Greenspan’s ’63 essay foretold subprime inaction

Jonathan Weil

Why did Alan Greenspan fail to act while the roots of the subprime-mortgage crisis spread? Here’s one possible explanation: The Ayn Rand disciple held fast to his unwavering laissez-faire beliefs.

Yesterday’s New York Times carried a front-page article chronicling the many warnings the former Federal Reserve chairman received about aggressive subprime lenders luring unsuspecting customers into crazy mortgages they never could afford. “Where was Washington?” the newspaper asked. And where was Alan?

There was Edward Gramlich, the late Fed governor, who urged Greenspan in 2000 to have Fed examiners investigate the industry. Greenspan said no.

Activists from a California housing group, the Greenlining Institute, met with Greenspan in 2004, urging him to press lenders for a voluntary code of conduct.

Greenspan wasn’t interested and didn’t give a reason.He offered a weak defence: The Fed wasn’t equipped to investigate and wasn’t to blame for the housing bubble and bust. Greenspan’s recent memoir, The Age of Turbulence, offers no satisfactory answers either.

Greenspan said he knew “the loosening of mortgage credit terms for subprime borrowers increased financial risk.” Yet he “believed then, as now, that the benefits of broadened home ownership are worth the risk.”

No, I believe the best answer can be found in an August 1963 article called ‘The Assault on Integrity’ that Greenspan, then 37, wrote for Rand’s monthly journal, The Objectivist.

Judging by how he rebuffed Gramlich and others, it looks like he followed his old instincts as the subprime mess festered.

“Protection of the consumer against ‘dishonest and unscrupulous business practices’ has become a cardinal ingredient of welfare statism,” Greenspan began his essay, which Rand included in her 1967 book, Capitalism: The Unknown Ideal.

“Left to their own devices, it is alleged, businessmen would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings. Thus, it is argued, the Food and Drug Administration, the Securities and Exchange Commission, and the numerous building regulatory agencies are indispensible if the consumer is to be protected from the ‘greed’ of the businessman.

“But it is precisely the ‘greed’ of the businessman or, more appropriately, his profit-seeking, which is the unexcelled protector of the consumer.

“What collectivists refuse to recognise is that it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product.”

“Reputation, in an unregulated economy,” Greenspan said, “is thus a major competitive tool.”

This view of the world might well explain why Greenspan did nothing. Yet if he’d said these words anytime in the past 20 years, they would have rung false to many people familiar with the 1980s savings-and-loan crisis, the corporate scandals touched off by Enron Corp., or the housing bust.

“He still believes philosophically what he wrote 30, 40 years ago,” says Greenspan biographer Jerome Tuccille, author of the 2002 book Alan Shrugged.

“But he must know we don’t have a truly competitive free-market economy, and that’s the context he was writing about. He must know the propensity of corporations to put greed ahead of their reputations.”

Greenspan wrote: “It requires years of consistently excellent performance to acquire a reputation and to establish it as a financial asset. Thereafter, a still greater effort is required to maintain it: a company cannot afford to risk its years of investment by letting down its standards of quality for one moment or for one inferior product; nor would it be tempted by any potential `quick killing.”

“Newcomers entering the field cannot compete immediately with the established, reputable companies, and have to spend years working on a more modest scale in order to earn an equal reputation.

Thus the incentive to scrupulous performance operates on all levels of a given field of production. It is a built-in safeguard of a free enterprise system and the only real protection of consumers against business dishonesty.”

“Government regulation,” he went on, “is not an alternative means of protecting the consumer. It does not build quality into goods, or accuracy into information. Its sole `contribution’ is to substitute force and fear for incentive as the `protector’ of the consumer.”

Minimum standards, he said, gradually become the maximums, and regulation undermines the moral base of business dealings. “It becomes cheaper to bribe a building inspector than to meet his standards of construction. A fly-by-night securities operator can quickly meet all the SEC requirements, gain the inference of respectability, and proceed to fleece the public.

In an unregulated economy, the operator would have had to spend a number of years in reputable dealings before he could earn a position of trust sufficient to induce a number of investors to place funds with him. “Protection of the consumer by regulation is thus illusory,” he said.

“Rather than isolating the consumer from the dishonest businessman, it is gradually destroying the only reliable protection the consumer has: competition for reputation.

“While the consumer is thus endangered, the major victim of `protective’ regulation is the producer: the businessman.”

The largely unregulated subprime-lending industry, of course, didn’t turn out this way. Countless mortgage brokers and lenders didn’t care about their reputations. Wall Street banks, which packaged and pitched the loans as AAA securities, didn’t care about theirs either. There were quick killings to be had.

Four decades later, Greenspan’s argument seems almost childlike in its idealism. Yet, judging by his inaction, it looks like he never stopped believing.