This has a certain sad irony. Recall that Greenspan once was an associate of Ayn Rand, the philosophical novelist who provided a moral defense of the free market, or as she put it, the separation of state and economy. Greenspan even contributed three essays to Rand’s book Capitalism: The Unknown Ideal—one for the gold standard, one against antitrust laws, and one against government consumer protection.

It was slightly bizarre when Greenspan accepted President Reagan’s appointment to run the Fed—maybe he thought that as long as the Fed exists, better someone like him run it rather than one who really believes government should centrally plan money and banking. Be that as it may, Greenspan went on to pursue an easy-money policy in the early 2000s that is widely credited, along with the government’s easy-mortgage policy, for the boom and bust that followed.

During a congressional hearing two years ago, Greenspan shocked me by blaming the free market—not Fed and housing policies—for the financial collapse. As the New York Times gleefully reported, “[A] humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets.”

He said he favored regulation of big banks, as if the banking industry weren’t already a heavily regulated cartel run for the benefit of bankers. Bush-era deregulation is a myth perpetrated by those who would have government control the economy.

But now Greenspan, going beyond what even President Obama favors, calls on Congress to let the 2001 and 2003 Bush tax cuts expire—not just for upper-income people but for everyone. “I’m in favor of tax cuts, but not with borrowed money. Our choices right now are not between good and better; they’re between bad and worse. The problem we now face is the most extraordinary financial crisis that I have ever seen or read about,” he told the Times.

He says he supported the 2001 cuts because of pending budget surpluses, but now that huge deficits loom, new revenues are needed.

Why? Brian Riedl of the Heritage Foundation says that since the cuts, “The rich are now shouldering even more of the income tax burden.” The deficit has grown not because we are undertaxed but because government overspends. “Tax revenues are above the historical average, even after the tax cuts,” Riedl writes.

Given the stagnant economy, this is the worst possible time for tax increases. (Is there ever a good time?) Taking money out of the economy will stifle investment and recovery, and it’s unlikely to raise substantial revenue, even if that were a good thing.

Finally, the stupidest thing said about tax cuts is the often-repeated claim that “they ought to be paid for.” How absurd! Tax cuts merely let people keep money they rightfully own. It’s government programs, not tax cuts, that must be paid for. The tax-hungry politicians’ demand that cuts be “paid for” implies the federal budget isn’t $3 trillion, but $15 trillion—the whole GDP—with anything mercifully left in our pockets being some form of government spending. How monstrous!

If cutting taxes leaves less money for government programs, the answer is simple: Ax the programs!

That Alan Greenspan thinks of the General Theory as his font of economic knowledge only adds to the depressing quality of this article. There it said that “the Fed Chairman has been known to rise from his chair midconversation and read aloud relevant passages from that 65-year-old book for visitors.” It is anyway quite clear from the actions he takes that Greenspan does think this way, but it is only one more indication of just how deeply ingrained Keynesian theory has unfortunately become.

Even the simplest distinction between public spending and tax reductions seems too difficult. It is all stimulus, and in the structure of a Keynesian model it all comes to the same thing. Yet the two could not be more different. Tax cuts move expenditure out of the hands of the public sector and, so long as the budget remains in surplus, add to the momentum of the economy.

In contrast, unproductive public spending pulls an economy down with a relentlessness apparently impossible for any Keynesian economist to fathom. Such public spending, especially if it takes budgets into deficit, inevitably makes matters worse.

Keynes’s only interest in writing the General Theory was to encourage greater levels of public spending. He had been an advocate of higher spending for a period going back more than a decade by the time his magnum opus was finally published in 1936. There is nothing Keynesian about tax cuts. Tax cuts were never on Keynes’s agenda, and to infer that lowering taxation is in any way a “Keynesian” approach is an anachronism read backwards into what might have been said instead of what actually was said.

And we have an example of such Keynesian expenditure policy before us, if anyone would care to look. Japan has suffered under the effects of Keynesian demand stimulation for almost a decade now. The effect has been to take the relatively mild slowdown experienced internationally at the beginning of the 1990s and turn it into an ongoing, ever-deepening recession that shows not the slightest sign of retreat.

Japan is the paramount example of what happens through public-sector spending. There have been no end of pseudo-explanations for what has been an unexampled disaster. The rise in public-sector spending and the rise in the level of public debt have left the Japanese economy floundering. There will be no escape until the Japanese recognize the nature of the problem and bring their budget back into surplus and start to wind the level of public spending back.

Such a profound demonstration of the incapacity of Keynesian theory to provide useful policy guidance ought to have kindled somewhere a recognition that the theories now propagated in one textbook after another leave something to be desired. That this is not so only presents yet one more instance of how beliefs will persist even in the face of no evidence that they describe reality.

To find that the head of the Federal Reserve in the United States is a devotee of Keynes should be a further example of how poorly based monetary policy is. That we are now in serious risk of a global recession is largely related to the decisions of the Fed over the past two years. Other central banks throughout the developed world have followed the same processes, which have led to the same sorry outcome.

It is the modern Keynesian model that provides the theoretical advice that leads economies one after the other to adopt policies that do not work. We can keep applying these theories year in and year out if we like, but if we do, the hope must be that at some stage it will be recognized that these policies continuously lead us into outcomes entirely different from those that were supposed to occur and that alternatives to the current mismanagement of economies everywhere are possible and need to be put in place.

Many factors led to the global financial fiasco, Norberg writes, including a naive policy that privatized profits and socialized losses, risk-taking based on blind faith in computer models’ ability to predict the market, and a false sense of security bred by government assurances that the taxpayers would back up bad loans. This brought an unsustainable growth of assets and liabilities.

The title of the Swedish original (which I read) is A Perfect Storm, an expression describing an event where a rare combination of circumstances drastically aggravates a bad situation. That certainly describes the financial implosion that began in 2007. Norberg explains the events leading to the credit crunch through one chilling example after the other. The conscious actions of financial, political, and bureaucratic decision-makers and consumers might not have been too dangerous in themselves, but in combination they proved utterly disastrous.

According to Norberg, after the dot-com bubble and 9/11, Federal Reserve Chairman Alan Greenspan acted to avoid a recession by stimulating the economy with record-low interest rates in a sort of “pre-emptive Keynesianism.” But the Fed misjudged the state of the economy and kept the interest rates down far too long. Effective interest rates actually turned negative, building the momentum for another bubble.

The low rates encouraged even greater risk-taking, not to mention a mountain of debt passed on to the future. Instead of going into a recession, the global economy saw an artificial, temporary rise in prosperity. China’s policy of keeping its currency undervalued to stimulate its exports while pumping its surplus of capital into U.S. bonds supported the process and hid the imbalances created by the Fed.

