Economic Principals

So unexpected was his sentiment that at first I thought I had misheard. The speaker, a well-respected market commentator who was carving the turkey, said that gradually following George W. Bush down the "worst ever" path into history might be Alan Greenspan.

Bush was one thing; none of us around the table that evening would disagree. But Greenspan? He is more accustomed to the adulatory treatment accorded him last week by an anonymous Financial Times diarist, who relied on commentary from an embattled market participant for this Observer item:

Not everyone can be as prescient as Alan Greenspan, the former US Federal Reserve chairman, who warned of "irrational exuberance" years before the internet bubble finally burst. Take, for example, his successor, Ben Bernanke. His reading of the still-unwinding fall-out from the US subprime crisis has been less than astute, according to some commentators.

In a recent note to clients, Merrill Lynch economist David Rosenberg selected a series of quotes from Mr. Bernanke this year that might already haunt him. On February 14, for instance, he noted that "some tentative signs of stabilization have recently appeared in the housing market." Then, on March 28, he said "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained."

On May 17, the message was still relatively sanguine. "We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect any significant spill-over ... to the rest of the economy or the financial system," said the Fed chairman. And this, on June 5, shortly before the credit squeeze hit: "Fundamental factors -- including solid growth in incomes and relatively low mortgage rates -- should ultimately support the demand for housing. and at this point the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or financial system."

Even now, as investors grimly await hundreds of billions of dollars of losses on subprime debt and warnings of a recession mount, the Fed still proclaims optimism and warns against expecting rate cuts. A case of irrational calm, perhaps?

But suppose you turn this story on its head. After all, the narrator is a mouthpiece for one of the principal offenders in the subprime mess, a firm still hoping for a bailout. (Merrill Lynch already has sacked its CEO). But if Greenspan was so prescient, why did permit the housing bubble to get so out of hand, before retiring as chairman of the Federal Reserve Board in 2006?

Suppose, as my friend expects, that the credit crunch is just beginning, that the worst is yet to come. Suppose that Bernanke is still in the throes of finding out just how great is the mess that had been left him by his predecessor, the Maestro. Suppose, too, that Greenspan is working overtime to protect his reputation, and is scarcely a disinterested source of information and commentary.

Suppose, in other words, that Greenspan had been right when in December 1996, when he raised the specter of "irrational exuberance;" right, too, in facilitating the remarkable boom of the late 1990s; but wrong in thinking that central bankers don't have to worry about preventing asset bubbles. Markets around the world dropped sharply on his remarks that day -- until traders recognized that he had said just the opposite of what they had feared; that in fact he did not intend to take away their bowl of punch. (The Standard & Poor 500 Index had gone up 34 percent the year before, and would climb another 20 percent in 1996.)

Greenspan asked, "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?" He added, "We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability."

So the S&P soared 31 percent in 1997 (after a famous Business Week cover story asserted that Greenspan now believed that the US economy had entered a "new era" of enhanced productivity; 26 percent in 1998, and 20 percent in 1999. In March 2000, the market peaked. By January 2001 the economy was sliding into a recession. Congress cut taxes; the Fed cut rates to as low as 1 percent in 2003. The recession proved to shallow and relatively short-lived.

But those record low interest rates kindled the housing bubble.

To be sure, the last fifteen years have been wild and crazy times. The end of the Cold War, a decade of depression in Japan, the gold rush in the former communist countries, an impeachment trial in the United States, China's entry into global markets, the Asian financial crisis (and the meltdown of Long Term Capital Management), the specter of Y2K computer glitches, the deadlocked election of 2000, the European slowdown following monetary union, the 9/11 attacks, the invasions of Afghanistan and Iraq, the enormous US tax cuts on the eve of war. Hardly did Greenspan have a free hand. Yet, especially after 2001, he was a willing handmaiden of economic policies that have since turned out to be disadvantageous.

The question of the moment is not so much one of rampant banker greed -- Fortune asked the other day "What Were They Smoking?" -- as one of failed regulation. As recently as April 2005, Greenspan himself was touting the rapid developments in securitization that permitted US banks to write nearly a trillion dollars of subprime mortgages and sell them in impenetrable packages to financial institutions around the world.

Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country .... With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. ... [W]here once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending; indeed, today subprime mortgages account for roughly 10 percent of the number of all mortgages outstanding, up from just 1 or 2 percent in the early 1990s.

Today hardly anyone knows with any precision who owns what, much less what particular assets, once rated triple- and double-A, are worth today. Estimates of the necessary write-downs run as high as $200 or even $300 billion. The situation is reminiscent of the savings and loan crisis of the late 1980s, except that then it was decentralized S&Ls and the developers to whom they lent who bore the brunt. This time the biggest banks are at risk, some of them of outright bankruptcy; pension funds, here and abroad, will report substantial losses; and, of course, tens of millions of individual homeowners will feel the pain. Only a fraction will lose their homes to foreclosure.

The darkest possibility was hinted at last week by Paul A. Samuelson, of the Massachusetts Institute of Technology, at 92 still the greatest public policy economist of the age, writing in the International Herald Tribune:

All through the years of the Great Depression, Wall Street publicists and President Herbert Hoover would repeatedly declare: 'Recovery is just around the corner.' They were wrong. And history repeats itself....

As one of the economists who helped create today's new-fangled securities, I must plead guilty. These new mechanisms both mask transparency and tempt to rash over-leveraging....

The situation is not hopeless. New, rational regulations that discourage predatory lending and rash borrowing could help a lot. Also, as we learned during the Great Depression, the government's Treasury and its central bank must be both lenders of last resort and spenders of last resort. Speculative markets will not stabilize themselves....

Watch developments closely. If America's Christmas retail sales fail badly -- as they could when high energy prices and high mortgage costs pinch consumers' pocket books -- then be prepared to accelerate credit infusion by central banks on the three main continents.

The crisis will pass, of course, though maybe not before the next election. The lengthy period of suspense contributes to the atmosphere of danger. What's needed now -- besides forbearance and alacrity in keeping with the situation -- is narrative coherence in the broadest sense.

The last dozen years have been a spell-binding chase of one thing after another. It is easy to lose track of the broad outlines of what has happened in the world. The Cold War ended, and sovereign states beyond the United States and Europe began to grow -- China, India and Russia especially rapidly.

Yet every American war since the Revolution has ended with a memorable recession, with the interesting exception of World War II, which saw the emergence of a new sort of on-going confrontation that included Korea and Vietnam. Perhaps the frenzied decade that followed the end of the Cold War will bring a return to form, as an over-stimulated American economy finally settles on a new horizon.