Greenspan Embraces "Regime Uncertainty" Explanation
By David Henderson
In a recent e-mail alerting me to an important 2011 piece by Alan Greenspan that I somehow had missed (“Activism,” International Finance 14:1, 2011: pp. 165-182), Jeff Hummel writes the following:
One of the unusual features of the current recession is the long persistence of high unemployment. Despite the claims of Carmen Reinhart and Kenneth Rogoff, deep recessions accompanied by financial panics are usually followed by steep and rapid recoveries, at least in U.S. history, with the exception of the Great Depression. (This was demonstrated in a paper by Michael Bordo and Joseph Haubrich.) Most explanations for the current persistence of high unemployment fall into one of three broad categories:
1. Insufficient aggregate demand. This is the position of the Sumnerites who advocate more monetary stimulus and the Keynesians who advocate more fiscal stimulus. While I agree with Scott Sumner that Bernanke’s monetary policy was too tight when the crisis hit during 2007-2009, I think that is irrelevant now. Why hasn’t there been sufficient time for inflexible wages or prices to adjust?
2. Structural unemployment. This is the explanation offered in different forms by Arnold Kling, Tyler Cown, and others. Although I agree with Bryan Caplan’s critique that inflexible wages are still necessary for this explanation to work, it does provide some basis for the persistence of the inflexibility. But that only pushes the question one step back; why is the amount of structural unemployment so much greater in this recession than in past recessions?
3. Regime uncertainty caused by government activism. This is the thesis developed by Robert Higgs to explain the length of the Great Depression, and he has invoked it for the recent recession.
Now to the Greenspan piece. Although he does not use the words “regime uncertainty,” a term introduced by Robert Higgs to describe what he believes led to the slow recovery from the Great Depression, Alan Greenspan endorses regime uncertainty as an explanation of the U.S. economy’s slow recovery from the recent recession. Some choice excerpts follow.
From his abstract:
I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s. I conclude that the current government activism is hampering what should be a broad-based robust economic recovery, driven in significant part by the positive wealth effect of a buoyant U.S. and global stock market.
For non-financial corporate businesses (half of gross domestic product), the disengagement from illiquid risk is directly measured as the share of liquid cash flow they choose to allocate to illiquid long-term fixed asset investment (henceforth, the capital-expenditure, or ‘capex’, ratio). In the first half of 2010, this share fell to 79%, its lowest peacetime percentage since1940.
His bottom line:
That non-financial business had become markedly averse to investment in fixed, especially long-term, assets appears indisputable. But the critical question is, why? While most in the business community attribute the massive rise in their fear and uncertainty to the collapse of economic activity, they judge its continuance since the recovery took hold in early 2009 to the widespread activism of government, in its all-embracing attempt to accelerate the path of economic recovery.
Greenspan’s version of Harold Demsetz’s “Nirvana Fallacy:”
Regrettably, the evidence is such that policy makers and economists can harbour different, seemingly credible paradigms of the forces that govern modern economies. Those of us who see competitive markets, with rare exceptions, as largely self-correcting are most leery of government intervening on an ongoing basis. The churning of markets, a key characteristic of ‘creative destruction’, is evidence not of chaos, but of the allocation of a nation’s savings to investment in the most productively efficient assets – a necessary condition of rising productivity and standards of living. But human nature being what it is, markets often also reflect these fears and exuberances that are not anchored to reality. A large number, perhaps a majority, of economists and policy makers see the shortfalls of faulty, human-nature-driven markets as requiring significant direction and correction by government.
The problem for policy makers is that there are flaws in both paradigms. For example, a basic premise of competitive markets, especially in finance, is that company management can effectively manage almost any set of complex risks. The recent crisis has cast doubt on this premise. But the presumption that intervention can substitute for market flaws, engendered by the foibles of human nature, is itself highly doubtful. Much intervention turns out to hobble markets rather than enhancing them
His incredibly strange, incorrect statement:
For the second half of the 20th century, Americans, belatedly dismayed with the restraints of regulation, dismantled most controls on economic activity.
Where is the uncertainty?
It is impossible to judge the full consequences of the many hundreds of mandated rulemakings required of financial regulators in the years ahead by the Dodd-Frank Act. The degree of complexity and interconnectedness of the global 21st century financial system, even in its current partially disabled form, is doubtless far greater than the implied model of financial cause and effect suggested by the current wave of re-regulation. There will, as a consequence, be many unforeseen market disruptions engendered by the new rules.
Greenspan’s Little Bit of Hope:
However, the political kick-back on federal ‘bailouts’ (and activism generally) may dissuade policy makers from a repetition of the large-sized interventions of the recent past. And if indeed the current crisis is a once-in-a-century event, the current ‘anything goes’ regulatory ethos in a crisis could eventually fade and deficits may undergo contraction. Importantly, any withdrawal of action to allow the economy to heal could restore some, or much, of the dynamic of the pre-crisis decade, without its imbalances.
Note: I am on vacation at my cottage in Minaki, Canada, which explains my less-frequent posts and my less-than-usual replies to commenters.
Update: Before posting this, I decided to check quickly, given my limited connectivity, what other bloggers were saying about Greenspan’s piece. Here’s Brad DeLong.