Predictably, artificially low interest rates inflated the real estate market. No sector of the economy is more sensitive to interest rates than real estate, and American politicians put massive pressure on two government-sponsored enterprises, Fannie Mae and Freddie Mac, to lower their standards to enable vast numbers of unsound mortgages. The resulting foreclosures will leave a terrible mark in the minds and on the credit reports of millions.

Norberg is no less critical of the actions of the Wall Street capitalists. Weak oversight of money placed in investment and pension funds, coupled with huge bonus systems, encouraged shortsighted gambling with other people’s money. Lurking behind all that was the assumption that there was little risk because the mortgage-backed securities were implicitly guaranteed by the federal government.

In the public debate following the credit crunch, many argued as if the financial markets were ruled by laissez faire, but the credit-rating agencies had an oligopoly due to regulations. Such regulations break down the barriers between the government and the market. The problem was not too little regulation. Rather, it was faulty regulation upheld by a multitude of national and international agencies. Tough international bank regulations punished traditional banking, while pushing bad loans into a shadow banking system to avoid transparency.

Financial Fiasco ends on a pessimistic note, predicting that we will see extensive, long-term government involvement in the financial sector for years to come. “Create a crisis, and people will give you more power to fight it,” Norberg writes. He points to the risk that politically well-connected corporations and interest groups will not only further distort competition (as in the case of TARP), but also cause new losses and crashes. Politicians in many European countries have already subtly begun to require that banks concentrate lending in their national economies. A growing financial protectionism would throw more gravel in the financial machinery. We might also see a new wave of trade protectionism.

The book’s most important lesson is that the problem isn’t the current recession, but the previous boom. It was during the boom that poor investments were made based on hidden inflation and far too optimistic forecasts. The recession is the cure, when labor and capital are reallocated to better uses and productivity improves.

In its brevity, the book provides an interesting, accessible explanation of the reasons for and consequences of the financial crisis. It would have benefited, however, from specific recommendations on how to get to a freer economy. What must we do—or undo—to prevent politicians from repeating the boom and bust cycle? There is a dire need for a sound policy, but unfortunately hasty and simplistic “solutions” based on populist slogans have prevailed. Norberg says that people must realize that government has its limitations, but he doesn’t tell us just where we should draw the line.

David Henderson and Jeff Hummel have written a remarkably pro-Greenspan article, “Was Money Really Easy Under Greenspan?” (www.tinyurl.com/cuf3ug).  The authors overlooked several points that would undermine their portrayal of Fed chairman Alan Greenspan as an anti-inflationist and the best Fed chairman ever. (Better than Paul Volcker?) To conclude that Greenspan “oversaw relatively low and stable inflation” is surely missing the mark. Granted, the Consumer Price Index (CPI) rose “only” an average 3.1 percent a year during his tenure as Fed chairman (1987–2006), but I’d hardly call it anti-inflationary. Moreover, the CPI is a notorious price index aggregate that largely ignores price bubbles in areas such as real estate and the stock market. If you judge Greenspan by the value of the dollar—and certainly one of the missions of the Fed chairman is to defend the nation’s currency—then Greenspan witnessed a substantial overall decline in the value of the dollar against the hard European currencies and the Japanese yen. The gold price, another bellwether, declined during most of the Greenspan years—a plus—but then took off, doubling in price during Greenspan’s final years.

Messrs. Henderson and Hummel also largely ignored the frequent changes in monetary policy, from easy to tight and back again. As measured by the Fed’s discount-rate policy, he switched policies seven times in 19 years. A stable non-inflationary monetary policy is surely the sign of a good Fed helmsman.

Clearly Greenspan’s worst period was the cheap interest rate policies of 2002–04. The authors fatally underplay the role Greenspan played in cutting rates far below the natural rate, due to his unwarranted fear that the United States was facing a deflationary collapse a la Japan. As a practitioner on Wall Street, I witnessed firsthand the malinvestments that were caused by the Fed’s deliberate plan. (I find it remarkable that Messrs. Henderson and Hummel made no reference in their article to the Wicksellian “natural” rate of interest hypothesis, a fundamental factor in the Austrian theory of the business cycle.)

Mortgage rates and real estate prices were clearly affected by this Greenspan cheap money policy, and so were the pricing of REITs [real estate investment trusts], closed-end income funds, and the carry trade, which sold at huge premiums as a result of 1 percent interest rates. Investment bankers and hedge-fund traders were constantly borrowing short and investing long during this 2002–04 time period. Then when the Fed started raising rates sharply, REITs and closed-end income funds collapsed very quickly, and the economy fell apart.

In short, the authors failed to disaggregate, as the Austrians are always emphasizing.

But their biggest sin of omission was to ignore the monstrous excessive monetary growth in the BRIC countries [Brazil, Russia, India, China] and emerging markets. The monetary aggregates rose much faster in China and the emerging markets than the G8 nations. We live in a global economy, and that money had to go somewhere, and it not only went into the BRIC economies, but also they bought a large amount of securitized U.S. mortgage securities, and profited from the yield spread.

Did Greenspan’s low interest-rate policy contribute to the artificial mortgage boom? Despite his denials, it did very definitely. As the Economist states (“A Tale of Two Worlds,” May 8, 2008), “Apart from the Gulf states, few countries still peg their currencies to the dollar, but most try to limit the amount of appreciation. This means that as the Fed cuts rates there is pressure on emerging economies to do the same, to prevent capital inflows pushing up their exchange rates.” The worldwide easy money policies lead to worldwide asset bubbles, commodity inflation, and unsustainable economic growth.

Consequently: “Emerging economies were partly to blame for America’s housing and credit bubble. As China and Gulf oil exporters purchased American Treasury bonds in order to hold down their currencies, this pushed down bond yields and helped to fuel the housing boom. Low yields also encouraged investors to seek higher returns in riskier assets, such as mortgage-backed securities.”

Finally, I find it incredible that Messrs. Henderson and Hummel would defend Mr. Greenspan’s indefensible record as a bank regulator. The Fed’s charter requires the chairman to oversee bank management policies, and the reckless way that banks promoted subprime and Alt-A mortgages can be laid at the feet of a complacent Federal Reserve Board. Contrast his approach to Canada’s strict banking regulations, which categorically prohibited these shameless banking policies north of the border.

David R. Henderson and Jeffrey Rogers Hummel respond:

Mr. Skousen would “hardly call” Alan Greenspan’s average annual inflation rate of 3.1 percent “anti-inflationary.” Neither would we. Nor did we. As Mr. Skousen admits, we wrote that Greenspan “oversaw relatively low and stable inflation.” This is not perfect, as we noted in our article.

