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In his recent essay “Never Saw It Coming” (November/December 2013), Alan Greenspan makes two central arguments: first, that virtually no one foresaw the 2008 U.S. financial crisis and, second, that irrational “animal spirits” were the root cause. If true, these propositions would absolve policymakers such as Greenspan of blame. But neither holds water.
The truth is that many experts worried about the U.S. housing bubble and predicted a crash, even if they couldn’t pin down its timing or severity. As early as 2002, Congress summoned Greenspan himself to discuss “the possible emergence of a bubble in home prices,” a concern he repeatedly dismissed. A year later, the economists Robert Shiller, who won last year’s Nobel Prize in Economics for his work on financial crises, and Karl Case voiced just that worry. Also in 2003, 50 of the top U.S. newspapers ran a combined 268 stories referencing a “housing bubble.” By 2005, they had run an additional 1,977 such stories.
What turned the eventual bursting of that bubble into the worst financial crisis since the 1930s was not animal spirits but unregulated derivatives -- complicated financial instruments whose value is “derived from” an underlying asset. Some derivatives, such as corn futures, can help economic growth, but that did not happen here. In the case of home mortgages, financiers bundled millions of toxic loans using the mortgage income as supposed backing. Then, they created a second layer of derivatives supposedly based on the value of the first set, and so on. In the end, the total package -- built on such strange-sounding concoctions as “synthetic collateralized debt obligations” and “naked credit default swaps” -- had a face value of $35 trillion, 14 times the value of the mortgages supposedly backing them. This explains why the 2008 financial crisis was so much larger than the housing crash that triggered it.
Greenspan was one of the chief advocates of deregulating finance, including derivatives. Testifying before Congress in 2005, he asserted that even if home prices declined, they “likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages make it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.”