is—from my judgment, it's the canary in the coal mine. After being—after extensions (inaudible) extensions—being relatively flat, it took off earlier this year and hasn't gone up hugely, and I cannot say to you that other aspects of loan demand have increased. Certainly, mortgage demand has not, and that's the bigger—much bigger item.

And so we're not getting that secondary effect, but when we start to get it, for whatever reason, then you begin to get real interest rates rising. And because—remember, in this process that drove the stock prices higher, it is basically a very significant decline from an extraordinarily elevated equity premium.

JPMorgan has got, I think, the best measure of that that I've seen, and what they showed is that at the—the peak of the problem, their equity premium, which is the rate of discount—or the rate of earnings required on an equity investment to become viable, their figures showed that we were at the highest equity premium in fifty years. And I think, probably going back earlier, that series didn't go back beyond that.

But what that basically means is that there's huge discounting. And, you know, putting it in psychological terms, it is fear at its maximum, and basically there is a limit to human fear, and that's where we got, and then that kicked the market all the way up. We are still in areas which are sort of average, no longer very high, but we're not at very low levels, either, yet.

TETT: So essentially what you're saying is that we've got the makings—we have a lot of trapped cash in the system, a lot of trapped money the banks aren't using that are just piling up at the central bank, we have equity markets being elevated, we have demand low. It sounds like a very bubbly territory. Do you think it's time for the Federal Reserve to raise interest rates and get back to a more normal system or normal financial market?

GREENSPAN: It's one of those questions that I cannot answer. Or I should say, I can answer but won't. But overall, let's—you know, look at what really is moving markets. There's a presumption that the Federal Reserve can control intermediate interest rates. It can control overnight rates by—basically it controls the supply side. But the critical rate is no longer the federal funds rate. It's the interest rate being paid by the Federal Reserve banks to hold reserve balances, and should, for example, they decide to relend them, then remember what happens, is that basically the reserve balances go down, and that is technically a tightening of monetary policy.

So the Federal Reserve doesn't want to do that or allow that to happen. It has got to raise rates to attract the funds to keep the reserve balances where they are. And so I think that the real pressure is going to occur not by an initiation by the Federal Reserve, but by the markets themselves beginning to require ever higher rates of interest paid by the Federal Reserve to hold the funds that the Federal Reserve deems where they want monetary policy to be.

TETT: So, essentially, what you're saying is the real risk now is that the Federal Reserve is going to lose control of the process.

GREENSPAN: I'm sorry. I don't follow what you mean.

TETT: Well, essentially what you're saying is that we're all talking as if the Federal Reserve can very gradually and smoothly control this return to normality. The image that some of your former colleagues have used to me is a bit like a plane coming into land and very slowly and smoothly, gradually descending as they put interest rates up or they stop—stop the asset purchases.

What you're essentially saying is what's going to really drive this return to normalization is something that the Federal Reserve cannot control, which is what the market demands as the price of keeping money with central banks. I mean, the Federal Reserve is not in control in this case.

GREENSPAN: Remember, we've never had any experience of anything like this. So I'm not going to sit here and tell you I know exactly how it's going to come out, nor an economist term, what the elasticity of demand is and what prices will do. I know almost for sure one thing—that real long-term interest rates are below where human time preference is.

And I use the experience of a long multi-century, millennia, of remarkably stable interest rates, which is the best reflection we have of how the human species essentially discounts the future. It's what tells them how much seed corn to put aside from a crop. It makes all of those decisions about how much production you hold back from consumption and invests, whether it's in axes or hatchets or whatever, or it's in transistors, you know? It's all the same species.

TETT: Right.

GREENSPAN: I think periodically you have to look at that, when you're at—are at sea, your profession becomes more relevant than mine.

TETT: This is Chairman Greenspan celebrating the power of anthropology, which I love. But...

GREENSPAN: So I just want to say, one of the things about this book—for those of you who are interested—this is a combination of classical economics and behavioral economics with Keynes' animal spirits all the way through it.

TETT: That's a great elevator pitch.

GREENSPAN: Thank you.

TETT: A quick question, though. I mean, or two questions. One is, given what you're saying about the magnitude of the task currently facing the Federal Reserve, and given that this has never been seen before, if you were a betting man today, and you have been trading the markets in the early parts of your career, what probability would you give to the Federal Reserve being able to exit these challenges without creating another financial crisis?

GREENSPAN: Well, let's leave the word "crisis" out.

TETT: OK, extreme instability or volatility.

GREENSPAN: May I—if I can use the substitute term "turmoil"...