Mr. Skousen points out that the consumer price index “largely ignores price bubbles in areas such as real estate and the stock market.” True. The CPI measures the cost of living, not the value of assets. As for gold, the price on August 11, 1987, when Greenspan became Fed chairman, was $461.20 per ounce. It had risen to $568.75 by January 31, 2006, the day he left office. That’s an increase of 23.3 percent, or an annual average of only 1.2 percent, far below the average inflation rate.

Mr. Skousen insists on measuring Fed policy by the discount rate. We argued that even the federal funds rate, which commentators other than Mr. Skousen tend to use, is not a good measure and that the best measure is the growth of the monetary aggregates. Mr. Skousen does not challenge our argument; he ignores it.

As for the real estate boom, we never denied it. Nor do we deny that low interest rates contributed to that boom. Rather, we questioned the role of the Federal Reserve in bringing about those low rates, an argument that Mr. Skousen does not grapple with.

Mr. Skousen claims our “biggest sin of omission” was to ignore the “monstrous excessive monetary growth” in other countries. Well, yes. We were evaluating Greenspan’s policy, not the policy of other central banks.

Finally, Mr. Skousen faults Greenspan for not regulating banks more. Although we did write that Greenspan contributed to the “too big to fail” doctrine, our preference is still deregulation and, as we noted, ending the Federal Reserve.

Those who wish to read an extended reply to our critics can go to www.tinyurl.com/csuae8 for details.

Most readers will be interested primarily in knowing what Grant thinks about our current financial crisis. Prominent politicians have declared that it’s due to that nasty old villain, the free market. Not even close, says our author. Instead he points to the belief held by former Fed chairman Alan Greenspan that the U.S. economy needs steady inflation. Following the dot-com recession of 2000, Greenspan feared that the economy would suffer from deflation if the Fed didn’t shovel in loads of money. That’s just what he did, driving interest rates down to almost nothing.

Grant, who obviously learned his economics and history well, looks askance at Greenspan’s beliefs. For one thing, there is nothing to fear from deflation. The American economy had long periods of deflation in the nineteenth century while at the same time enjoying rapid economic growth. That was in the primitive days prior to wizards in Washington expertly running macroeconomic policy, but, amazingly, things worked out quite well.

Furthermore, Grant understands that the government can

In 1999 Brooksley Born, head of the Commodity Futures Trading Commission (CFTC), tried to bring CDSs under the regulatory umbrella of her agency. Born was stymied by Greenspan, Treasury Secretary Robert Rubin, and Securities and Exchange Commission Chairman Arthur Levitt. She eventually resigned and the dispute was effectively settled in 2000 by the passage of the Commodity Futures Modernization Act (CFMA), which prohibited the CFTC from any further examination of CDSs. Details of the dispute can be found in an October 15, 2008 Washington Post article titled “What Went Wrong,” by Anthony Faiola, Ellen Nakashima, and Jill Drew. But the article itself went wrong when it saw only deregulation and free markets in a fiasco caused by regulation and central planning. It failed to consider the full implications of the CFMA itself, nor did it address the disastrous side effects of an international agreement known as the Basel Accord, both of which made credit default swaps anything but a free-market failure.

Who’s in Charge?

As neat and tidy as it might be to portray Born as the advocate of regulation and Greenspan, Rubin, and Levitt as opponents, it was actually a dispute among government officials over which of them should be in charge. The confusion derives from the nature of CDSs themselves.

When someone borrows money the lender is always concerned about the possibility that the borrower will not repay the loan. There are various ways for the lender to protect against that risk. The lender can sell the loan to someone else, who assumes both the right to collect the payments and the risk that the borrower will fail to make them. The lender can require the borrower to find someone willing to guarantee the loan—that is, someone who agrees to pay if the borrower defaults. Or the lender can make a separate contract with an unrelated third party who, in exchange for a premium paid by the lender, agrees to make the same guarantee to pay the lender if the borrower defaults.

A CDS is an example of the third option. The party paying the premium—the lender in this example—is considered the buyer of the CDS. The seller of the CDS is essentially providing default insurance, so a CDS can be viewed as an insurance contract and might be subject to regulation by government officials who oversee the insurance industry.

It is also, however, a form of derivative—a contract that derives its value from another asset or contract (in this case, the actual loan), but which can be settled separately by a payment of cash or some other highly liquid asset. In fact the parties to a CDS don’t actually need to have any relation to the loan: You and I can enter into a CDS in which I pay you a premium and you promise to pay me money in the event General Motors defaults on bonds that neither you nor I own. In this case, you and I are both speculating (or gambling) on a possible future event and neither one of us can be described as insuring the other against risk. Thus a CDS may be viewed as a form of futures contract and might be subject to regulation by government officials who oversee the futures industry.

Many of the biggest players in the CDS market turned out to be banks. Only about 40 of the more than 5,000 banks in the United States traded CDS contracts, with three of them—J.P. Morgan Chase, Bank of America, and Citigroup—trading more of them than all other banks combined. Commercial banks ended up as major buyers of packages of loans known as mortgage-backed securities that were protected by credit default swaps, and many investment banks were involved in these transactions. Thus a CDS may be viewed as a product supporting banking and lending and might therefore be subject to regulation by government officials who oversee the banking industry.

Finally, since an overwhelming percentage of credit default swaps are associated with either publicly traded bonds or publicly traded mortgage-backed securities, a case could be made for classifying a CDS as a form of investment security, which might be subject to regulation by the government officials who oversee the securities industry.

Despite the Post’s portrayal, Born may actually have come the closest to advocating a free-market policy. Although she was never able to get far enough to develop her ideas in detail, as head of the CFTC she likely would have had the authority to regulate CDS contracts that were traded on public commodity futures markets. The three men opposing her prevented these contracts from being publicly traded at all. As a result, credit default swaps could only be traded privately, keeping this market in the hands of a relatively small group of big players whose subsequent missteps might have been prevented or their impact minimized by such public trading.

Private Versus Public Trading

The distinction between private and public trading is important. Private contracts are those resulting from one party directly contacting another and negotiating a mutually acceptable agreement. While government courts claim jurisdiction over the enforcement of these contracts, the content of the contracts is generally up to the two parties.

Starting with the Securities Act of 1933, however, the federal government defined certain financial transactions as public matters and claimed the authority to regulate or prohibit them. Any contract that results from advertising or general solicitation, any use of an exchange that makes it possible for buyers and sellers to be matched up without knowing each other, or even the mere fact that one of the parties is an individual with a net worth under $1 million and an annual net income under $200,000 can be sufficient to claim the contract is a public matter.

The Commodity Futures Modernization Act, by prohibiting the CFTC from regulating credit default swaps, prevented it from authorizing public trading of CDSs on futures exchanges. In other words, the CFMA regulated public trading in the severest manner possible: It forbade it.

