Nothing like having Greenspan calm the market. Why is it his written word is clear but his spoken word (Greenspeak)is spoken in "tongues".
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Greenspan: Wall Street to Blame for Economy
Former Federal Reserve Chief Alan Greenspan squarely blamed Wall Street this week for irrational decision-making that has pushed the U.S. economy to the brink.
The economy, riding now on the edge of what is likely to be a serious contraction, can and will right itself - once home prices revert to pre-bubble levels, Greenspan wrote in the Financial Times this week.
Greenspan figures there are 800,000 too many homes on the market, only about half of which will be absorbed by normal population growth during 2008.
"The level of home prices will probably stabilize as soon as the rate of inventory liquidation reaches its maximum, well before the ultimate elimination of inventory excess. That point, however, is still an indeterminate number of months in the future," Greenspan wrote.
Yet the bigger issue is far more troubling. Imploding banks invested in those excess homes are likely to lose more than $1 trillion before all is accounted for, say some economists.
The virtual collapse of Bear Stearns over the weekend was overdue, and there's no guarantee that other famous financial names are any safer, here or in Europe.
For free-market proponents like Greenspan, quickly moving events have been unsettling to say the least.
"Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief," Greenspan wrote.
"But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance."
Greenspan predicts that the immediate outcome will be changes to international bank regulations, known as Basel II. He notes that the free market is already at work, too, as investors demand more capital and collateral at the banks.
Editor's Note: The Recession's Silver Lining. What it Means for Investors.
Yet he questions the wisdom of leaving the ultimate free market - Wall Street itself - in charge of managing risk so large that it can derail the world economy.
"The essential problem is that our models -- both risk models and econometric models - as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality," Greenspan wrote.
Greenspan suggests that the models are only as good, of course, as the inputs, which have relied for too long on counting expansion and contraction as if they were roughly equal forces.
In fact, he wrote, expansion is so slow and insidious that it creates an entirely different set of problems compared to contraction, which we seem to understand pretty well.
During the problematic phase - the long expansion - banks tend to take their eye off the ball, and they do so for one utterly predictable reason: Wall Street punishes losers.
"One difficult problem is that much of the dubious financial-market behavior that chronically emerges during the expansion phase is the result not of ignorance of badly underpriced risk, but of the concern that unless firms participate in a current euphoria, they will irretrievably lose market share," Greenspan wrote.
Simply put, actually keeping the kind of cash around that might save a bank from a significant downturn - the kind of money one would need to avoid becoming the next Bear Stearns - is not likely to stay sitting in the vault during an expansion.
"Today, or at least prior to Aug. 9, 2007, the assets and capital that define triple-A status, or seemed to, entailed too high a competitive cost," Greenspan wrote.
Greenspan offered no magic bullet, except to say that forecasting models should probably stop trying to figure out what should happen and instead go ahead and price in the risk of what will happen: yet more bubbles.
"Asset-price bubbles build and burst today as they have since the early 18th century, when modern competitive markets evolved," he wrote.
"To be sure, we tend to label such behavioral responses as non-rational. But forecasters' concerns should be not whether human response is rational or irrational, only that it is observable and systematic."
The idea is not new, Greenspan notes, explaining that most models now try to include what Keynes called "animal spirits," the propensity of people to act like people -- greed and fear included in the equation.
Greenspan has been criticized for his role in the housing mess, specifically for holding down interest rates in the 1990s for too long, a charge he dismisses outright. In previous articles, for instance, he made the case that central banks no longer really control long rates.
Now, he counsels that we all just get used to bubbles and their effects.
"Discontinuities are, of necessity, a surprise. Anticipated events are arbitraged away. But if, as I strongly suspect, periods of euphoria are very difficult to suppress as they build, they will not collapse until the speculative fever breaks on its own," he wrote.
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