Saturday 11 October 2008

Interesting comment by Alan Greenspan

The article is an excerpt is a from his new chapter in the updated edition of "The Age of Turbulence", published 10 September 08.

As Greenspan says, it’s all about underpricing risk. Mind you I'd say it was really about underpricing the risks involved in misaligned incentives (that allowed, for example, Freddie Mac's CEO taking US$14 mil the month before they implode!). And it is becoming about underpricing the risk of environmental collapse if climate change isn't addressed.

But is Greenspan right in suggesting that periodic bouts of euphoria, followed by depression, are part of the human conditions, like some sort of economic bi-polar syndrome, and that all we can do is be flexible enough to be ready for the alternating shocks?

I'm only an amateur in this area, but was surprised at him saying: “I was appalled and shaken when the financial system failed to protect itself more effectively against a euphoric boom. We at the Federal Reserve had always counted on banks in particular to avoid the most troublesome risks”. A weak comment in the face of, again, obviously misaligned incentives.

He then lays down the challenge with “I know of no regulatory system or degree of protectionism that can transmute irrational exuberance or debilitating fear into a stable growing economy.”

Has he missed a key point? The implied, albeit often disputed or ignored by some classes of market theoreticians, role of government as guarantor of last resort has been brought out into the open in a way not seen for 70 years. Sustainable financial systems depend on an over-riding framework of governance and guarantee that both limit cannibalising activity when things get particularly torrid and ensure the broader needs of society are figured in decisions about how the sector goes forward.

(I've just been reading Nick Robins' sobering book on the East India Company, with its description of the ghastly outcome of corporate behaviour without governing frameworks when the Company manages to both create and then make worse through short-termist behaviour the vast Bengal famine in the late 18th century.)

Long-term investors such as pension funds, to ensure the sustainability of their returns, surely need to make sure (improved) governing frameworks are in place that will protect and enhance those returns. They have a vested interest in pushing governments to design and manage systems accordingly; but, in a intellectual environment to date dominated by the servants of short-termism, they’re going to have to contribute more to the thinking behind this.

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