With only private trading permitted, the general public was effectively excluded. Furthermore, remember that private contracts must result from direct negotiations and that there is a prohibition on providing any public information about them that might be deemed advertising or general solicitation. This provided an overwhelming edge to the biggest players who traded them the most, as the high costs of contacting potential counterparties, negotiating contracts individually, and compiling private information created enormous economies of scale. Thus the federal government didn’t merely declare credit default swaps off-limits to the CFTC; it also effectively created a trading cartel for the largest banks, insurance companies, and hedge funds catering to wealthy investors.

Credit default swaps were invented by a team led by Blythe Masters of J.P. Morgan in 1997 as a tool for hedging the risk of default on loans. In a truly free market, regulated exclusively and severely by Messrs. Profit and Loss, she would today be hailed for this great invention. Prices are information, and the cost of a freely traded credit default swap provides a far better estimate of the risk on a debt instrument than the opinion of a credit rating agency that doesn’t personally suffer from a default and expresses its opinion in the form of letters. The meaning of a AAA or BB rating is vague and debatable, while a CDS priced at 1.08 percent on an 8 percent bond indicates that it is the equivalent of a risk-free 6.92 percent bond.

Furthermore, making the risk tradable would allow virtually all of us to choose, if we wished, to include small amounts of CDSs in our diversified investment portfolios. We could increase our personal investment returns modestly in exchange for sharing in a tiny portion of the total risk associated with lending. We wouldn’t all need to become experts in them. Mutual funds could put together diversified portfolios of CDS contracts and develop track records to draw our investments, and asset managers would have the incentive to become more informed in order to serve clients better. As a personal financial adviser, I would love to have that option for the client portfolios I manage.

Finally, the widespread trading of CDS contracts would help minimize counterparty risk—the danger that the party with whom we’ve contracted will not honor his obligations. With many people able to trade them, the portion held by any one player could be reduced and those who overexposed themselves to risk would have a ready market to hedge their own activities.

How Government Made the CDS a WMD

Unfortunately, government intervention helped make credit default swaps toxic. The explosion in the use of CDSs was not a free-market phenomenon. In 1988 the Basel Committee on Banking Supervision, an international body made up of representatives from all the major central banks, produced the Basel Accord, which went into effect in 1992 in the United States and most other participating countries. The accord set capital requirements for all banks that weighted assets based on their risk. The Basel II Accord was signed in 2004 to refine the requirements.

Under the Basel Accords the lowest capital requirements for a bank were not for the loans they personally originated and understood best but for AAA-rated securities. The safest direct loans are home mortgage loans to borrowers with excellent credit whose loan amounts don’t exceed 80 percent of the property value. These loans to “prime” borrowers have a risk weighting of 35 percent under Basel II. But if such loans are packaged into a mortgage-backed security rated AAA, the risk weighting is only 20 percent, reducing the amount of capital the bank must keep on hand and increasing its profits. Thus a bank has the incentive to sell the loans it has originated and replace them with AAA securities. Indeed, Basel II virtually mandated that banks sell their loans if they wanted to be competitive. The biggest buyers, Fannie Mae and Freddie Mac, two government-sponsored enterprises operating as profit-making businesses, benefited enormously from this regulation-inspired activity.

Not all loans are to prime borrowers with large down payments, however. Because of various government mandates, such as the Community Reinvestment Act, incentives were created to lend to less creditworthy borrowers with low or no down payments. Although most of these loans were not made by banks, they too were packaged into mortgage-backed securities, and many of them found their way to banks as AAA-rated securities.

How so? Why would a package of loans to subprime borrowers get the same high rating as a package of loans to prime borrowers? Through the magic of a CDS. Although the loans themselves might have a high risk of default they were protected by credit default swaps sold by entities that were themselves rated AAA, such as AIG Insurance, and CDSs were given AAA ratings as a result. A package of subprime loans might be rated BB (below investment grade), getting a prohibitive 350 percent risk weighting under Basel II, but that would be reduced to 20 percent weighting as a CDS-protected AAA security.

This was an international phenomenon. In September a report of the Center for European Policy Studies described the bailout of AIG Insurance by the Federal Reserve as a bailout of the European banking system. AIG was exposed to nearly a half-trillion dollars in credit default swaps, $300 billion of it to provide regulatory capital relief to European banks subject to Basel II. On September 15, 2008, the credit-rating agencies Standard & Poor’s and Moody’s downgraded AIG’s debt rating. Ironically, the price of credit default swaps on AIG itself had been rising for months, demonstrating the superiority of CDS pricing to credit ratings in the timely identification of borrower difficulties. This triggered contractual obligations for AIG to post tens of billions in additional collateral to guarantee its own ability to perform on the CDS contracts it had sold. There was some evidence that AIG could have arranged financing through various hedge funds or American banks but it apparently didn’t like the terms of these loans. It obtained a better deal from the Fed, even though the central bank has no oversight authority with respect to insurance companies. Had AIG not been able to post the additional collateral, the CDS protection it offered would no longer have preserved the AAA ratings of the securities in the European bank portfolios it was insuring, and capital requirements would have increased by as many as 161⁄2 times for some of the assets held by these banks.

Jury Still Out

So how significant were credit default swaps in the financial meltdown of 2008? For the firms that went bankrupt, such as Lehman Brothers, or those that were taken over, such as Bear Stearns, or those that had to cede significant control in exchange for government bailouts, such as AIG, very. They were big players in the CDS market who made some bad bets and failed to hedge their own risks.

It is not nearly as clear that there is any systemic problem with credit default swaps. In a November 15, 2008 article, “The Meltdown That Wasn’t,” the Wall Street Journal noted, “Lehman Brothers was supposed to be exhibit A. The firm was on one end of roughly $5 trillion in CDS contracts, according to Moody’s, and Lehman was itself the subject of $72 billion in CDS, in which other investors were betting on Lehman’s success or failure. Here was the doomsday scenario, with a major player in CDS going bankrupt. It turned out to be the meltdown that never melted.”

Lehman failed and the government let it fail. There is no evidence the liquidation had anything to do with problems for any other player. Businesses go bankrupt all the time, and it is best for the long-term health of an economy that incompetent managers cease to manage.

Credit default swaps didn’t melt down at all. The market for them continued to function smoothly even as the traditional credit markets were struggling. There were many causes for the housing boom and bust that played the biggest role in the financial panic of 2008, and it is quite plausible to wonder if CDS contracts are being scapegoated to distract from other, more likely villains. The role of CDSs in satisfying regulatory capital requirements appears to have been a major reason for the explosion in their use. If there is any failure there, it is in the unforeseen consequences of the regulations that came from the Basel Accords. They should be modified or repealed.

