Greenspan: But the way up was sooooo good!

Alan Greenspan, in an incredibly candid moment about the incentives he faced as Fed Chairman:

The Fed’s “easy money” policy created an excess of cash that inflated equity and asset prices, leading to both the technology bubble of the late 1990s and the housing bubble in this decade.

While Mr. Greenspan acknowledges that he could have done something to avert the housing crisis, he contends his hands were tied.

“If we tried to suppress the expansion of the subprime market, do you think that would have gone over very well with the Congress?” Mr. Greenspan said. “When it looked as though we were dealing with a major increase in home ownership, which is of unquestioned value to this society — would we have been able to do that? I doubt it.”

Mr. Greenspan said that if he had taken steps to prevent the crisis, the outcome would have been painful.

“We could have basically clamped down on the American economy, generated a 10 percent unemployment rate,” he said. “And I will guarantee we would not have had a housing boom, a stock market boom or indeed a particularly good economy either.”

But Greenspan also almost stumbles onto the explanation to why the rating agencies' ratings failed so poorly, attributing it to "the Good Housekeeping seal of approval" as opposed to what it really was – Basel I and II requirements:

Mr. Greenspan also lays the blame on the ratings agencies and the people that trusted their judgment for the proliferation of the mortgage derivatives that were a major part of the current financial crisis.

“What we have created in this world is an aura around the credit rating agencies about certification from them is the Good Housekeeping seal of approval,” Mr. Greenspan said. “I will tell you the record of a lot of the forecasters of ratings have not been distinguished. They never were.”

Calomiris explains how the government essentially gave up regulatory power to the ratings agencies:

Unlike typical market actors, rating agencies are more likely to be insulated from the standard market penalty for being wrong, namely the loss of business. Issuers must have ratings, even if investors don’t find them accurate. That fact reflects the unique power that the government confers on rating agencies to act as regulators, not just opinion providers. Portfolio regulations for banks, insurers, and pension funds set minimum ratings on debts these intermediaries are permitted to purchase. Thus, government has transferred substantial regulatory power to ratings agencies, since they now effectively decide which securities are safe enough for regulated intermediaries to hold.


Ironically, giving rating agencies regulatory power reduces the value of ratings by creating an incentive for grade inflation, and makes the meaning of ratings harder to discern. Regulated investors encourage grade inflation to make the menu of high-yielding securities available to them to purchase larger. The regulatory use of ratings changed the constituency demanding a rating from free-market investors interested in a conservative opinion to regulated investors looking for an inflated one.

The problem here is that the government realizes that it cannot itself tell investors which financial products are good investments, so rather than realize that that's something that has to be left up to the market, they close their eyes, hand power off to the ratings agencies, and hope it all turns out okay. Surprise, it didn't!