THE STASH OCTOBER 2, 2009
So I was anticipating this post from the moment Felix Salmon sat down in front of me during Alan Greenspan's talk at today's Aspen Institute/Atlantic conference in Washington. And he doesn't disappoint, particularly on the subject of derivatives. Greenspan said that, yes, there were problems with credit default swaps (basically, insurance on bonds and bundles of mortgage-backed securities--the kind of thing that brought down AIG Financial Products). But he warned us not to get carried away: "I’m saddened by the fact that the problems in CDS have been generalized to all financial derivatives," he said. For example, Greenspan argued that there haven't been any real blow-ups with interest-rate or foreign-exchange derivatives.
To which Salmon replies:
Given the extreme measures which have been taken by the world’s central banks, and given the fact that global capital imbalances remain enormous, there’s clearly a lot of tail risk in the interest-rate and fx [foreign exchange] markets. If volatility there spikes in some unprecedented way — which is entirely possible — then no one knows who could end up becoming spectacularly unstuck in those markets.
The only thing I'd add is that there was, if not quite a contradiction, then at least a real tension between Greenspan's blithe reassurances about derivatives and his broader comments on regulation, the gist of which was that regulation works best when it doesn't depend on the regulators' forecasting ability. Here's what he said (more or less--these are contemporaneuous notes):
You can regulate effectively if you do not require a forecast. With capital [i.e., higher capital requirements for financial institutions, which Greenspan supports], there's no forecasting problem. There's just an examination. ... When you’re dealing with issues which require a forecast, the best forecaster is right 70% of the time… You may be wrong more often than not. ... The idea that you can get regulators to spot the next crisis misunderstands what a crisis is. By definition, a crisis is a discontinuous break in asset prices… It's unexpected. … Before the crisis, everyone expected the source of the next crisis to be the American current account deficit, problems with the dollar. …
That all makes a lot of sense to me. I share his skepticism of regulators' ability to spot problems in advance, and I too prefer that we implement reforms that don't rely on regulators' collective wisdom. But here's the thing: If I were so down on our ability to anticipate the next crisis, or even the source of the next crisis, I'm not sure I'd be so outspoken about the wonders of interest-rate and foreign-exchange derivatives, which, as Salmon says, could easily lead to another global meltdown. To the contrary, I'd be trying to come up with the sorts of "dumb" regulatory changes (dumb in that they don't rely on regulators' omniscience--things like tighter restrictions on leverage, mandatory centralized clearing, etc.) that would make such meltdowns less likely, and less damaging if they arise.
Now, maybe Greenspan supports that stuff, too. But, if so, you could hardly tell from his derivatives boosterism.