Alan Greenspan Is Still Trying to Justify His Bad Decisions

What the maestro doesn't understand

by Robert M. Solow | December 16, 2013

photo credit: Getty Images

You remember Alan Greenspan: you know, the one who was chairman of President Gerald Ford’s Council of Economic Advisers from 1974 to 1977, and was then appointed chairman of the Federal Reserve Board by President Ronald Reagan in 1987, a position that he served in for nineteen years, retiring just in time for the financial crisis. His reputation as grand maestro of monetary policy and general oracle about the economy has gone downhill since then, but I think it is only fair to say that he was a very good chairman of the Fed.

Greenspan was masterly in the first two challenges that popped up during his tenure. When the stock market collapsed by almost a third one day in October 1987, the Fed did the classically right thing. It made clear that it stood ready to provide every bit of the liquidity that might be needed to keep the financial system functioning, so that anyone who acted in panic would probably live to regret it. There was no financial breakdown, and the real economy was essentially unaffected by the episode. Score one for Greenspan.

During the long Clinton-era upswing from 1992 to 2000, Greenspan and the Fed faced a much more complex problem, and again did the right thing. Nearly all of the punditry and probably most professional economists (including those in the Fed itself) believed that the key inflation-safe unemployment rate (below which inflation arrives and accelerates) was something like 6.5–7.0 percent. As the upswing continued and the unemployment rate drifted down below that level (and, you may remember, budget surpluses appeared), the Fed was beset with urgent reminders that the time had come, and maybe passed, to tighten credit and choke off the boom before the inevitable inflationary disaster arrived.

Greenspan looked at the data and the economy around him, and saw few, if any, signs of gross imbalance or impending inflation, and persuaded his colleagues to let the expansion go on. In the end the unemployment rate dipped briefly below 4.0 percent without trauma. Greenspan thought that productivity was improving faster than anyone or the conventional measurements realized, and that was what provided the room for further expansion. He was right, though there were several other factors that helped, as became clearer after the fact. Never mind: it was an exhibition of pragmatism and cool that saved the economy from wasting trillions of dollars of output in unnecessary unemployment and idle capacity.

Greenspan’s reputation has suffered from two big mistakes.

There ends the plus side of the Greenspan ledger. On the minus side, Greenspan’s reputation has suffered from two big mistakes. The first was his failure to see the importance of the housing bubble and the dangerous vulnerability of the financial mechanism that supported it. Had he done so and punctured the bubble promptly, the economy would have been spared the prolonged weakness that it is still suffering. The second was his deep-seated conviction that the unregulated financial system was self-stabilizing, that the self-interest of all those clever and experienced participants with a lot of their wealth at stake would keep the accumulation of risk within tolerable bounds. So he promoted deregulation and financial consolidation (as did others, of course) and, when this simple faith proved wrong, allowed disaster to strike. I think that the first mistake may be partially excusable, but the second mistake was a catastrophe, and it was not an accident.

Hindsight leaves no doubt that it would have been a great idea to prick the housing bubble early. But imagine that Greenspan and the Fed had done so. Suppose they had tightened credit, pushed interest rates higher, put an end to the housing boom, and thus—very likely—created a standard recession like so many of the others. They would surely have been pilloried for destroying a nice prosperity in midstream and creating painful unemployment. And for what? To prevent a later financial crisis? But no financial crisis would be actually visible, not in this version of history. How could anyone know that one had really been averted? It was still a mistake to have let the bubble continue, blandly claiming that it would be easier to pick up the pieces later on. It stands as a bad grade in the Greenspan report card. But it was not simply a matter of foolishness and ideological fantasy.

The second mistake, the bigger one, was both. An unregulated financial system, no matter how many smart people have megabucks in the game, can easily become over-leveraged and then fatally underestimate or ignore the amount of risk that financial institutions have taken on and the depth to which their risky balance sheets contaminate each other in hidden ways. When the edifice starts to collapse, central bankers and other policymakers may be left with the choice between bailing out the very people and institutions whose behavior created the crisis and letting the edifice collapse, doing even more harm to millions of people who played no active part in the disaster. The point is that this was not just a bad hair day, or one of those cases where nature presents nothing but bad options. It was a case of bad ideas coming home to roost. Greenspan was a prominent opponent of financial regulation, and it cost him (and us).


Greenspan’s new book is obviously intended to show that his errors were only partial and that he has found useful ways to correct them, and thus to refurbish his reputation as oracle-in-chief. It fails. His argument is thematically vague and analytically weak. In the end it sounds like the same old right-wing conviction that the unregulated or very lightly regulated market knows best.