The Born Supremacy

Still, had Born gotten her way in 1999, many good consequences might have come from it:

1) Publicly traded CDS contracts almost certainly would have priced the risk of various debt instruments more accurately than the credit-rating agencies have done. As mentioned, CDS prices showed AIG was in trouble before the rating agencies acknowledged it.

2) Large players in the CDS market would have had a convenient way to hedge excessive risk exposure without being limited to hedge funds, big banks, insurance companies, and the federal government.

3) The inefficiencies in pricing that have allowed players such as J.P. Morgan Chase to make large profits on the basis of superior information would have been replaced with a more efficient market and level playing field.

4) Individual investors would be able to diversify portfolios more and earn some of the returns available in this market instead of being available only as taxpayers to bail out the incompetent.

5) Counterparty risk would be massively reduced by the much greater number of participants in the market.

Born may be getting the last laugh. In October 2008 the Chicago Mercantile Exchange announced plans to establish exchange trading of credit default swaps. In spite of the posturing of some politicians there is enough recognition of the benefits of derivatives to ensure that the markets for them will be expanding rather than disappearing. While we can only hope exchange regulation will be limited to the enforcement of contracts, regulated public trading is better than none at all.

The democratization of credit default swaps has begun. Greenspan, Rubin, and Levitt may have meant well in trying to limit CDS trading to big players, figuring that the public wasn’t ready to assume the risks associated with new financial instruments. Unfortunately the massive taxpayer-financed bailouts have shown that the public was going to bear the cost of failure in any event, and the primary result of their elitist attitude was to concentrate risk unnecessarily within a handful of firms whose exposure made them too big to succeed.

In little more than two years, Greenspan’s legacy has been reevaluated. At hearings of the House Oversight Committee, he tried to save as much of his original reputation as possible. Chairman Henry Waxman set the tone by observing that the entire economy was paying the price for Greenspan’s inattention to the risks in the subprime mortgage market.

Greenspan’s defense reminded me of a famous scene in the movie Casablanca. The flawed but ultimately heroic Captain Renault (played by Claude Rains) announces that Rick’s was being shuttered until further notice. Asked why, Captain Renault stated (as he accepted his nightly winnings) that he was “shocked” to discover that gambling was going on. In a similar vein, Greenspan expressed to the House committee his “shocked disbelief” that risky lending had been going on during his tenure.

As Fed chairman, Greenspan was the architect—the “maestro”—of a low-interest policy that flooded the economy with cheap credit after the collapse of the dot-com bubble in 2000-01. Real (inflation-adjusted) short-term interest rates were negative for several years. Risk premiums were driven down to historic lows—indeed, they all but disappeared. These elements made for a classic asset bubble. As economic historian Gary Gorton recently noted (in his paper, “The Panic of 2007”), the whole subprime house of cards would have tumbled down if housing prices had simply stopped rising, much less begun falling. They stopped rising and then began falling in 2007 and into 2008.

We’re Forever Blowing Bubbles

Economists have been observing and analyzing asset bubbles for centuries. Adam Smith talked about the South Sea company (and its bubble) in The Wealth of Nations. The effects of credit policy—first of ease then restriction—were well-analyzed by nineteenth-century economists. In the twentieth century, booms and busts were the central focus of business-cycle theorists. These included such figures as the British economist J. M. Keynes and the Austrian economists Ludwig von Mises and Friedrich A. Hayek. Mises and Hayek in particular linked the development of asset bubbles to easy-credit policies of central banks. Later, entire schools of economics—Keynesian, Monetarist, etc.—wrote on the topic.

The elements of a classic bubble should not have eluded the Fed chairman. The Fed sets the Fed funds rate, the rate at which banks lend to each other. That rate greatly influences other short-term lending rates. For three years, the Fed funds rate was at or below 2 percent. For one year in that period, the rate was 1 percent. That cheap-money policy fostered the leveraged borrowing and risk-taking that characterized the subprime mortgage market. Elsewhere I have called this “casino capitalism.” (See my “Subprime Monetary Policy,” The Freeman, November 2007)

In an October 18 interview with the Wall Street Journal, Anna Schwartz, the eminent economic historian (and coauthor with Milton Friedman of A Monetary History of the United States), observed that asset bubbles—“manias,” as she calls them—always have the same cause. “If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.” In the dot-com bubble it was equity shares of high-tech start-up companies. In recent years it has been residential real estate. The asset may change, but not the cause—monetary policy.

Grant Me Fiscal Discipline, but Not Yet

Why do central bankers repeat the same mistakes over and over again? Dr. Schwartz has the answer: “In general, it’s easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well.” I guess we could call this “feel-good” monetary policy.

How did Greenspan answer the question of why he had been so accommodative, so loose? He told us he was merely following orders, complying with the will of Congress. He had done “what I was supposed to do, not what I’d like to do.” This is followership, not leadership. It’s also just not so.

Under Article I, Section 8, of the U.S. Constitution, Congress has the power “to coin money, regulate the Value thereof, and of foreign coin, and fix the Standard of Weights and Measures.” Though at times controversial, courts have endorsed Congress’s power under that clause to create a central bank and delegate to it the conduct of monetary policy. The Fed was designed and structured to have operational independence. While the seven governors are political appointments, the presidents of the 12 reserve banks are not. The Fed has always been self-financing and needed no appropriation from Congress. That design has maintained its operational independence.

The House hearing should have focused not on Greenspan’s personal failings but rather on institutional failure. The Fed was created in 1913 to save the country from recurring financial panics. It was a bankers’ bank that would provide liquidity to ordinary banks, so that credit squeezes would no longer bring economic activity to a halt. By the 1920s, economists like Irving Fisher were arguing that central banks could manage money and keep its value more stable than did the gold standard. So the promise of central banking was stable prices and the end of panics and credit squeezes.

The Fed got off to a rocky start. After World War I, the economy was hit by the panic of 1920-21. By some measures, it was the sharpest panic in U.S. history. The Great Depression followed, beginning in 1929 (full recovery did not occur until after World War II). Monetary policy was thought to have improved after the war. But then came the inflation of the late 1960s, 1970s, and into the 1980s. Some economists believed they detected a “Great Moderation,” first in residential construction in the 1980s and later in real growth (GDP) and inflation. Every time observers thought central bankers had got it right, there was another mania, another panic, another recession.

Today, nearly 100 years after the founding of the Fed, we are in the midst of financial panic, experiencing a credit squeeze, and caught between inflationary and deflationary forces.

At some point even the most ardent supporters of central banks must question whether there is an institutional flaw in them. Some critics think the restoration of the gold standard would be the cure. Some think central banks themselves must be abolished. More of the same is unthinkable. Financial instability is, unjustly, undermining the case for free markets.

