Alan Greenspan, former chairman of the Federal Reserve Board, is defending U.S. monetary policy in the years leading up to the financial crisis, arguing that the real problem was a lack of capital at financial institutions.

In a paper published by the Brookings Institution, Greenspan argues that insufficient capital was at the heart of the widespread damage caused by the financial market meltdown, and he stresses that higher capital and liquidity requirements are the most important reforms that must be taken in response to the crisis.

“In the years leading up to the current crisis, financial intermediation tried to function on too thin a layer of capital, owing to a misreading of the degree of risk embedded in ever-more complex financial products and markets,” he says.

Greenspan says that a global housing price bubble emerged fueled by low long-term real interest rates, and a delinking of monetary policy from long-term rates. In the paper, he defends the low rates set by the Fed, which were set as low as 1% in 2003, which some have argued drove the housing bubble to dangerous heights. “I thought at the time that the rate decrease nonetheless reflected an appropriate balancing of risks. I still do,” he said of the rock bottom rates designed to protect against the perceived risk of deflation at the time.

Moreover, he argues that the Fed could not have been expected to prevent the bubble. “Given inappropriately low financial intermediary capital and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt [the crisis could have been prevented],” he says. “Those economic conditions are the necessary, and likely the sufficient, conditions for the emergence of an income-producing asset bubble.”

“To be sure, central banks have the capacity to break the back of any prospective cash flow that supports bubbly asset prices, but almost surely at the cost of a severe contraction of economic output, with indeterminate consequences. The downside of that tradeoff is open-ended,” he maintains.

Instead, the long period of prosperity, low inflation, and low long-term interest rates “reduced global risk aversion to historically unsustainable levels,” he says.

That bubble started to unravel in the summer of 2007, he notes, but the high degree of leverage in the economy “set off serial defaults, culminating in what is likely to be viewed as the most virulent financial crisis ever.”

“The major failure of both private risk management and official regulation was to significantly misjudge the size of tail risks that were exposed in the aftermath of the Lehman default. Had capital and liquidity provisions to absorb losses been significantly higher going into the crisis, contagious defaults surely would have been far less,” he argues.

As a result, Greenspan recommends that the primary policy response should be: increased regulatory capital and liquidity requirements on banks; and, significant increases in collateral requirements for globally traded financial products.

Additionally, he says that regulation can serve as a backup to capital requirements and market discipline by: enforcing collateral and capital requirements; requiring the issuance of some debt by financial institutions that will become equity, should equity capital become impaired; limit certain types of concentrated bank lending; prohibit a complex corporate structure whose sole purpose is tax avoidance or regulatory arbitrage; inhibit the reconsolidation of affiliates previously sold to investors, especially structured investment vehicles; and, require ‘living wills’ that mandate a financial intermediary to indicate on an ongoing basis how it can be liquidated expeditiously with minimum impact on counterparties and markets.

However, he sees other regulatory reform proposals as misguided. “The notion of an effective ‘systemic regulator’ as part of a regulatory reform package is ill-advised,” he says, adding, “The current sad state of economic forecasting should give governments pause on the issue.”

“Unless there is a societal choice to abandon dynamic markets and leverage for some form of central planning, I fear that preventing bubbles will in the end turn out to be infeasible,” he concludes. “Assuaging their aftermath seems the best we can hope for. Policies, both private and public, should focus on ameliorating the extent of deprivation and hardship caused by deflationary crises.”

IE