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19 March 2014

Greenspan - Rock Star or False Prophet?

In the years since the financial crash in 2008, the finger of blame has been pointed at a range of targets; one name that keeps cropping up is that of Alan Greenspan, the former Chairman of the Federal Reserve. That’s quite a come-down; I’m sure many readers will remember how he was feted as the rock star of economic policy, the man who kept the boom rolling on through the 1990s and into the early years of this century, assuredly navigating the ship of monetary policy even through the stormy waters of the dot com bubble and its bursting. Now, he’s largely reviled as – amongst other epithets – “one of the twenty-five people to blame for the financial crisis” (Time Magazine). Plenty of people who heaped praise on him before 2008 as they banked their chunky salaries and bonuses have now discovered that, actually, they disagreed all along and sub-prime was an accident waiting to happen. That is of course true, but not so many of those who now trumpet that did in fact appreciate it at the time.


With the benefit of hindsight, playing with interest rates in such a way as to encourage (in some ways, almost, oblige) lenders to follow a policy of lending money to what objectively would be called bad credit risks on the back of an assumption that ever-rising property prices would prevent default, without considering that if, at any time and for any reason, interest rate then began to rise, was a pretty stupid policy. There were some – honourable exceptions to my generalisation – who did indeed point this out at the time, but they were in a minority.

Ayn Rand, Objectivism and the Gold Standard

But how did Greenspan get to that point? I was recently sent an article that he wrote for Ayn Rand’s ‘Capitalism: the Unknown Ideal’ (published in 1966), in which he praised the gold standard. The piece is worth reading and can be found here: . Greenspan was of course during the 1950s and 60s an ardent supporter of Rand and her doctrine of Objectivism and this essay articulates very clearly his enthusiasm for the case supporting the gold standard. I’m not going to rehash the entire article here, but essentially he outlines how fractional reserve banking based on a universal gold standard works. Interest rates are driven by the availability of credit and imbalances are resolved by the free movement of gold from one country to another. That’s probably – in its pure form – an unachievable utopian ideal, and indeed through the twentieth century, governments realised that actually, if they could increase reserves to fill in periods when the availability of gold was restricting activity – in other words, when the readjustments were taking place – they could, they thought, create indefinite growth. In simple terms, since only a small fraction of depositors are likely to want to withdraw their assets at any given time, you can safely increase the availability of credit and beyond that, you can create new ‘assets’ to allow you to expand lending even further. Keep that going, and, as if by magic, you can have everlasting growth.

Except it doesn’t really work like that; constantly increasing the supply of money in the end leads to inflation and that inflation erodes value and destroys savings. The Greenspan of 1966 put it like this:

 “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.”

Changing Views?

Now, one may or may not agree with that analysis, but it’s interesting that the Greenspan of Federal Reserve Chairman times seems in many ways to have been responsible for a policy which was very close to the one he dismissed as a shabby secret in 1966. Why would he have done that? 

First, I think one has to acknowledge the undoubted political pressure of the times; after the 11th September attacks, the economy had to be supported. Thus a reduction of interest rates was probably logical. However, the continuation of that policy fuelled the boom in borrowing, sowing the seeds of disaster that would blossom as rates were increased later to cool the overheating. 

Secondly, hubris; I suspect that he followed that policy because it was meeting great acclaim. It was successful, right up until the moment when it wasn’t, and by then it was too late. 

Thirdly, the massive rise in complex financial derivative products, that was itself a result of the huge increase in computing power, facilitated multi-dimensional trades and risk-taking that would even ten years earlier have been almost impossible. 

Fourthly, pragmatism. Theories work up to a point. Beyond that point, the reality of the situation kicks in, and the world is too chaotic a place for the majority of ‘soft’ theories - I exclude maths and science here; economics likes to consider itself a science, but it’s not. It’s an attempt to describe chaotic systems and predict how they may work, no more than that. 

Surprising Shift?

So should we be surprised to see Mr Greenspan seemingly espouse the very policy in 2001 that he condemned in 1966? Not really; the world changed a lot in those 35-odd years; he was just trying to adapt to changing circumstances. That’s why the economic rock star became one of the people responsible for the crisis of 2007/08. Given the information available, without the benefit of hindsight, who’s to say we wouldn’t all have done the same?



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