TETT: Turmoil. Yeah, turmoil will be good. We like turmoil.

GREENSPAN: ...I don't think it's possible.

TETT: You don't think it's possible?

GREENSPAN: No, I think that—remember, we had that first tapering discussion, we got a very strong market response. And then we reassured everybody to have no—remember, tapering is still slowing the rate of increase—we're still increasing the balance sheets. And the ECB is starting anew—the ECB's got far greater problems than the Fed has. The Fed is in reasonably good shape in that regard.

TETT: Well, that's not reassuring.


TETT: I'm going to turn to the audience for questions in one minute, but before I do though, I just want to ask though, one of the really interesting chapters in your book is about gold. And there's been a lot of media debate in the past about your views on gold.

You yourself oppose a question as to why would anyone want to buy this barbarous relic—I don't know whether John Paulson is in the audience—but it's an interesting question. But do you think that gold is currently a good investment given what you're saying about the potential for turmoil?



TETT: Do you put...

GREENSPAN: Economists are usually perfect in equivocating. In this case I didn't equivocate. Look, remember what we're looking at. Gold is a currency. It is still by all evidences the premier currency where no fiat currency, including the dollar, can match it. And so that the issue is, if you're looking at a question of turmoil, you will find, as we always have in the past, it moves into the gold price.

But the gold price is actually sort of half a commodity price, so when the economy is weakening, it goes down like copper. But it's also got a monetary characteristic which is instrinsic. It's not inbred into human beings—I cannot conceive—of any mechanism by which you could say that, but it behaves as though it is.

Intrinsic currencies like gold and silver, for example, are acceptable about a third party guarantee. And, I mean, for example at the end of World War II, or just at the end of it, Germany could not import goods without payment in gold. The person who shipped the goods in would accept the gold, and didn't care whether there was any credit standing—associated with it. That is a very rare phenomenon. It's—it's the reason why, for example, in a renewal of an agreement that the central banks have made—European central banks, I believe—about allocating their gold sales which occurred when gold prices were falling down, that has been renewed this year with a statement that gold serves a very important place in monetary reserves.

And the question is, why do central banks put money into an asset which has no rate of return, but cost of storage and insurance and everything else like that, why are they doing that? If you look at the data with a very few exceptions, all of the developed countries have gold reserves. Why?

TETT: I imagine right now, it's because of a question mark hanging over the value of fiat currency, the credibility going forward.

GREENSPAN: Well, that's what I'm getting at. Every time you get some really serious questions, the 50 percent of the gold price determination begins to move.

TETT: Right.

GREENSPAN: And I think it is fascinating and—I don't know, is Benn Steil in the audience?

TETT: Yes.

GREENSPAN: There he is, OK. Before you read my book, go read Benn's book. The reason is, you'll find it fascinating on exactly this issue, because here you have the ultimate test at the Mount Washington Hotel in 1944 of the real intellectual debate between the—those who wanted to an international fiat currency which was embodied in John Maynard Keynes' construct of a banker, and he was there in 1944, holding forth with all of his prestige, but couldn't counter the fact that the United States dollar was convertible into gold and that was the major draw. Everyone wanted America's gold. And I think that Benn really described that in extraordinarily useful terms, as far as I can see. Anyway, thank you.

TETT: Right. Well, I'm sure with comments like that, that will be turning you into a rock star amongst the gold bug community. In fact, you're probably trending on Twitter today. But we do have time for half an hour for questions now. I'm sure what Chairman Greenspan has said has been very provocative and controversial, so I'm sure there will be a lot of comments and questions. Please, please, please keep them very short and brief, and it will be courteous, but not compulsory, to identify yourself. So—and there are some microphones coming.

QUESTION: Hamid Biglari, TGG Group. Chairman Greenspan, in light of your observation about the low likelihood that markets would escape turmoil as QE is tapered off, I'm wondering if you could comment on the impact on the—the relative impact on emerging markets in light of the fact that they're far more financially leveraged now than they were fifteen years ago, when we had the last round of significant crisis there, and the potential for capital outflows as the dollar depreciates.

GREENSPAN: Yeah, it's difficult to make generalized judgments about emerging markets, because too many of them have very warped political systems. I mean, take Brazil. With Rousseff coming in, I mean, it is remarkable what she has done in a negative way to Brazil, yet those are in the GDP figures. I mean, take Venezuela. Same problem, same cause.

