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Sunday, June 19, 2011

Mind-Games: On the Self-Regulatory Market

Two days after the LTCM bailout was agreed to in 1998, a worried Alan Greenspan, leaning toward raising rates at the time, cut the federal funds rate. It was not enough to calm the markets, and he cut it again three weeks later. . . . It was not the self-correcting powers of the markets but aggressive central bank intervention plus a new round of irrational speculation that provided a floor under the downward financial prices and the calamitous consequences of bad Wall Street decisions. It was not even the LTCM rescue alone by private banks that saved Wall Street” Madrick, p. 281).
“Alan Greenspan learned no lessons from these events about the inherent instability of a completely free market in finance. He still insisted markets regulate themselves” (Madrick, p. 282).
Analysis:
Milton Friedman believed that government regulation keeps markets from being efficient; he assumed that the market mechanism is capable of regulating itself. That increasing uncertainty and risk might reach a point that a market mechanism would freeze up, or collapse, rather than simply incorporate the increased volatility through pricing is a point extrinsic to the efficient market thesis. That theory submits that markets tend toward equilibrium, rather than spiraling out of control.
Testifying before Congress after the credit crisis of 2008, Alan Greenspan was asked by Henry Waxman (D-Calif) whether the government-averted credit-market collapse had prompted any revision of the retired Fed Chairman’s economic paradigm. Greenspan admitted to a flaw in the ointment of self-regulatory market theory. In spite of 40 years of evidence to the contrary, official Washington’s font of economic wisdom had drawn a blank.
Lest the human mind be left without an operative paradigm by which one can make sense of the world, by mid June 2011, Greenspan had mentally reduced the fly in the ointment to a mere footnote. Asked by Charlie Rose on The Charlie Rose Show what how the crisis had changed his understanding of the market mechanism and economics, Greenspan admitted his surprise that bank CEOs do not always operate their banks so as to keep them solvent. This is how the financial crisis of 2008 had changed his view of the market mechanism after all. Of course, such a fault could be attributed to distortive government regulation (e.g. regulation Q limiting deposit interest) rather than to some inherent weakness in the market mechanism being able to regulate itself.
Greenspan had backtracked; he had unlearned his lesson much like an alcoholic “forgets” that he or she has admitted to having a drinking problem.  Faced with a fundamental flaw in a paradigm on which it relies, the human mind can succumb to retreating to the safety of denial. In his Structure of Scientific Revolutions, Thomas Kuhn tells us that it can be a generation before the downfall of a reigning paradigm is finally recognized, after the current proselytizers have passed and the people to come, without a vested interest in the prevailing paradigm, have taken their place. Perhaps it is only the human mind writ large (i.e, intergenerational) that advances, or really learns.
Lest we have to wait for the dead to bury themselves, we can affirm and acknowledge right now that the market-mechanism is not inherently self-regulating, and that this flaw is not caused by government regulation. Instead, markets can collapse—just as a human being freezes up from fear when risk and uncertainty hit a certain threshold—only to be revived by governmental intervention.  

Source:
Jeff Madrick, Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present (New York: Alfred A. Knoff, 2011).