Stop Putting Words in Greenspan's Mouth

Among the many factors that sent the stock market tumbling last week was Fed Chairman Alan Greenspan's speech Thursday night to a conference sponsored by the Office of the Comptroller of the Currency. (I'm assuming that's the United States' Comptroller of the Currency, though I'm not really sure what the comptroller of the currency, as opposed to a comptroller of a company, does.)

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Greenspan's speech, which dealt with the "fundamental sources of risk" and the limitations of the traditional risk-management models financial institutions use, did not spook an already nervous stock market because anyone actually read or listened to the speech. It spooked the market because Greenspan mentioned the reality of market panics, and because he linked "Dutch tulip bulbs" with "Russian equities." God only knows what would have happened had he mentioned "tulip bulbs" and "Internet stocks" in the same phrase.

Greenspan didn't make that connection, but a lot of outside observers did, leading to the inevitable conclusion that, in his typically oblique way, the Fed chairman was trying to talk down stock prices in general and Internet stock prices--which, though not quite as gaudy as they were back in April, are still pretty hefty--in particular.

This is the wrong conclusion. Although Greenspan did speak to the idea that investors are starting to see stocks as not much more risky than bonds (an idea associated with the authors of Dow 36,000--see Slate's "Crapshoot" for a critique of this idea), the real focus of his speech was something much broader, namely the way financial panics tend to eradicate the delicate distinctions between different classes of assets, distinctions that any market system needs in order to invest for the future.

The two most striking things about financial panics, at least in the modern economic world, are that they happen more often than one would expect in a normal (bell-curve-shaped) distribution of events, and that when they happen, they tend to spread rather than remain localized. What Greenspan was arguing was that we have to take these considerations into effect when we think about managing risk in the future. Specifically, he said, banks have to set aside "higher contingency resources--reserves or capital," and recognize the limits of the models they're using. Panics can't be anticipated, after all. That's what makes them panics.

Now, you might say that this speech should have spooked the stock market, since the Fed chairman was saying that sudden crises of investor confidence can descend without warning. But that is something we all knew already. More to the point, saying a crisis can descend without warning is not the same as saying that it can descend without causes. Talking about the current stock market as a bubble without taking into account the extraordinary performance of corporate America--which Greenspan himself cited in his speech--is to treat all episodes of investor confidence as identical. They aren't.

More important, Greenspan's real point was that there are few safe havens once a financial crisis starts. Last year, for example, during global crisis, investors flocked to the 30-year Treasury bond but were totally unwilling to buy the 29-year bond, even though the difference in risk between the two assets was presumably minimal. In that sense, saying that stocks are riskier than bonds because the stock market could crash is wrong. If crashes determine risk, then there are very few assets that you can really call safe. In that sense, if Greenspan was trying to talk down the stock market, he was trying to talk down all markets. Which I think tells us that he wasn't trying to do anything of the sort. His message was a simpler one: Be more careful than you think you have to be.

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