Begin with the book’s title and subtitle. The analogy between a map and a theory is a useful device. Fathers-in-law are always pointing out that any economic theory ignores this or that obvious fact about the real-world economy. But a map on the scale of one to one is precisely useless. A map on the scale of one to 500,000 is useful for most purposes, but you cannot expect it to show every bend in the road or every dirt track leading north. Greenspan does not seriously discuss the goals and the limitations of reasoning about the economy. He talks some about his early life as a forecaster, and he is clear that economic policy has to be based on forecasts: policies undertaken now will have effects in the future, and sensible economic policy usually has long-run goals anyway. But the reader of this book will learn little or nothing about the process of forecasting other than that it is difficult and that the results are always uncertain. Duh.

The new Greenspan concedes that the decisions made by participants in the economy are not always governed by rational adaptation to given facts, and that this failure leads to unpredictability and instability. Instead the economist-forecaster-policymaker has to take account of “animal spirits.” (The phrase was introduced into economics by Keynes and was recently revived by George Akerlof and Robert Shiller.) This is a step in the right direction, but even here Greenspan does a poor job. He rattles off a long list of what he regards as “inbred” propensities of people and groups to behave irrationally, or at least non-rationally, in economic matters. They include fear, euphoria, aversion to risk, preference for early rewards over larger later ones, herd behavior, dependency on peers, a bias toward dealing with people close to home, competitiveness, reliance on a code of values, a bias toward one’s relatives, self-interest, and self-esteem. That comes to twelve propensities, some broad, some narrow, some vague, some precise, some important, some less so, and Greenspan says that there are more of them.

I suppose that this is progress if you had not previously realized that such tendencies are at work in economic life. For the rest of us, who knew this, it is not much help. Given a free hand with a dozen miscellaneous propensities, I can explain anything after the fact. To get anywhere, one needs an immense amount of pedestrian analysis. Under what circumstances does fear overcome euphoria, and by how much, for how long? Under what circumstances does self-interest overcome home bias, and by how much? How does competitiveness interact with this or that code of values, and how are they changed in the process? The phrase “In my experience” occurs depressingly often in the book. Greenspan’s experience and intuition are not to be sneezed at, but this is not how a serious argument is made.


How is it made? It is supposed to be done with data and statistical analysis. There is a lot of that in the book too, but most of it cannot be taken at face value. Here I have to be a little technical, but I will stretch for lucidity. Many of Greenspan’s assertions about the economy rest on a statistical technique called linear regression. Suppose that you want to study the relation between two variables—say, quarterly retail sales of strawberry jam and the average price at which it is sold. You can plot the figures for a series of quarters on squared paper: each dot shows the price and quantity for a particular quarter. You can then visualize their mutual relation, and find a line or other curve that best summarizes it, as well as various measures of how close that relation is. (All of this can be extended to more than two variables, but visualization is harder.)

That part is easy. But how do you interpret the resulting line or curve? What does it mean? What does it tell you about the market for strawberry jam? Long tradition says that price and quantity occur where “supply equals demand,” or more completely where a rising supply curve (showing how much jam will be produced at various prices) intersects a falling demand curve (showing how much would be bought at various prices). Then why don’t we observe just one price and one quantity, the same in every quarter? Obvious answer: because the supply curve shifts from time to time (good or bad strawberry crop, higher or lower wages, and so on), and so does the demand curve (consumers are better or worse off, or their feelings change about substitutes like raspberry jam and peanut butter). Each observation marks the intersection of that quarter’s supply and demand curves. So what does that line or curve that more or less connects the dots mean?

Well, it doesn’t mean much. It really cannot be interpreted just by looking at it. If you want to learn something about the market for strawberry jam, you will need a much more complicated analysis, looking closely and quantitatively at the sources of those shifts in supply and demand curves. The simple regression line is more or less uninterpretable. But many of Greenspan’s regressions are of this general kind, and fall under this general suspicion. What is strange is that he must know this: what I have just been saying is the stuff of every elementary textbook of econometrics. Many of his regressions would not be acceptable in a term paper. I suspect that what we are really being asked to rely on is “In my experience” or some such intuitive claim. The regressions are there to illustrate the interpretation, not to generate it. That is a different matter altogether, because intuitions and prejudices tend to be inseparable.