And you have an awful lot which creates problems with the data. So getting a clean—clean shot at, so to speak, full evaluation of emerging markets, you got to, first, take that consideration and then take China out and put it aside and examine that separately. That, of course, is the 800-pound gorilla in the emerging markets, and it's a fascinating history that they've developed.

So it's so difficult to generalize on this, but clearly, to the extent that you get developed countries in some difficulty, it invariably impacts the emerging nations, especially those who are commodity producers.

TETT: Right, we go to another—two more questions here, and then we'll go over here, so...

GREENSPAN: This is all murderer's row up in the first row.


QUESTION: I wonder if we could turn to Europe—Byron Wien from Blackstone—I wonder if we could turn to Europe for a moment. Germany has slowed down, perhaps because of the impact of Ukraine, and Germany is the engine of growth for Europe. Europe is in danger of slipping back into recession. What should Mario Draghi do to avert an economic catastrophe in Europe?

GREENSPAN: Well, I'm always been, in effect—in the original edition of this book, which goes back to '13, 2013, I raised some serious question about the viability of the euro generally. And, indeed, I had the privilege of sitting in with the G-10 governors which—there are eleven of them, and almost all are European. The whole emergence of what ultimately became the euro was thoroughly discussed in that period amongst that group, and it was very interesting to see what they had in mind.

They were struggling with the question of two world wars on European territory in a very short period of time. And they were looking for ways to integrate politically the euro area. And they came up with—as they put it—we would like to replicate a currency which was the fifty states of the United States. And they came up with this, fully understanding that it meant cultures had to be become pro-European and not individual, and that eventually, say, Italians would behave like Germans.

Well, on January 1, 1999, when the euro came into place, and everything was locked in place—and I must admit, extraordinarily smooth—and I think basically was over—and the beginning of a very heavy international boom, where there was no competitive disadvantage. If you could produce it, you could sell it.

And so what was happening is that, with the lower euro interest rates for—for example, Italy—I mean, they came down 500 basis points as they moved into the euro. That meant they could borrow, and did, very heavily—Greece, Portugal, Spain, Italy borrowed heavily. There is no evidence that the notion that many of the European central banks believed that when in the euro all of the—all of the peripheral Southern European countries would behave like Germans. From day one, they didn't. They—instead of devaluing, they always did when they were in trouble, they borrowed from Northern Europe.

Today, what we really need is the ability of a lot of these countries to devalue. And this is the ultimate—there's no—I mean, you know, like you're asking, where do we go from here? Well, the only place we go from here is to free the currencies to readjust, because they're now extraordinarily imbalanced with respect to (inaudible) and all you need to do is, there's a facility in Europe called TARGET2, which reflects the intra-central banks lending to each other. And lo and behold, you've got the Bundesbank lending very large net balances to Italy and Spain.

And very recently, as Draghi went towards expansion, it shows up—it showed up immediately in the TARGET2, whereas the German Bundesbank lending net to other members of the TARGET2 group was going down steadily. And then in the last three or four weeks, it's turned back up. That is telling you that this is not a solution to this.

The only solution, as I've put it in the book originally, is actually a full political integration of Europe, because if that occurs, then the currency problem disappears.

TETT: And if it doesn't occur, you think it breaks up?

GREENSPAN: I'm sorry?

TETT: If it doesn't occur, if political integration doesn't occur, do you think the euro breaks up eventually?


TETT: So yet more turmoil, if not crisis.

GREENSPAN: Yeah, this is—I mean, when you've got pressures pushing and pushing and pushing, you—there's no end to that until it cracks.

TETT: Right. Well, I'll ask you later for reasons to be cheerful, but...

GREENSPAN: I mean, look, the problem is, I can't—if somebody can figure out a way beyond this, I'd be delighted to embrace it and I'd even be delighted to embrace the fact that I was wrong, but I can't find any evidence of that.

TETT: Right, well, next question. Then we'll come to the side.

QUESTION: Gregg Feinstein from Houlihan Lokey. Earlier, you acknowledged that the Fed's impact on the economy has been muted. Certainly, though, people acknowledge that the Fed's effect on actually the market has been enormous. And it seems as if the Fed is able to influence asset prices easier than the underlying economy. And each time that the market seems to tremble, as a result of the interrelationship and the leverage in the world financial system, it seems as if the Fed simply comes to the rescue. And they make some statement about how long they're going to wait to raise interest rates and things sort of head back up again.

So is there—is there a complacency on the part of investors that has developed that any time that the market shakes—because it's all they can do—that the Fed is going to come to its rescue, and then interrelated to that and going back to your gold question, is it then that an elected government will always choose inflation over austerity, because you're going to lose your job if you do austerity, that is causing some of the confidence in gold, because it's the only way out of this, is to inflate our way out of it?

