'I made a mistake' admits Greenspan

Financial Times reports Greenspan as having made the following comment during hearings at Capitol Hill: "I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders".

Greenspan is viewed by many as an oracle-type personality, but I have had misgivings against him (against the Fed (of which he was chairman), to be precise) for the following reason:
During the 18 year period when Greenspan was at the helm, whenever a crisis arose, the Fed came to rescue by significantly lowering the Fed Funds rate, often resulting in a negative real yield. The Fed did so after the 1987 stock market crash, the LTCM debacle, and the Nasdaq bubble burst. The Fed's pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. The result - every time the Fed put was in action, the bubbles just shifted from one asset class to another and kept becoming bigger. I had warned that the Fed's action of cutting interest rates in 2007 would not solve the issue, but would just postpone it and in the process create additional bubbles. I was right - Fed's action did create a bubble in commodities and emerging market equities. These bubbles have burst now, creating havoc in the process.

Coming back to Greenspan, I am happy that he has now admitted that unbridled deregulation is bad for the markets. I agree that capitalism is good - it is indeed our best hope to create equitable and sustainable development and prosperity. However, capitalism needs to have conscience. Recent event prove that markets are incapable of self regulation.

Many people believe that it is not the job of the central bank to identify and deflate asset bubbles – I beg to differ. When asset bubbles get created and finally burst, they cause heavy damage to sections of the populace which had no role to play in creating the bubble. The recent financial meltdown shows very clearly that it is not just the speculators who get affected – crises do have an effect on the economy, on jobs, and on the livelihood of poor families.

Some people do argue that central banks do have very limited tools. The plight of the Reserve Bank of India (RBI) in managing the relentless capital inflows into the Indian equity and real estate markets last year is a case in point. The RBI had to soak up USD from the market, releasing Indian currency. This increased liquidity in the system and also pushed inflation upwards. To flight inflation, RBI had to increase benchmark interest rates – the increase in interest rates increased the interest rate differential and led to even higher dollar inflows. It was a vicious cycle.

The world has become so complex that unless there is coordinated action from most of the central banks, it will be difficult to craft an effective response. Many people think China should let its currency appreciate faster. Try telling that to Chinese authorities who need to ensure 10% GDP growth to keep the political system stable!