Greenspan on the sub-prime crisis

How to deal with asset bubbles? At the policy level, Alan Greenspan's view is: not much. If central banks act to fend off bubbles, they risk derailing growth. The best they can do is manage the problems that arise when a bubble bursts.

In an article in FT, Greenspan seems to suggest that firms do not have much of a choice but to ride the bubble. Not to do is to lose market share.

A financial crisis is heralded, in fact defined, by sharp discontinuities of asset prices. The crisis must thus be unanticipated. The fact that risk was heavily underpriced for much of this decade was broadly recognised in the financial community, but the timing of the sharp price correction was nonetheless a surprise.

Recent history is replete with such underpricing persisting for years. Those market players who withdraw from “long” commitments at the first sign of an excess of exuberance, risk losing market share. They thus continue “to dance” as Chuck Prince, the former Citigroup chairman put it, but always assume they will have time to exit the markets. The vast majority invariably fail. When the current crisis emerged, it was assumed that the weak links would be unregulated hedge and private funds. The losses, however, have been predominately in the most heavily regulated institutions – banks.

We see this happening all the time . No fund manager wants to exit the stock market in a hurry; banks are reluctant to switch off the lending tap; investment banks' proprietary trading desks are reluctant to forgo long positions. This is fine as long as the institutions concerned do not pose systemic risk when they fail. That is not the case in the sub-prime crisis. As Greenspan points out, banks are the biggest losers and this is what is creating problems for the world economy. It's hard to see how we can regulate banks with a lighter hand after the recent experience.