GREENSPAN: That's what history tells us. But, remember, there's a deeper question here. This—you're making that statement, for example, in, let's say, 1880 or 1890. I'm being—I'm trying to trace where we are. Those statements never arose back in that period, because the big debate was between whether you had gold or silver. But the fact the fiat currency expansion got very tarnished with—you know, in 1775, we printed a whole bushel full of continentals. And one of the fascinating things about that period is the fact, for the first year or two, there was very little evidence that that had any effect on prices, meaning that that paper currency circulated with the same value as specie.

And there is an extraordinary—there's an extraordinary lag which exists between actions of that type and consequences. Now, eventually the continental was not worth a continental. But it took a long while. And I think that we're looking at very similar things now. This, again, is a human propensity.

One of the things that I really used this book to write was to develop a concept of, how do you shift from a system where everybody is acting rationally, which is what all of our models basically said, to one which is—where reality is, where peoples are acting intuitively, in various different types of forms.

Irrationality is, in many respects, systematic. You can model it. And, indeed, I show in many cases why, for example, fear is demonstrably a much stronger force than euphoria. And so that—you know, you look at the unemployment figures, the unemployment figures go up sharply and down very slowly.

This is—types of things which I think we've got to understand and—one of the reasons I say, as a conclusion in this book, that the non-financial parts of our economy behave very well. They're highly capitalized. And essentially, it is the financial system which is wholly divorced—it's a different function than the type of things we do in the non-financial area—one, it has to do wholly with allocation of savings into investment.

That is where animal spirits really run wild. And we have to understand that better than we do now. And this is the reason why everybody knew there was a bubble in 2008, but to my knowledge, nobody—even when we knew on a Monday morning that Lehman was going to go into—was going to default, did we get the reactions right away. It took several days before the whole system broke down. And if you can't forecast something like that, what good is forecasting?

TETT: Do you regret not having pricked the bubble in, say, 2005?

GREENSPAN: No, because by then, I think it was—you can't—well, one of the things I've concluded in the book is that pricking the bubble short of collapsing the economy doesn't do anything. We tried at the Fed, for example, in 1993 to—actually, 1994—we raised the federal funds rate by 300 basis points, which is a huge amount in a short period of time with—we went up 50 basis points, 75 basis points, and we did slow what was an—call it incipient rise in the Dow, for example. It stabilized.

And we got what we thought was a previously unachieved safe landing, and so we started patting ourselves on the back, and lo and behold, as soon as we stopped tightening, the Dow took off again. And the reason is that markets are very complex. The markets observing the fact that 300 basis points did not disrupt the economy changed the equilibrium level of the Dow Jones Industrial Average from here to there, and the markets just took off.

There is no evidence, which I'm aware, where central banks have incrementally tightened. The only occasion where we actually saw something is when Paul Volcker's Fed hit late 1979 and early 1980, put a clamp on the economy, and it's only by bringing the economy down that you could burst the bubble. And that is very bad news, in the sense that this is not—the only place where incremental tightening actually defuses bubbles is in econometric models. And that's because they're misspecified.

TETT: Right, well, that's not very reassuring, either. But we have some questions over here. The woman there.

QUESTION: Jeff Schafer, JRShafer Insight. It's always very interesting, Chairman Greenspan, to hear what you have to say about the economy. My sense—I think you share it—is that if you look back over the last 100 years, whenever we had financial turmoil, housing has been at or very near the center of it. And we're now looking at a trend in Washington towards re-legitimatizing subprime mortgages and their financing by Fannie Mae, putting off the holding requirements for mortgages, and the general looks like willingness to reconstruct the mortgage system we had before the crisis.

I'm wondering what you think of that and where you think we're headed with housing finance in this country.

GREENSPAN: Question one, not much. Question two, territory we'd just as soon not be in. It's—we have got a tendency to do that over and over. You can—quite right, looking back 100—you go back 200 years, you'll find it, too, so don't worry about it.

TETT: So are we creating a new subprime...


TETT: Are we creating more subprime mortgage problems?

GREENSPAN: I think at this stage that—it's too soon to tell, but we're not—see, remember what's happened.

TETT: Or is it the case that we have so many other problems to worry about first, this is...

GREENSPAN: Here's the issue, that—remember that one of the consequences, as essentially the way we dealt with the mortgage crisis is we made the mortgage market henceforth non-recourse loans. So what happens is that if you can't foreclose on the property and get it back, your down payments tend to be much higher. And, indeed, that is exactly what happened.