Show trials of principals like that of Alan Greenspan appeal to a sense of schadenfreude, but they are no substitute for some serious rethinking of our monetary institutions.

Nassim Nicholas Taleb is famous for introducing us to black swans. Though these rare creatures have long been used among academic philosophers to explain the shortcomings of reasoning by induction (“Every swan I’ve ever seen has been white, therefore all swans are white.”), Taleb uses the black swan as a stark metaphor for the inevitability of highly improbable events. In other words, black swans are rare, but one will swim by eventually.

As far as Wall Street—particularly the people with a large stake in getting things right—is concerned, this financial crisis involved a confluence of events. Some of these black swans were set in motion by government, like flexible lending standards to extend home ownership, Fannie and Freddie, and a mortgage-friendly tax code. Others were set in motion by willfully ignorant bankers, big shot risk-modelers, and people believing they could live beyond their means. It all came together in a fantastic cascade of failure. The trouble is, no one—neither government nor market actors—can predict such a large-scale event. Black swans happen.

The other important thing to remember is that the economy is a chaotic system. Most of the time chaotic systems achieve a sweet spot between order and chaos, which is a good thing if an economy is to be robust. Chaotic systems, though, change constantly and involve dynamics that are highly sensitive to initial conditions.

An Ecosystem, Not a Machine

Sadly, we’re getting a whole lot of precisely the wrong kind of thinking in response to this crisis. Indeed most of the bad thinking arises from viewing the economy through the lens of a false metaphor: economy as machine. We’ve heard pundits accuse the government or banks of being “asleep at the switch.” But in a complex system, there is no switch. We’ve heard people ask how to “fix it,” “run it,” or “regulate it,” suggesting if just the right sort of genius controlled the rheostats, we’d get just the right sort of economy.

The economy is not like a machine at all. It is rather more like an ecosystem that no one can run, fix, or regulate. The hubristic sort of person who thinks he or anyone can run an economy is the victim of what Hayek called the “fatal conceit.” If given power, the planner will end up making the rest of us the victims of his false metaphor.

It is ironic that Alan Greenspan—once adored by the press but now pilloried by it—is being blamed not only for wielding a laissez-faire ideology that supposedly caused the crisis, but also for failing to predict a black swan. Greenspan was a single, powerful government bureaucrat in charge of gathering enough data to determine the “right” interest rate for a multitrillion-dollar economy. Given the size of that task, he did pretty well for many years. But he was one man. He was housed in a government building. He held an unelected office and made decisions in a bureaucracy that has a monopoly on money and influences the price of credit, at least in the short run. One can hardly call that free-market fundamentalism. Whether Greenspan offered artificially cheap credit or not, interest rates were only one factor among many. To have asked him to predict the best of all possible worlds and adjust interest rates accordingly would have been to ask him to be an oracle channeling the knowledge only God would have. Greenspan is not omniscient. Nor is Bernanke. No one is. But to “run” an economy would require not only omniscience, but omnipotence as well—a power that would bend the actions of millions to its singular will.

Whatever your ideological persuasion, the economy is a complex system that cannot be planned, designed, or have its black swans regulated away. Far from the caricatures sketched in the papers, this is precisely what serious free-market types have been saying for years. That’s why it’s a little more than silly to blame free-market ideology for the current mess, and a little more than mendacious to claim that government fingerprints won’t appear all over the crisis when the postmortem is done.

Hunting Black Swans with Shots in the Dark

The timeless nostra of the politician are to prime the pump (machine metaphor) and to regulate. It seems so simple. But that response is deceptively linear. If you could ask FDR, might he now concede his policies stretched the Depression out for a decade beyond what was necessary? He listened to J.M. Keynes and a coven of interventionists. If we agree that our mixed economy is a complex system, then we also have to agree that the benefits the partly free market confers are an emergent property of that system. If we attempt to regulate away the rare, unforeseen black swan event, the costs of our hubris will be terrible, for we will regulate away untold benefits, too.

In the real world the question may come down to whether we should accept a couple of years of painful market adjustments or decades of recession caused by the blunt instrument of politics. Devastating unintended consequences and unseen effects will follow government attempts to clean up a mess made in great measure by its own hand. Why? Because no one possesses a God’s-eye view of the economy. Government intervenes within the system as part of it, not from outside of it. Nor is the economy an instrument to be manipulated to positive effect—at least not over the long term. That is why Keynes got it so terribly wrong and why the economy must heal itself from within in a distributed, holistic way.

People want government, like God, to come down and fix the unfixable, or explain the inexplicable. That’s why they’re finding it easier to blame greed for our current financial crises. But greed is rather more like gravity: When you fall, you can blame either Newton or the banana peel on the ground.

The profit motive is a good thing when it operates in an environment where bad bets are punished with losses and good investments are rewarded. Only government can distort that healthy profit-and-loss system, giving people incentives to make bad decisions. And it’s in this environment that greed is no good to anyone. It turns out, however, that greed—or better, rational self-interest—can help our economy stabilize faster than government ever could. As the lubricant of our economic system, self-interest will cause a million market actors to recalibrate and to direct resources to projects that create value in our society. We the people will temper our irrational urges and mitigate our risks if government restores the rules that let profit and loss bring discipline. But if government continues to change the rules to bias the market in favor of irrational behavior, rent-seeking, and corporatism, the chaotic aspects of the system will continue to wobble out of equilibrium. Black swans will become commonplace.

How wrong I was. By the time of this writing, the mainstream press had delivered the “consensus” judgment that blind faith in the free market fostered the housing bubble. Jacob Weisberg’s Slate column, “The End of Libertarianism,” sums up this official verdict: “We have narrowly avoided a global depression and are mercifully pointed toward merely the worst recession in a long while. This is thanks to a global economic meltdown made possible by libertarian ideas. . . . [A]ny competent forensic work has to put the libertarian theory of self-regulating financial markets at the scene of the crime.”

Just to make sure that the free market got the blame for the financial meltdown, Alan Greenspan himself testified to Congress that he had been “shocked” that self-interest (in the absence of paternalistic regulation) did not compel financial institutions to adopt adequate risk controls. Greenspan—viewed by the average pundit as a staunch libertarian—went so far as to say that he “found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”

I will argue that government interventions, not laissez faire, caused the housing bubble and the ensuing financial crisis. In addition to describing some of the general factors involved, we will focus specifically on the blame attributed to the “unregulated” market for credit default swaps.

