Too Smart for Their Own Britches

On October 23, 2008, former Fed Chief Alan Greenspan appeared before the House Committee on Oversight and Government Reform to testify about the recent credit freeze caused by the sub-prime mortgage mess. He read from a prepared text and then took what were mainly softball questions from committee members.

I pored over every word contained in Greenspan’s written testimony before that committee. I also listened carefully to Greenspan’s response to questions from the House panel. This is a man of great intelligence who simply cannot sit before other people and express in common language what he did and why he did it.

Greenspan was a key factor in causing the credit markets to fall apart. He kept interest rates too low, too long, and refused to introduce regulatory measures that might have kept the house of cards from crumbling. His written testimony was more like an excuse than an explanation. I won’t bore you with all of the 50-cent words that he used as a shield.

Greenspan’s basic and most absurdly memorable explanation for the sub-prime fiasco was to state its cause as originating from, “A flaw in the model that I perceived is the critical functioning structure that defines how the world works.” Huh! Is he kidding? Please read that quote again. With a straight face, Greenspan told everyone within earshot not only that there is a complex mathematical computer model that defines how the world goes ‘round & ‘round, but that the model is a financial one. How overly simplistic!

It appears that while he was Fed Chairman, Greenspan placed great faith in economic models. Although he did not specify in his testimony the one to which he referred, there are several candidates. One is known by its abbreviation, CAPM (The Capital Asset Pricing Model). Another is the Black–Scholes model. Developers of both received Nobel Prizes for their work.

Greenspan defended the use of computerized risk management models which became the backbone for the trading of mortgage-backed securities. Heck, he testified, there was nothing wrong with them; it’s just that people didn’t feed in the right data.

So many smart people, so little wisdom. Have I said that before?