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Maestro Nurtures a New Too-Big-to Fail Crisis: Simon Johnson

Just tell the government to back off and all will be fine.

That’s what former Federal Reserve Chairman Alan Greenspan seems to say in “Activism,” an article published in the Spring issue of International Finance available on the Council on Foreign Relationswebsite.

“Current government activism is hampering what should be a broad-based robust economic recovery,” he writes.

If we follow his advice this time, and if his line of reasoning prevails in the 2012 presidential election, we’ll stumble again into another boom-bust-bailout crisis.

Sometimes it seems like there are two Alan Greenspans. One is an advocate of the free market, in which all participants sink or swim. The other favors government subsidies and specific outcomes masquerading under the banner of “free markets.”

The heyday of the real free-market Greenspan was in the first months of the credit crisis in 2008. “If they’re too big to fail, they’re too big,” was his catchphrase. At that moment, he cut through the fog of crisis and articulated an impressively bipartisan view.

Many thinkers, such as Allan Meltzer (from the right) and Joseph Stiglitz (from the left), agreed with Greenspan on this and probably only this. Kansas City Federal Reserve President Thomas Hoenig and Democratic Senator Sherrod Brown were also in accord. Eugene Fama, a finance professor at the University of Chicago and the father of the efficient-markets doctrine, said on CNBC last year that “too big to fail” is “perverting activities and incentives,” giving big financial firms “a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside.”

Greenspan Failures

Anat Admati of Stanford University, along with a Who’s Who of top finance professors, has written about the need for more capital throughout the financial system, including big banks, precisely because we can’t handle the failure of major institutions. Or look at the book by Gary Stern and Ron Feldman (of the Minneapolis Fed), years ahead of its time in 2004, called “Too Big To Fail.” All the failures of the Greenspan era are foreshadowed there.

But then there is the other Greenspan, the one who was chairman of the Federal Reserve Board for almost two decades, and who is now back with a vengeance. Greenspan while in power, of course, was really a supporter of specific outcomes, even when those involved banks becoming ever larger and risks becoming more concentrated in key parts of the financial system.

Concentrated Risks

In the last decade of his watch, combined assets in the largest six bank holding companies rose from 17 percent of U.S. gross domestic product to more than 50 percent (this measure now stands at 62 percent). As Fed chairman, Greenspan presided over the demise of the last vestiges of restrictions on megabanks. The Fed implicitly blessed the build-up of concentrated risks in the form of over-the-counter derivatives such as credit-default swaps, which figured in the failures of both Bear Stearns Cos. and Lehman Brothers Holdings Inc. (LEHMQ)

This wasn’t all the Fed’s doing. The Securities and Exchange Commission was also complicit and the Treasury Department, under Robert Rubin and Larry Summers, in some instances led the charge. But Greenspan was a leading proponent of the view that if someone powerful in finance wanted to do something, that must be OK. This isn’t a view that anyone generally holds for other sectors. Even pro-business advocates say excessive concentration in one industry is bad for society and for business.

Fear of Failure

This view of finance lacks strong intellectual underpinnings. And it’s one that Greenspan himself held after the credit crisis revealed that officials fear the failure of major financial institutions.

Now, Greenspan seems to have relapsed into a form of his older self. His latest writing says the problem with the U.S. economy today is an excess of government “activism.” If only, he says, the government would back off, firms would become more willing to use their cash hoards to increase investment spending and hiring.

But Greenspan today ignores the more brutal reality: We are still experiencing the aftermath of a major financial crisis and this time isn’t different at all, as any reader of Kenneth Rogoff and Carmen Reinhart knows. Our situation is simple and sadly classic. Policy makers, led by Greenspan, allowed the financial system to become dangerous and, in some key aspects, out of control. The recovery is similar to those following almost all financial crises: When part of the financial system fails, the rest comes back only through active resuscitation.

Of course, the major questions for private industry are: Will credit collapse again, and what happens when the Fed steps back from supporting markets?

Greenspan’s argument is insidious. But this isn’t about free-markets, in the sense that all participants can fail without getting any kind of bailout. Many smart people are working hard to become or to remain too big to fail. And Greenspan is again urging us into another damaging cycle.

(Simon Johnson, co-author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown” and a professor at MIT’s Sloan School of Management, is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Simon Johnson at sjohnson@mit.edu

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net

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