Despite their confident judgments of guilt, critics such as Jacob Weisberg point to very few specific regulatory changes that (allegedly) fostered the housing boom and the related vulnerability of so many financial institutions to the ensuing crash in home prices. The only two concrete examples I have seen are the gradual repeal of Glass-Steagall throughout the 1990s and the Commodity Futures Modernization Act in 2000. To his credit, Weisberg candidly admits that he can’t point to a smoking gun: “[N]eglecting to prevent the crash of ’08 was a sin of omission—less the result of deregulation per se than of disbelief in financial regulation as a legitimate mechanism.”

Generally speaking, Weisberg and others accuse Alan Greenspan, Phil Gramm (former chairman of the Senate Banking Committee), and SEC chairman Christopher Cox of willfully ignoring, for ideological reasons, warnings about the growing market in credit derivatives.

At this point, we note that even if this were the whole story, it wouldn’t necessarily prove that these men (and other policy makers) were mistaken in their actions. Two exaggerated analogies will illustrate the point: Suppose an environmentalist group had lobbied for the government to ban all new house construction starting in 2002, or suppose a Marxist organization had lobbied for the nationalization of all real estate in 2002. Either of these moves, in retrospect, probably would have averted the housing bubble and its related consequences. But surely that doesn’t mean government officials back in 2002 would have been wrong to reject these proposals.

By the same token, Greenspan and others had valid reasons for resisting new regulations on the evolving markets in derivatives. As we will explain below, these complex assets can promote efficiency through risk transference. In other words, the world economy grew faster than it otherwise would have because of the proliferation of derivatives. So even if Weisberg and others are right, and the financial crisis is the fault of unregulated derivatives, it is still an empirical question whether avoiding the housing boom and bust would have been worth more than the extra consumption made possible all over the world from the market-driven growth in derivatives.

Government Mistakes: Sins of Commission

In contrast to the vague declaration that “someone should have done something!” offered by the critics of the Invisible Hand, proponents of the free market can point to specific government interventions that fostered the excesses of the housing boom. Most obvious is Greenspan’s handling of the Fed funds target rate and the growth of the monetary base following the dot-com crash. Greenspan’s easy-money policy coincided with the upswing in the housing boom. When the Fed began raising rates, housing prices tapered off and then began plunging. The connection between Fed policy and the housing bubble is so obvious that even mainstream analysts endorse the theory.

Other possible culprits include the Community Reinvestment Act (CRA), a Carter-era measure that was strengthened in 1995 and used to pressure banks and thrifts that enjoyed deposit insurance into lending in all neighborhoods where they accepted deposits, including low-income, weak-credit areas. Many analysts have also placed at least some blame on the Federal Housing Administration as well as the government-sponsored enterprises Fannie Mae and Freddie Mac. Through explicit or implicit federal backing, these agencies were able to bolster the secondary market for mortgages and allow applicants who otherwise would not have qualified to obtain mortgages.

When cataloging government interventions that may have contributed to the housing boom, we should mention the existence of the Working Group on Financial Markets—also known as the “plunge protection team”—that was established in response to the 1987 stock-market crash, as well as belief in the “Greenspan put,” the Fed’s perceived promise to provide bank liquidity when needed. As we will see, the financial crisis of 2008 was largely the result of institutions failing to protect themselves from (what seemed to be) improbable but catastrophic scenarios. Even though writers such as Nassim Nicholas Taleb have been famously warning about “fat tails” or “black swan” events, investors could quite rationally have downplayed these warnings. “After all,” high-level managers could have reasoned in the midst of the housing boom, “in the event of an absolute meltdown, the federal government will swoop in to save us. They couldn’t possibly stand back and let the entire investment banking industry collapse.” The bailouts engineered by Paulson and Bernanke have vindicated this belief. In retrospect it is not obvious that firms such as Lehman Brothers and Bear Stearns behaved foolishly. If politicians tell a man playing roulette that he can keep all of his winnings but will only suffer 20 percent of his losses, is it really irrational for him to borrow large sums of money to wager on the game?

Credit Default Swaps

The poster child for the (alleged) failure of the deregulated financial sector is the market for credit default swaps (CDSs). These contracts are traded over the counter, so no one knows exactly how much exposure they contain, but estimates place the worldwide notional value of all CDSs in the neighborhood of $50 trillion at the end of 2007. It was largely because of its issuance of CDSs that the giant insurer AIG needed a government bailout. The AIG episode showed that the financial panic was not limited to firms that foolishly overinvested in mortgage-backed securities but also could spread to those companies that had issued credit default swaps on the bonds of these now at-risk firms.

Although in practice CDSs can be complex, the idea behind them is simple. The seller of a CDS agrees to compensate the buyer in the event of a “credit event,” such as GM’s defaulting on its bonds. In return, the buyer makes periodic payments to the seller. The obvious analogy is to an insurance contract, but the difference is that people can buy a CDS on GM bonds even if they don’t own GM bonds. It is as if someone bought fire insurance on his neighbor’s house.

One reason these contracts are structured as “swaps,” rather than standard insurance, is to evade the regulations governing traditional insurance products. For example, if AIG wanted to sell life insurance to a man in Florida, it would have to set aside reserves according to Florida law in order to make it more likely that AIG could fulfill the policy if the man died a week later. In contrast, if AIG sold a Florida man protection against a bond default by GM, then the government allowed AIG much more discretion in how it handled this new potential liability on its books.

It is easy to see why critics of pure free markets have such disdain for the credit-default-swap market. This seems to be a clear case where short-term greed led to reckless behavior, which would have been prevented by prudent government oversight.

Yet matters are not so simple. After all, the shareholders and creditors of AIG were presumably not complete idiots. Did they care less about protecting their wealth than politicians in D.C. did? Did they understand derivatives less well than government bureaucrats understood them? Looking at the matter from a different angle, why would the buyers of

CDSs simply assume that the counterparty would make good on the contracts if government regulations did not enforce the same safeguards applied to traditional insurance?

It turns out the Invisible Hand did lead everyone to seek safety. Although all the details are not yet available, as of this writing it appears that AIG’s risk models (primarily developed by academic consultant Gary Gorton) were not to blame for sinking the company. Rather, AIG was driven into the arms of the government because its large clients (such as Goldman Sachs) insisted on larger and larger amounts of collateral as the financial crisis continued.

Plagued by Illiquidity

In other words, Gorton’s models may still prove to be fairly accurate. AIG was not crippled by a string of unexpected credit events (and consequent payouts). What actually happened is that the holders of CDSs issued by AIG became scared about its ability to honor its contracts, and AIG could not continue to operate while satisfying all of the growing calls to put up more collateral against these outstanding time bombs. In short, AIG was plagued by illiquidity, not necessarily by insolvency. It is true that AIG executives failed to prepare adequately for this contingency, but it nonetheless removes some of the mystery behind its failure when we realize that AIG may very well have correctly assessed the risk of its positions—it just failed to predict correctly how its customers would assess this risk, in the midst of a global financial panic and also during a period when there was a “credit crunch” among large institutions.

