Greenspan's principal-agent problem (24 Oct 2008)

Former Fed chairman Alan Greenspan testified in Congress yesterday on his contributions to the current financial crisis. To the surprise of virtually everyone, he admitted fault. House Oversight Committee chairman Henry Waxman basically told him that he was making decisions ideologically and that his ideology was inadequate; Greenspan admitted it was true.

“I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms,” Mr. Greenspan said. Referring to his free-market ideology, Mr. Greenspan added: “I have found a flaw. I don’t know how significant or permanent it is. But I have been very distressed by that fact.” Mr. Waxman pressed the former Fed chair to clarify his words. “In other words, you found that your view of the world, your ideology, was not right, it was not working,” Mr. Waxman said. “Absolutely, precisely,” Mr. Greenspan replied. “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.”

This is flabbergasting, most of all Greenspan's claim that he believed that the "self-interest of organizations" would protect shareholders. It's almost as if he'd never heard of the principal-agent problem. Bankers make big bonuses when they take big risks and increase revenue; those risks are in the interests of their bonuses, not in the shareholders' long-term interests. And what's more, shareholders had even less idea of what was happening on trading floors with respect to derivatives and securitizations and the whole alphabet soup of financial arcana. Management was making bets with shareholder's equity. Incentives were misaligned. It was only a matter of time before the whole system melted down. But this isn't the failure of the "free market," at least how your average free-market ideologue would understand it. Dean Baker explains how Greenspan's testimony makes him a faux Randian. Ayn Rand would say be as greedy as possible and let shareholders look out for themselves, if they can. And the fee market ideologue would say those who fail, fail; they don't get bailed out. But that is not what was happening on Wall Street, which is not the "free market". It's not free because the government and taxpayers were tacitly paying for it all along:

The banks were able to get access to vast amounts of capital because everyone had faith in the "too big to fail" doctrine. In other words, all the people who lent Bear Stearns, Lehman, AIG, Goldman and the rest money felt secure because they thought the government would come to the rescue at the end of the day if the hotshots messed up big time.
With the exception of Lehman Brothers, these folks were right. The Wall Street hotshots were gambling not only with their shareholders' money, but they could also count on the security blanket of a government bailout if they really got into trouble. In other words, they were gambling with the taxpayers' money also.
This is important because the Wall Street hotshots didn't have and don't want a free market. They want to be able to take big risks with other people's money, both their shareholders and the taxpayers.

The point, as always, is that talk of "free markets" is a disguise for trying to slant the markets in your favor. The same goes for "spreading the wealth," as Will Wilkinosn explains: "democratic politics just is a wealth-spreading exercise, and there’s no avoiding it. If you’re gonna pick sides, you’re just picking your favorite redistributive poison."

Judging by what has happened to income distributions over the past eight years, Republicans want to spread it up, concentrate it in the hands of the established and already well-connected. Democrats -- I hope -- intend to spread it around.