Wednesday, September 09, 2009

Greenspan is right, there will be more financial crises in our future

A Reuters article entitled "Another financial crisis inevitable: Greenspan" reports on a speech by former Federal Reserve Chairman Alan Greenspan on the inevitable prospects for future financial crises. Greenspan is of course correct when he says that "crisis will happen again" and that the cause will be "the unquenchable capability of human beings when confronted with long periods of prosperity to presume that that will continue." In other words whenever "investors" once again start treating risk as irrelevant, the foundations of our financial system will once again begin to crumble. He correctly fingers the prime culprit as speculation as he says that "human beings begin to take speculative excesses with the consequences that have dotted the history of the globe basically since the beginning of the 18th and 19th century." Why can't we cure this speculative urge? Human nature. Greenspan says "It's human nature: unless somebody can find a way to change human nature we will have another crisis."

Sure, we can change the rules and regulate the dickens out of our financial system, but human nature and the attendent desire to speculate will always lead people to figure out how to game the system in ways that no human rules could have necessarily predicted.

Sure, we can "fix" the banking system, but the next big crisis will probably be somewhere else, somewhere where we didn't expect it. As Greenspan says, "crisis will happen again but it will be different."

A second problem of human nature as I see it is simply "monkey see, monkey do." If only one firm utilized some exotic financial practice the impact on the overall system could be easily contained, but once one firm is wildly successful at cheating fate, all of the other firms go into copycat mode and then a non-threat rapidly becomes a systemic issue.

What he did not say explicitly is that the best way to deal with these unpredictable and unknowable crises is the infamous "Greenspan Doctrine" where rather than figure out how to avoid the crisis in advance we simply focus on having the flexibility and resources to clean up the mess after it happens.

What about all of the experts who predicted this crisis? As the old joke goes, Economists have predicted nine of the past five recessions. In other words, there are always a subset of economists and analysts who are predicting impending doom, but most of the time they are flat out wrong. Trying to isolate and determine which tiny subset of doomsayers are correct this or next time is quite the fool's errand.

I say stick with the Greenspan Doctrine, but at least make some attempt to highlight asset prices that are way out of whack. Of course, even Greenspan tried to do that once with his infamous "irrational exuberance" comment which fell on quite deaf ears. Still, the concept deserves another crack. People really do need to be aware when risk is rising even if perception of risk is falling. A strictly quantitative measure is appropriate even if the rhetoric of risk does not ring clear in our minds.

Now, whether the next big crisis is in 10, 20, 25, 50, or even 75 years is of course complete speculation. Sure, we will have plenty of mini-crises along the way as people continue to thrill to stressing the limits of our system, but hopefully we will continue to have enough flexibility and resources in the government's financial arsenal to counteract the whims of human nature.

-- Jack Krupansky

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