This is not just academic logic-chopping. Consider what is probably Greenspan’s most eye-catching and weighty conclusion about the way the American economy works. It connects two variables: one is “Government Social Benefit Payments to Persons,” and the other is “Gross Domestic Saving,” both expressed as percentages of GDP. Domestic Saving includes saving by households, by businesses (undistributed profits), and by governments (budget surpluses, with deficits counted negatively). The “Gross” means that no account is taken of depreciation of existing assets. Greenspan’s Iron Law is that the sum of these two numbers is approximately constant, at least for the last half-century in the United States. That is a pretty fraught claim: it means that every time the United States adds a billion dollars to Social Security benefits or Medicare payments or unemployment insurance outlays we are forcing a billion-dollar reduction in family saving or in the retained earnings of business, or an increase in government deficits, or some combination of these. Why is that so important? I’ll get to that part of the argument in a moment. It is certainly intended to impress the reader with the potential for evil of those Government Social Benefit Payments to Persons.

Alan Greenspan
Illustration by Zansky

This is perhaps the main takeaway from Greenspan’s book. So what is the evidence for it? To begin with, Greenspan shows you a graph of the time path of that crucial sum from 1965 to the present. It clearly fluctuates, but it exhibits no upward or downward trend. Is it “approximately” constant? Well, its range of fluctuation is a little more than 5 percent of GDP. That doesn’t strike me as negligible, especially when you take into account that, since 2000, each of the two constituents of the sum runs between 10 and 20 percent of GDP. In fact, when you think about it, what you see is that the Benefits component has been tending to rise gently while the Saving component has been tending to fall gently. That is no doubt interesting, and it explains why their sum has no trend, but it seems a little flimsy as support for the Iron Law that a dollar of benefits causes a dollar of saving to go away.

So Greenspan turns to a linear regression connecting Saving and Benefits. (There is a third variable, but we can ignore it for this discussion.) Sure enough, it says that on average an added dollar of Benefits is associated with about a dollar of lower Saving. But we are back in the strawberry jam situation: each of these quantities—Government Benefit Payments to Persons and Gross Domestic Saving—is the outcome of complicated economic processes. The way they move through time by themselves cannot tell us about those underlying causal factors, any more than the movement of prices and sales of jam can by themselves tell us about the supply curve and the demand curve and the events that moved them.

Looking back at the time paths themselves, we can see that there are definite business-cycle effects. Benefits rose sharply and Saving declined sharply between 2007 and 2009. Something very similar happened during the sharp recession of 1974–1975, and again, though it was maybe not so pronounced, in the recession of 1982. It is not hard to tell a plausible story: claims on benefits rise and savings fall off when the economy sinks into recession, unprofitability, and unemployment. But there is no implication that the rise in benefits causes the reduction in saving. I have already mentioned the longer-run increase in benefits and decrease in saving; but there are too many plausible stories about that to be discussed here. What emerges is that what I have called Greenspan’s Iron Law is built not so much on evidence as on ideology.


The role of saving in Greenspan’s thought is interesting because here, too, he seems to ignore certain commonplace truths. He believes that the long-run health of the American economy requires a substantial increase in the rate of private and public investment. (This means real investment in plant and equipment and not mere paper investment, although the financial system has an indispensable role to play.) For us, a rising standard of living rests on technological progress and therefore on the capital investment needed to convert new ideas into produced goods and services. There is no disagreement about this, certainly not from me. Next, all economists understand the accounting fact that in the end all real investment has to be matched either by domestic saving or by borrowing abroad. We already borrow abroad, so we can focus on domestic saving.

The mere fact that Saving and Investment as measured are defined to be equal does not mean that the amount of investment the economy does is limited by the amount of saving that is available. It emphatically does not mean that if only there were more saving there would always be more investment. In 2012, for instance, real business investment in plant and equipment amounted to 12.5 percent of real GDP. That is not bad by historical standards, but Greenspan and I wish there were more. Why are businesses not buying more plant and equipment? It is not for some lack of saving: corporations are flush with cash, and borrowing costs are historically low. No, businesses are not investing more because they have no confidence that they will be able to sell their added output of goods and services profitably. There are not many eager buyers out there or in the offing. (Of course some technology-based investment is aimed at cost-reduction and at bringing new products to market. A lot of that kind of investment is going on all the time.) Suppose that families, firms, and governments suddenly decided to save more. That is the same as deciding to spend less. There would be fewer eager buyers out there and even less incentive for businesses to invest, even in new products.

