Greenspan reveals his ignorance

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With his limited understanding of things financial, Greenspan should never have been Fed chairman. Bernanke is the same.

Greenspan said: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief.” He’s not Claude Rains, either. He really is shocked.

He’s shocked that banks overextended themselves into risky loans? Under his oversight? Some at least of the major bank failures in 1930 had the same factor involved (Caldwell and Company, Bank of the United States). Foreign banks that lent long-term to industry and also bought industrial stocks ran into solvency problems too.

The fact is that in any central banking system, there is no economic check on extending risky bank loans when the whole system has a single currency. Member banks can piggyback or pyramid loans (and thus grow demand deposits) on their reserves with the central bank. With a central bank in place, it is not only a question of inflation and greater capability of making loans, it is also a question of making more risky loans; for a bank can always go to the discount window or count on the Fed flooding the whole system with reserves. And deposit withdrawals are a non-factor as a check on risky bank lending because of deposit insurance. A gold standard may possibly hamper this over-extension, but not if the central bank neutralizes it. In 2008, we do not even have a trace of a gold standard, so there is no real check except regulatory oversight. The deposit insurance guarantee merely amplifies the banks’ tendency to overextend loans to risky ventures and securities.

The overseers of the banking system like Greenspan thought that banks would not overextend because of the risk that the equity would be wiped out. If he understood finance, he’d know that in a levered capital structure like that of banks, the managers have an incentive to take more risk. They roll the dice while collecting big salaries and stock options. If they win, they get big payoffs from the options. If they are too big to fail, the Fed or FDIC (and now the Treasury and tax payers) will bail them out when they lose. They may even retain their jobs.

10:50 am on October 23, 2008