Some highlights from former Federal Reserve Chairman Alan Greenspan’s commentary at The American on why all financial bubbles are not bad and how the world might avoid what increasingly appears to be an inevitable next financial crisis.
Bubbles, the root of the 2008 crisis and earlier ones, for reasons I will discuss later, have become more prevalent. All bubbles deflate, by definition. But most deflate without debilitating economic consequences. On the fateful day of October 19, 1987, for example, the Dow Jones Industrial average plunged 23 percent, the all-time daily record. I defy anyone to find economic disruption in the GDP figures following that date. I believe there was none. Similarly, in the dot-com boom, capital losses, as in 1987, were huge. But the owners of the toxic assets were mainly pension funds, households, and mutual funds; all suffered very large capital losses, but few ever got to the point where they defaulted on debt. And it turns out that the only two times in recent history in which we experienced real contagion in the financial markets were in late 2008, when, as AEI’s Peter Wallison has documented, there was a very destructive subprime mortgage crisis, the toxic assets of which, of course, were highly leveraged. And in 1929 we experienced a leveraged broker loan crisis. The result was contagious defaults.
The question before policymakers is how to avoid such breakdowns in the future. As far as I can see, the only way to address such issues is to recognize that euphoria-driven bubbles are an inherent consequence of human nature over which we have little or no control. Successful financial policy, in my experience, ironically spawns the emergence of bubbles. There was never anything resembling financial euphoria, or the bubbles it creates, in the old Soviet Union, nor is there in today’s North Korea. At the Federal Reserve during my tenure, we often joked that our greatest fear was that policy might be too successful. Achieving an underlying stable rate of growth and low inflation appears to have been a necessary and sufficient condition for the emergence of a bubble. We would conclude with mock seriousness that optimum monetary policy for bubble prevention was to create destabilizing inflation.
Can bubbles be prevented from rising once markets are in the grip of euphoria? At the Fed, we tried to defuse the nascent dot-com bubble of 1994. We failed…
He goes on at some length, but, I lost interest after the mid-1990s bubble-fighter reference.
The message appears to be: “It wasn’t my fault, we were too successful at the Fed, you can’t control animal spirits, and we’ll always have bubbles”.