In a recent paper, former chairman of the Federal Reserve, Alan Greenspan argues that monetary policy didn’t contribute significantly to the housing bubble; he lays most of the blame on a glut of global saving that lowered interest rates worldwide. He also argues that if the Fed had tightened more in response to “irrational exuberance” it would have damaged the real economy at a time when overall inflation was under control. He provides some empirical evidence to support these arguments but I still find it hard to believe that the fed funds rate didn’t affect longer-term rates, including ARMs, and thus the housing market. But he makes a good point when he argues that it’s hard for central bankers to deliberately burst a bubble when the real economy seems to be doing well – even though in retrospect it might have been less harmful if we had had a moderate recession earlier in this process, thereby potentially forcing some much earlier deleveraging without the disastrous effects we later experienced. His argument that higher capital requirements and contingent debt along with “living wills” spelling out how a firm will unwind if disaster strikes all seem like good ideas. He is opposed to the idea of a systemic regulator on the grounds that it’s impossible to foresee when a “black swan” is going to appear.
One of the most interesting portions of the paper is called “the purpose of finance.” Here, he argues that the sector is vital to efficiently funneling saving into productive investments. He notes that the sector has grown as a share of GDP over recent decades but not because more assets are under management. The question that intrigues me is whether the productivity gains in the real economy are linked in any way to the growth of this sector – perhaps because of greater complexity and the need for greater skill in managing the process – or whether the sector has reaped big rents because of the scarcity of what I would call “reputational capital” and the inelasticity of the demand for its services. It may be some of both but rents are, in my view, a big part of the picture. Investment bankers earn rents for the same reason that real estate brokers earn rents: their fees are a small portion of the total cost of the deal and no buyer wants to risk engaging a new or unknown entrant into the field with a big and important transaction.