The structure of credit always rests on three legs:
- The power and willingness of financial intermediaries to create the securities that savers and speculators seek to hold.
- The possession by counterparties of the income streams to make good the cash flows the securities promise.
- The underlying real values to make good pledges even should the income streams of counterparties vanish.
There are thus three kinds of raid on financial markets:
- Securities that are not what savers and speculators were led to believe they were.
- Counterparties who do not in fact have the income streams they said they did.
- Underlying assets that are not worth the values they were pledged for.
Alan Greenspan class that these three types of fraud on the market are not the business of central bankers and other financial regulators, but only of prosecutors, juries, and judges. The word "fraud" appears three and only three times in his new book, The Map and the Territory. And each time the only thing he has to say about fraud is that it was not and is not any of his business:
Parenthetically, I do not consider addressing fraud to be regulation. Rampant fraud can significantly diminish the effectiveness of market competition, but fraud is theft and an issue of law enforcement...
Much, though not all, of what advocates of broadened oversight of finance are combating falls under the scope of fraud. Again, this is not the province of regulation but of enhanced law enforcement. Misrepresentation, the major source of consumer complaints, is fraud and should be readily addressed in more widespread enforcement of existing law...
The dot-com and housing bubbles bred much fraud, much of which, I suspect, to date, has gone undetected. We will never be able to fully prevent such wrongdoing. Its malignant roots are too deeply embedded in our nature. So is our inbred sense of justice in seeking to punish wrongdoers. But regulatory punishment of bubble malfeasance, beyond proven criminal fraud, which of course should be vigorously prosecuted, does little to restore our economy to where we would like it to be. Revenge may be soul satisfying, but it is rarely economically efficient...
Alan Greenspan is wrong. Fraud was and is his business. The stability of the entire credit system depends on their not being even one type of fraud--and the Federal Reserve he oversaw tolerantly watched the growth of all three in his last years as Chair. His complaisance at fraud--his never drawing the connection between fraud and securities that were not what they were said to be, counterparties without the incomes they claimed to have, and underlying assets that were not worth what they were pledged--and thus the stability of the financial system--is the reason why history will judge that he was profoundly unsuited to head a central bank, that four presidents were unwise to nominate and four senates unwise to confirm him, and that his reputation is today in shreds.
Larry Summers politely hints at the problem in his Financial Times review of The Map and the Territory:
[Greenspan] sidesteps the issue by asserting his focus on regulation, rather than fraud.... But matters may not be so simple.... [P]eople can be manipulated without being defrauded. If, as J.K. Galbraith observed, "Conscience is the knowledge that someone is watching", then questions of regulation and fraud are closely related...
Let me sharpen that: Greenspan sidesteps criticism that he should have done more to protect consumers in the run-up to the financial crisis by asserting that his focus is on systemic regulation rather than fraud. But only when regulation is inappropriately lax does fraud become more than small-scale froth. And once fraud becomes more than small-scale froth--once it becomes a mass-production industry--dotting the regulatory i's and crossing the regulatory t's does nothing to control systemic risks. For large-scale fraud means that the underlying asset values and income streams that are supposed to back financial claims do not exist. And the recognition that they do not exist is the collapse of trust in the web of financial intermediation that is a financial crisis, which can become devastating.
In retrospect, Greenspan belief that adults should rely on prosecutors to protect themselves against 419, AAA-ratings, and other frauds rather than being able to rely on regulators to police that values are what people say they are was a huge howler. It made Alan Greenspan a bad choice to run the Federal Reserve in the 2000s. His lack of concern with fraud in the 2000s has to be classified now as an economic-more-than-felony. Here, I think, Greenspan's Randite roots have led him astray: for Greenspan, there is moral value in not protecting people from the consequences of their actions--and "consequences of their actions" appears, for Greenspan, to include falling victim to fraud.