The Tragedy of the Commons Still Holds

Last week, former Chairman of the Federal Reserve Alan Greenspan dropped a series of epically-proportioned bombshells on fanatical free market ideologues and Republican politicians. The man at the helm of the Fed for 18 years - and one of the heroes of financial deregulation - admitted that he had been wrong to believe that self-regulation was the best way to police the excesses of America's financial sector. Mr. Greenspan, testifying before the House Committee on Oversight and Government Reform, said in reference to the current financial crisis, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief."

Mr. Greenspan further conceded, in an exchange with committee chairman Henry Waxman, that his personal faith in the ideology of Milton Friedman had led him to ignore sound advice on regulation:

“You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others,” said Representative Henry A. Waxman of California, chairman of the committee. “Do you feel that your ideology pushed you to make decisions that you wish you had not made?”

Mr. Greenspan conceded: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.”

Chairman Greenspan's final salvo was reserved for Republicans, who have attempted to provide political cover for the collapse of modern conservative ideology as it applies to Wall Street by attempting to lay the financial crisis at the feet of Fannie Mae and Freddie Mac, focusing on Democratic resistance to reform of those two quasi-public companies:

But Mr. Greenspan, who was first appointed by President Ronald Reagan, placed far more blame on the Wall Street companies that bundled subprime mortgages into pools and sold them as mortgage-backed securities. Global demand for the securities was so high, he said, that Wall Street companies pressured lenders to lower their standards and produce more “paper.”

“The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of the crisis) would have been far smaller and defaults accordingly far lower,” he said.

While all of this is edifying, what is most striking about Alan Greenspan's mea culpa is the willful blindness that apparently underpinned his thoughts on deregulation. In a speech at Georgetown University earlier in the month, Mr. Greenspan made it clear even then that he placed no value on market regulation:

“In a market system based on trust, reputation has a significant economic value,” Mr. Greenspan told the audience. “I am therefore distressed at how far we have let concerns for reputation slip in recent years.”

He reiterated these same sentiments throughout his tenure as Fed chief, and, in direct response to a 1994 congressional study that identified "significant gaps and weaknesses" in the regulation of the derivatives market, noted:

Risks in financial markets, including derivatives markets, are being regulated by private parties... There is nothing involved in federal regulation per se which makes it superior to market regulation.

Flatly, only a naif with no knowledge of human nature or history - or a corrupt shill - would look at Wall Street, and think to himself, "Yes. These guys are all about collective responsibility." The crucial - but obvious - thing that Mr. Greenspan missed (or refused to see) was that, for those most concerned with amassing as much wealth as possible in as short a period as possible, it is only the appearance of responsibility that has economic value.

The absence of regulation creates a lack of transparency that makes it impossible to tell if an institution is exercising real responsibility or merely cultivating the image of doing so. As long as there was no requirement for genuine accountability - and as long as there were enough people driven by greed to the exclusion of all else - investors were left to cross their fingers that financial institutions were sound, and it was only a matter of time before the meltdown we are seeing today took place.

As infuriating as this is however, it is no more maddening than the fact that Mr. Greenspan himself warned that derivatives could magnify financial crises because they link the fortunes of seemingly independent institutions:

“The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence,” he said... But he called that possibility “extremely remote,” adding that “risk is part of life.”

He was amazingly prescient in his analysis of the inherent risks, but just as amazingly tin-eared on the odds of catastrophe.

For all of the smoke and mirrors surrounding the alleged complexities of derivatives and the financial meltdown, there is a very simple fundamental question here that was either ignored or overlooked. Specifically, if derivatives like mortgage-backed securities are instruments for transferring risk (and making money in the process), and the market is driven by self-interest manifested as the desire to accumulate profits (in the best tradition of Milton Friedman), what other outcome, other than eventual collapse, was there going to be if risk was effectively removed as a consequence to either short term finances or institutional reputations?

The idea that one party can lend money to another that it has no intention of - or even concern about - ever collecting, and that this practice can be made the norm, is patently ludicrous. While Mr. Greenspan's assessment that risk is "part of life" is dead on, he missed the obvious fact that if everyone wrongly believes there is no risk to themselves in a given pursuit, it encourages risky behavior on the part of an increasing number of people. The distribution or sharing of risk, then - as in the securitization of subprime mortgages - becomes meaningless; in the aggregate, once past a point of equilibrium, more people taking lots of small risks is no better than a few people taking horrendous gambles. Regulation is designed to ensure that such tipping points are never reached. Without it, the market frequently over-corrects, destroying lives, wealth and sometimes even the entire economy as it seeks to stabilize on its own.

Although the bloom is clearly off the rose of Alan Greenspan's legacy, even his meager acknowledgment that he was culpable in bringing about the current crisis on Wall Street through blindered ideology is at least laudable. Personally, my impression of Mr. Greenspan is that he is an honorable man who did what he thought was best; unfortunately, what he thought best was too-easily recognizable as foolhardy to have been left unchallenged as it was. But while his good intentions and his narrow admission of complicity place him head and shoulders above the rest of the right wing cult of no-accountability, the terrible damage from his steady determination to let the foxes police the hen house remains.

All of this is not to say that free markets don't work; they do, but they are cold and dispassionate beasts with no affection for people. A market will indeed naturally seek balance if left to its own devices, but it will also often inflict tremendous human costs in the process. The tragedy of the commons - in which individuals acting independently in their own self-interest ultimately destroy a shared resource from which they mutually benefit - cannot be averted through laissez-faire policy, and we are facing dire consequences in order to prove once again a lesson we should have learned for good, a long time ago.