Greenspan’s The Map and the Territory
Alan Greenspan The Map and the Territory: Risk, Human Nature, and the Future of Forecasting Allen Lane 2013
Greenspan acknowledges that in the light of the financial crises of 2006-8 the usual justifications of unfettered capitalism were seen to be ‘not wholly accurate’, reviews the situation and concludes that unregulated free-market capitalism, unencumbered by welfare commitments or attempts at redistribution, is still best for everyone in the long-run.
The book is well presented, well supported by data and well reasoned. So much so, that a reader with different (or less settled)prejudices can easily identify clear points of departure.
Why pick on welfare? And doesn’t it have an up-side?
Greenspan combines three things in his conclusion: lack of regulation, lack of benefit spending and lack of redistribution. His book predates the current debate on inequality – although he does briefly discuss the subject – and so he doesn’t really consider redistribution as anything other than a means to fund benefits. Like Keynes, he regards ‘animal spirits’ and particularly irrational optimism as an essential part of the workings of a free market, and considers that high government spending damps down that optimism and so endangers the free market.
Much of the argument about the bad effect of spending on welfare would apply to other forms of spending, such as on defense. In the UK, 100 years ago it was found that the bulk of the population were in a very poor state, making poor soldiers. This was part of the motivation for the introduction of the welfare state, and for improvements following the second world war. If spending in support of defense is to be exempt from cuts, how much of welfare, health and education spending can be considered as essential to provide a pool of citizens from which soldiers can be drawn?
Greenspan also acknowledges the critical role of innovation in both normal growth and recoveries. But if – as he also acknowledges – wealth is increasingly concentrated and without government spending an increasing proportion of the population becomes unhealthy, poorly educated and disaffected, who is going to be innovative?
Investment: too little or too junky?
Greenspan also shows how government spending results in increased interest rates and hence reduced investments.
But Greenspan also details the role of sub-prime ‘investments’ in the crisis. Thus the problem seems to have been not too little investment but too much poor-quality investment. Although Greenspan doesn’t labour the point, government regulation (in the board sense) was partly to blame here.
Regulation: is it ever good?
Greenspan also regards regulation generally as damping down growth, and hence bad. He makes an exception for banks’ capital requirements, which he thinks should be bigger. This might drive some banks to the wall, but he would regard this as ‘creative destruction’. He is also – somewhat reluctantly – in favour of capping the size of financial institutions.
It seems to me that, despite his rhetoric, Greenspan is in favour of regulation, as long as it drives ‘bad’ organisations to reform or fail, resulting in a more vigorous economy. He is against regulation that is either a drag, or which props up ‘lame ducks’.
While Greenspan does not explicitly make reference to it, a key factor behind his thinking seems to be his ‘pragmatism’ of a certain kind. He seems to suppose that everyone has similar maps, and that while these do not accurately reflect the full risk territory they are all that anyone has, and in consequence a regulator can only follow their map, and so can do little about the kind of shocks of 2006-8.
An alternative view is that – particularly if one caps the size of financial institutions – no players will be observing the full territory and most players will be driven by share prices and bonuses and hence be taking relatively short term views. There is this scope for a regulator who can take a longer, broader, view and who is trusted to share players’ fears and – with the support of academia and international institutions – which can develop a more realistic map, focussing on longer-run issues, such as avoiding crises or capture.
I suspect that Greenspan would be cynical about this, but maybe the UK – for example – could do better?
Can regulators regulate?
Greenspan regards regulators as increasing uncertainty. This seems to be because they are a tool of governments, who sometimes like to be seen to be doing ‘something’, even if the consequences are uncertain. (Presumably limits on the size and capital ratios of banks could be stable, and hence would not necessarily increase uncertainty.)
In the UK there are attempts to minimise this by making the regulators quasi-independent. What matters is the overall impact on uncertainty. Greenspan doesn’t think that a regulator can really regulate effectively, and so only sees the bad side. But even if we suppose that regulators could help avoid or ameliorate crises, what matters is not some objective measure of uncertainty but business perception. This is a serious challenge for any regulator, but may not be insurmountable.
Is all growth equally good?
Greenspan claims that despite growing inequality everyone is better off, and he continually treats total growth as if were clearly the thing to maximize.
From the recent debate, it is not clear that ‘everyone’ or even most people are better off than they were a generation or two ago, or that even if this is the case that it will necessarily continue. Technically, median change in wealth would seem a better target than mean change. Since Greenspan doesn’t consider this, it could even be that by having this as a target 90% of the population would be better off in the long-run. This would require a radical rethink of economics (perhaps stimulated by a regulator?)
Do economies have unique equilibria?
Behind Greenspan’s analysis is the assumption that a real economy has a long-run equilibrium growth that it returns to after a shock.
Keynes showed that this is not necessarily so, and Greenspan gives no reason at all for relying on it. Keynes argued that it tended to be true because people believed it, and it informed their plans. Greenspan is assuming that this will continue, and that while shocks will recur, they will not be so great as to alter these long-run expectations.
Greenspan notes that booms and busts have taken place between limits, and – ‘pragmatically’ assumes that these limits will not be breached in the future. Yet Greenspan also acknowledges the tiny size of our sample of crises.
The key issue behind the book seems to be this: if anything exogenous to the ‘natural economy’, such as the reactions of governments or other big players, or coincidence with a natural disaster, had gone differently, could things have been very much worse? Would it have been – as Greenspan supposes – a temporary ‘creative destruction’ set-back followed by a bounce back, or could it have been worse?
Greenspan makes many comments that do not logically contribute to his conclusions and are not supported by his arguments, but which are presumably intended to curry the favour of his readers. These include:
- That behavioural economics gives valuable insights.
- That distributions have ‘fat tails’.
- That innovators may fail many times before they ‘come good’.
The only real use that Greenspan makes of behavioural economics is to acknowledge that his previous views were ill-founded, and that there may be systematic divergences from normative rationality. This is an insight that he might have got from Keynes, amongst others.
Next, Greenspan echoes Taleb in arguing that economies cannot be said to have narrow-tailed distributions. But in saying that they have fat-tailed distributions they are implicitly claiming that economies can be described as probabilistic. Now it may be, as they seem to suppose, that the only accessible maps are probabilistic, but that doesn’t mean that the ‘territory’ is. (I spoke on this at a mathematical finance conference in 2013.)
To me, his most interesting suggestion is that ‘creative destruction’ and hence growth relies on innovators who may fail multiple times before they succeed:
I see no way of removing periodic irrational exuberances without at the same time significantly diminishing the average rate of economic growth and the standards of living. For rising standards of living require innovators who have unlimited expectation of success and perseverance, no matter how many times they fail. Exuberance, the propensity for optimism, is required even if it runs to excess.
It would seem to follow from this reliance on perseverance that financiers should be protected from their failures, the exact opposite of Taleb’s view. This would seem to be an issue for regulators.
My general notes on:
See also a book launch, in which Greenspan notes that volatility has increased with time, and attributes this to increasing animal spirits. (I didn’t see this in the book. Alternative explanations could be a concentration of capital, increasing speculative market participation and technical developments such as high-frequency trading.) Pollock comments:
… with tossing a fair coin, we know the odds, but with forecasting the financial future, we don’t even know the odds. That’s because we’re dealing with uncertainty, not mere risk.
… innovations are creators of long-term growth, but they also create uncertainty and surprises, good and bad.
These seem good corrective insights. It would be good to see a fuller debate.