A Critique of Alan Greenspan’s Retrospective on the Crisis
Posted: 29 Jul 2010
Date Written: July 29, 2010
Alan Greenspan’s paper (March 2010) presents his retrospective view of the crisis. His theme has several parts. First, the housing price bubble, its subsequent collapse and the financial crisis were not predicted either by the market, the Fed, the IMF or the regulators in the years leading to the current crisis. Second, financial intermediation tried to function on too thin layer of capital – high leverage – owing to a misreading of the degree of risk embodied in ever more complex financial products and markets. Third, the breakdown was unpredictable and inevitable, given the “excessive” leverage – or low capital – of the financial intermediaries. Greenspan now focuses on desirable capital requirements for banks and financial intermediaries. Too high a capital requirement will not provide a sufficiently high rate of return on financial assets to attract capital. Too low a capital requirement unduly raises risk and endangers bank solvency.
The Fed, IMF and Treasury and the market lacked the appropriate tools of analysis to answer the following questions: what is an optimal leverage or capital requirement that balances the expected growth against risk? What are theoretically founded early warning signals of a crisis? I explain why the application of stochastic optimal control (SOC)/dynamic risk management is an effective approach to determine the optimal degree of leverage, the optimum and excessive risk and the probability of a debt crisis.
The theoretically derived early warning signal of a crisis is the excess debt ratio, equal to the difference between the actual and optimal ratio. The excess debt starting from 2004-05 indicated that a crisis was most likely. This SOC analysis should be used by those charged with surveillance of financial markets.
Keywords: Greenspan, Capital Requirements, Stochastic Optimal Control, Warning Signals of Crisis, Optimal Leverage and Debt Ratios, Bubbles
JEL Classification: C61, G11, G12, G14
Suggested Citation: Suggested Citation