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Greenspan's philosophy of buffers

by Robert Teitelman | Published July 27, 2011 at 1:48 PM

Back in 2005, hard on the devastation wrought by Hurricane Katrina, the media was full of the usual handwringing. How could this happen? Who was to blame? What could be done so that it never occurs again? Sound familiar? One of the more unusual ideas to surface was the notion peddled in the business magazines that Katrina somehow represented a failure of risk management, not just by the government, which had erected those levees, but by the population at large. And in the usual way, that large and woolly thought -- how would ordinary citizens have calculated the odds of Katrina, including the frailty of those levees? -- was attached to a trendy idea: that our failure to judge risk adequately is somehow related to our evolutionary makeup, formed millions of years ago when we were scampering, bare-legged across the savannas of Africa in search of either dinner or safety from lions and tigers. This failed to answer the question, but it certainly dressed it up in trendier clothing. And who could say it was wrong? And so we have the esteemed Alan Greenspan, who once again has stirred himself from his restless retirement to write a column in the Financial Times. Last heard from, Greenspan had declared that we were living in the best of all possible worlds -- markets division -- and that since regulators could never figure out what is happening they should just leave the whole damn system alone. And, oh yes, occasionally bad stuff happens. On Wednesday, Greenspan focused on the bad stuff. His notion, which is not novel, is that we spend way too much time worrying about bad stuff: building levees, trying to make Japan earthquake-proof and, of course, fixating on financial disaster. Mostly, he thinks we're crazy to build buffers of regulation and capital around the banking system. And the worst? Those bailouts.

"The choice of funding buffers is one of the most important decisions a society must make," he writes. "If policymakers choose to buffer their populations against every conceivable risk, their standards of living would almost certainly decline. ... Buffers are largely a luxury of rich nations." He then wanders aimlessly for several sentences about whether these buffers are part of the capital or equity of a country, before refocusing. "How much of the output should a society wish to devote to fending off once in 50 or 100-year crises?" In the 19th century, he argues, "when caveat emptor ruled, such risk judgments were not separable from the overall price, interest rate and other capital-allocating decisions struck in the marketplace."

This is about as sensible as evolutionary behaviorism applied to risk management. Greenspan was trained as an economist, and we unwashed should hesitate to debate him on technical economics. And in general he's right in the obvious point that too much protection can affect living standards. But what's "too much"? While attired in economic garb, Greenspan's op-ed isn't about the intricacies of economics at all: It's really a hash of half-baked political philosophy and broad-brush history. I'll grant Greenspan that in the 19th century Western world that caveat emptor did have a larger role than today. Short of defense and some internal improvements, governments had little interest in social welfare, which, in any case, was undoubtedly beyond the fiscal capacities of states anyway (at the least, their economies didn't generate enough surplus). He's also right that safety nets are a buffer enabled by affluence. That said, how many politicians were sitting around trying to figure out how much output to apply against potential disasters? How many financiers were pursuing risk management by calculating interest rates, price and other capital allocation decisions, particularly given unlimited liability? Given our clear failure to predict the future -- hey, Al, how's that debt ceiling going to work out? -- our counterparts in top hats and beaver coats were similarly wrapped in densest fog. They had fewer pretensions to believing they could see the future. They would be more modest in slinging around notions that we "know" a crisis will occur every "50 to 100 years" or for earthquakes, "one or two minutes every century." (Actually, the Japanese earthquake lasted a lot longer than that.) Not to pile on, but "50 to 100 years" isn't exactly a precise forecast of future cataclysms either.

But there's more that's wrong here. Greenspan's haziness on these matters wreaths a vast gulf of ignorance that we all -- expert, amateur, economist, poet -- share. We do not know. We cannot predict earthquakes, not to say devastating tsunamis that threaten coastal nuclear plants, not to say famines, pandemics, the rise of food prices, regional revolutions, serial killings, market failures. The past is no judge of the future. The world of man, and the world of men screwing around with nature, is profoundly dynamic. Did New Orleans get flattened because a) we threw up cut-rate levees, b) we allowed the Mississippi delta to deteriorate, c) global warming, or d) people decided to live in a flood zone? You give me the odds on any of that, particularly because we can't even seem to decide if global warming is real or not. Similarly, in an area Greenspan has more expertise, how do we know what kind of buffer is adequate to cushion or diffuse financial failure or panic? There is no magic number -- and it certainly can't be arrived at by consulting interest rates and prices. We suspect banks will fail; they always have. But when? Greenspan seems to think 2008 was rare, separated by periods of prosperity and profit making. But crises often bunch like buses. The European 19th century generally saw long periods of peace and tranquility after, say, 1848. How do you explain the nearly continuous and often global destruction of the 20th century? How do we know we're not entering a period of economic turbulence? How often in the past have we threatened default? And yet here we are.

Greenspan is quite right that wealthier nations can afford larger buffers. But he never quite gets around to mentioning the parallel reality that within a nation, wealthier citizens can afford far larger buffers than the less well off. Obviously, this disparity increases in an age of increasing inequality, economic weakness and fiscal difficulties. Personal buffers also loom far larger as a proportion of net income -- this sounds very economic -- to the poor than to the rich: The poor cannot afford insurance (see New Orleans) while the rich are hardly aware they pay for it. The poor may never recover from a "rare" crisis like the Great Depression or the earthquake in Haiti; the rich, if they're not stupid, can shrug it off. Greenspan's fear that we may be erecting too-high buffers resembles that ancient advice to invest in equities because they only go up. That works well, unless you happen to be 62 in 2008.

All this, by the way, helps explain why modern states have larger buffers. Because they're mostly mass liberal democracies, there is a general consensus that fairness requires the safety net in fundamental ways to undergird everyone. We understand the inherent unfairness of inequality, particularly in a disaster, personal or systemic.

Greenspan, tottering down the leafy path, wields this philosophy of the buffer to argue that our zeal for self-protection led to the decision to bail out Bear Stearns Cos. and all the bailouts that followed. He seems to believe that if his successors had allowed Bear to die, AIG, Lehman and the rest would have used the six months to buttress their capital and protect themselves. Is he kidding? The Bear failure would have been followed by considerable financial volatility. Any firm that tried to raise enough capital would have been next. AIG's problems were so deep -- and deepening -- that a capital raise wouldn't have saved it; and does anyone believe Dick Fuld, who did raise some capital, would have saved the firm? The fact is there's still a viable debate to be had about Bear and Lehman, but this is fantasy -- and again, untestable fantasy that we have sadly grown accustomed to hearing from the now-retired Former Greatest Central Banker Ever. - Robert Teitelman

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