And so we do have 30 percent down payments on standard prime mortgages. And that's enough of a suppression. But I will grant you that if you put government subsidized funds into the marketplace to create, quote, affordable housing without a full recognition of the fact that we've been exactly down that road before—and what was wrong previously is there's nothing wrong with subprime mortgages. We had a protracted period where this very small segment of homeowners who could not afford the huge down payments, the 20 percent down payments, but could meet the monthly payments of a fixed-rate loan, that market was actually functioning profitably for banks.

The problem happened when we decided that we wanted to expand the whole market, and the only way to do that was essentially with securitized loans.

TETT: And adjustable, yes.

GREENSPAN: And adjustable rate securitized loans, and that was the doom.

TETT: That was the problem.

GREENSPAN: As soon as we—as soon as we see adjustable rate loans of the type we're talking about, look out.

TETT: Right. Any more questions? Jacob and then Zach and then—very brief, because we're almost out of time.

QUESTION: Thank you. Jacob Frenkel, JPMorgan. You spoke naturally about the Fed and also the ECB, about the challenges and about the fact that it will not end easily or nicely. The question is, is there any role of governments and other policy instruments that should come in so that the burden will not be fully on the Fed and the ECB? And a bigger question is, is it possible that in the past few years, some of the central banks have actually entered into a territory that typically would have had to be addressed by governments?

GREENSPAN: He usually knows the answers to the questions he asks.


One of the statements I make categorically in the book, which is crucial, is I argue that there wasn't a single problem in the structure of intermediary finance, so to speak, that led up to the 2008 crisis that could not have been forestalled or contained with adequate capital, and that I go on further to demonstrate that we have a long history of capital requirements going up and going down for technical market reasons and then in more recent periods, regulatory areas.

But the fundamental question is, is that it appears that with the data we have—remember, the National Bank Act was enacted in 1863. We've got homogenous records for commercial national banks going all the way back, and you can see net income as a share of equity, capital equity, and despite the fact that that—that the ratio of capital—equity capital to assets in the banking system was going straight down after the Civil War.

The rate of return on equity was stable. The only way that can algebraically happen is the rate of return on assets went straight down. The argument I hear about—from—mainly from my old banker friends—Jacob excluded, needless to say—is that if you raise capital requirements, you reduce net return, and that's dangerous to the system.

You don't. The history of financial markets from my point of view suggests that the markets are continuously adjusting so that what the firm basic statistic which is consistent with human nature, if I may generalize it, that statistic is the net income relative to equity, because that's where the competitiveness in a global capitalist market functions.

And if you—if that is where the markets operate, and you raise regulatory capital requirements, you are going to raise the rate of return on assets. You're going to find very quickly that banks start to open up their spreads on lending of these types of assets. Why? Because they can do it and the markets force them to do it.

And you're going to find that if we get a significant capital increase, I think you're going to find the spreads on individual lending—from a cost of capital to the actual interest rate that the banks are charging—that is going to open up in precisely the symmetrical way that it did during the 19th century when we were going in the—wholly in the other direction.

And if that is the case, then we're saying that all we need to do to maintain a stable financial system is to get capital requirements to the level that in the event of default you don't get contagious defaults, which upends the non-financial system.

TETT: Right.

GREENSPAN: I argue in the book that the non-financial system operates very effectively, until it gets polluted by the distortions that occur when animal spirits take over the financial system. And that to me means that we're overdoing it. I've argued that Dodd-Frank is a mistake. It's going in the wrong direction. And I've argued that we don't need that much regulation, provided you get banks to put up capital. If there are going to be losses, that the shareholders of the banks do this.

I go into a long analysis where this is also related to productivity, the standards of living, to the inequality of incomes that occur as a consequence. It's a story which will go way beyond what she's going to allow me to talk.

TETT: Well, we are actually coming up to the end. I'm going to say, in an otherwise gloomy hour, that we have a point of cheer, which is that Chairman Greenspan has a simple solution to fix the banking crisis. Probably not one the banks want to take.

I think it's been a fascinating discussion. I take away three keys points, firstly, that the current state of the world is very unhealthy and unbalanced; secondly, that we're not going to be able to exit this without some form of turmoil or crisis, let's call it turmoil; and, thirdly, that Chairman Greenspan is trying to engage with these fundamental problems in a very refreshingly frank manner. And for that, I think we can all be very grateful, indeed. So thank you very much, indeed, for a fascinating debate.


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