In one sense Greenspan agrees that what inhibits business investment today is “uncertainty,” but when he is specific about this it appears to be uncertainty about the future of federal regulations, the Dodd-Frank Act in particular. He can of course read tea leaves as he sees fit. Given that corporate profits are currently very high, and that neither Dodd-Frank nor other prospective regulatory changes are likely to be draconian, I think it is much more plausible that the uncertainty that matters is about the level of demand, here and in potential export markets.

In better times, when the economy’s capacity to produce is being fully utilized, then indeed it will be true that investment is limited by saving. In a fully employed economy, if businesses want to buy more plant and equipment, the production of other goods, primarily consumer goods, will have to fall in order to make room. That is precisely to say that there will have to be more saving. There is good cause to worry about the low and falling saving rate of the American economy, but there is more urgent cause to worry about restoring the economy to full employment, and it is clear where the priority lies. There is certainly no excuse for confusing the two kinds of situation.


I mentioned earlier that a government budget deficit is a form of negative national saving. So reducing a budget deficit (or increasing a surplus) amounts to increased saving. The same logic applies: deficit reduction is bad policy in an economy that is not fully using the productive capacity it already has. What that economy needs is more buyers, not fewer. Deficit reduction can be good policy, growth-promoting policy, when the economy is fully employed and needs to generate new capacity.

All of this has to be old stuff to Alan Greenspan, and it is a puzzle why he evades it, unless his goal is ideological rather than analytical. There is no point in appealing to “the long run.” The long run is not some particular time in the future. Every quarter, every year, is the short run when it is happening. What economists usually mean when they say that something will be true in the long run is “when the economy has settled down to a well-behaved equilibrium,” which is almost always characterized by some approximation to full utilization.

There is another side to this central (unproved) claim that social benefits crowd out national saving dollar for dollar. The upper income groups pay most of the government’s income tax revenues. Most social benefits go to recipients lower down in the income distribution. So, even apart from deficit finance, social benefits are a transfer of income from richer people to poorer people, which is indeed their purpose. But the well-off save a substantial part of their (after-tax) incomes, while the poor naturally spend all or most of what they get (which is indeed the purpose). Social benefits are not only a transfer from richer to poorer, they are a transfer from saving to consumption.

According to Greenspan, this transfer is more than bad macroeconomic policy, it is an injustice. “In a free competitive market,” he writes, “incomes earned by all participants in the joint effort of production reflect their marginal contributions to the output of the net national product. Market competition ensures that their incomes equal their ‘marginal product’ share of total output, and are justly theirs.” I have already argued at length that the claim about macroeconomic policy is incorrect. So is the claim about justice.

Students of economics are taught that the outcome of a system of free competitive markets is (under certain conditions) “efficient.” That means only that no rearrangement can make one participant better off without making some other participant worse off. They are also taught that the actual outcome, including the relative incomes of participants, depends on “initial endowments,” the resources that participants bring when they enter the market. Some were born to well-off parents in relatively rich parts of the country and grew up well-fed, well-educated, well-cared-for, and well-placed, endowed with property. Others were born to poor parents in relatively poor or benighted parts of the country, and grew up on bad diets, in bad schools, in bad situations, and without social advantages or property. Others grew up somewhere in between. These differences in starting points will be reflected in their marginal products and thus in their market-determined incomes. There is nothing just about it.

Students of economics are taught about the efficiency of competitive markets, and they are also taught that judgments about “social welfare” or justice have to come from some other source. Here I have to introduce a question that I am not the best person to discuss. It is sometimes claimed that Alan Greenspan is a closet follower of Ayn Rand; he certainly had an early association with her circle. I got through maybe half of one of those fat paperbacks when I was young, the one about the architect. Since then I have found it impossible to take Ayn Rand seriously as a novelist or a thinker. In the past I have gone on the assumption that Greenspan’s ideas about economic life are his own, just what is contained in his writings, and the Ayn Rand question does not arise. But now there is this book, with its particular misinterpretation of mainstream economics, which might be thought to reopen the question if anyone is interested.

Anna Rosenberg Hoffman once said to me, when I was prattling on about what “the data” said: “What are you going to believe, the data or your eyes?” A hard choice. The Alan Greenspan I admired was a pragmatic central banker who was able to believe both the data and his eyes and to ignore the people who already knew the answer without looking. The author of this book makes a show of both, but not really. His eyes are too often closed and he seems to be listening to another voice, with quite conventional opinions, coming from somewhere stage right. 

Robert M. Solow is Institute Professor of Economics emeritus at MIT. He won the Nobel Prize in Economics in 1987.

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