The case of AIG also reinforces our earlier point about government intervention muting the potency of market incentives. It takes two to tango. The problem of AIG on the eve of its rescue was the fault not just of AIG’s managers and shareholders, but also of the counterparties who had bought billions of dollars worth of CDSs from the insurer. In a completely free market, these counterparties would be subject to the hazards of a potential AIG bankruptcy. In reality, however, huge firms such as Goldman Sachs could rely on the U.S. government to rescue them from their reckless exposure to AIG. In fact, the New York Times reports that Lloyd Blankfein, the current CEO of Goldman Sachs, was the only investment bank executive in the room when federal officials decided to rescue AIG—and this was mere hours after they had decided to let Lehman Brothers fail. (As for Goldman’s demands for more AIG collateral, even “too big to fail” companies exercise some caution—just not enough.)

People Make Mistakes in the Market

In situations such as the present crisis, there is a temptation for libertarian economists to look for specific government interventions that “caused” the problems. This is understandable, and indeed we have listed some of these factors. Yet we should also remember that failure is a normal part of the market process. Investors and entrepreneurs are not omniscient. Bankruptcies do not signal the inefficiency of the market any more than the overthrow of Newtonian physics proved the weakness of the scientific method—let alone that government should take charge of all scientific research.

In addition to the definite contributions of government policies, it is also true—and proponents of the free market should feel no shame in admitting—that many institutions were seduced by fancy mathematical finance models. Part of what happened is that the whiz kids from MIT and other top-flight programs made simplifying assumptions on the underlying probabilities of various events. For example, Moody’s might have rated a particular mortgage-backed security as extremely safe, since it was composed of thousands of small bits of mortgages spread all over the country. Before the housing crash, the conventional wisdom held that “real estate is local.” It was considered virtually impossible that all markets—from San Francisco to Las Vegas to Miami to Chicago—would experience a large spike in mortgage-default rates simultaneously. Nobody had ever seen such a correlated fall, so it seemed like a reasonable assumption. The models, based on this assumption, produced results confirming the safety of mortgage-backed securities.

When confronted with this reality many free-market thinkers want to blame a government policy. In the case of the ratings agencies, we do have some contenders. The most obvious example is that the dominant firms (Moody’s, Standard and Poor’s, Fitch) benefit from government regulations placed on banks and other institutions. If a bank or insurance company wants to invest in bonds the government insists that these bonds meet a certain level of safety. Of course, the bank can’t simply hire Joe the Bond Rater to slap “AAA” on them. The regulations insist that a reputable ratings agency meet certain criteria. In practice these rules ossify the ratings market, and partially protect Moody’s and the others from the repercussions they would have suffered after their disastrous evaluations of mortgage-backed securities during the housing boom.

But even if the critics were right and the present crisis was largely caused by faulty forecasts made in the private sector, it would not prove a crushing defeat for free markets. After all, there are plenty of examples of horrible business decisions made by private individuals. The Edsel and “New Coke” flops, Decca Records’ 1962 rejection of the Beatles because “guitar music is on the way out,” and the rejection by a dozen publishers of the initial Harry Potter manuscript are all examples of stupendous entrepreneurial error. Given the advantage of hindsight, it is easy enough for us to laugh at the businesspeople who made such boneheaded calls, and critics of the marketplace could easily enough infer that the free market can’t be trusted with the task of innovation.

However, the mere existence of entrepreneurial error is not an indictment of free markets. People can only achieve bold successes when they take risks. The virtue of the market is that it allows individuals the freedom to risk their own money—or that of investors whom they can convince to fund them voluntarily—reaping the rewards if they succeed and bearing the losses if they fail. There is no reason to suppose that government bureaucrats would have designed better models of risk assessment. Indeed, two Fed economists wrote a paper in 2005 claiming that there was no housing bubble!

What is truly ironic is that the government’s rescue efforts—supposedly made “necessary” by the “unregulated” market—only ensure that market discipline will be weaker. Not all major institutions were taken in by the derivatives hysteria during the housing boom. Warren Buffett famously warned his own investors in 2002 that derivatives were “financial weapons of mass destruction” that would at some point wreak unexpected havoc. The takeovers of AIG, Fannie, and Freddie, as well as the $700 billion bailout, reduce the relative strength of those firms that behaved more sensibly during the boom. If and when the next crisis occurs, it will be in part because the government has just shown that playing it safe and adopting a long-term perspective doesn’t pay in U.S. financial markets. It’s much more profitable to go for the risky yet lucrative payouts, and then run to the government if things turn sour.

Amidst the efforts to “control the narrative” and assign blame for the financial crisis, fans of the free market should not lose sight of the real benefits of derivatives. Futures contracts on oil, for example, allow producers and major consumers such as airlines to lock in guaranteed prices and confidently engage in long-term projects that would otherwise be too risky. Even the much-maligned credit default swap allows the transfer of risk in mutually beneficial trades. Especially in an uncertain financial environment, CDS contracts allow certain firms to raise cash more easily—because those lending them money can buy CDSs on their bonds—and the price of a particular CDS contract itself communicates information about the market’s view of the firm being insured. These benefits will all be seriously muted if the government stampedes in and imposes top-down regulations.

Despite the claims of their critics—and even of some of their fair-weather friends—unregulated markets are not to blame for the systematic mistakes of the housing boom. Yet even if private errors were the primary cause, it still would not follow that government bureaucrats would make wiser decisions in the future.

During the Keynesian dark ages persisting through the mid-1970s, no one—except a few monetary cranks and monetarist economists cloistered in their academic ivory towers—believed that the Federal Reserve’s monetary policy even mattered. This was a period when Paul Samuelson, who would go on to win the 1970 Nobel Prize in economics the second time it was awarded, could proclaim in a 1969 Newsweek column that “there is no sight in the world more awful than that of an old-time economist, foam-flecked at the mouth and hell-bent to cure inflation by monetary discipline. God willing, we shan’t soon see his like again.” Today almost everyone—economists, investors, and the general public alike—seems to have swerved to the opposite extreme. The Fed controls not only inflation, they seem to think, but also everything else that happens to the American economy, good or bad. The truth, however, is somewhere in the middle.

We are not arguing that Greenspan’s policies were perfect. Nor should anything that follows be construed as a defense of central banking or of the Federal Reserve. Particularly alarming is the way the lender-of-last-resort function has been expanding the moral-hazard safety net and mispricing risk—trends to which Greenspan no doubt contributed. Our ideal would combine abolition of the Fed and unregulated free banking.

Nonetheless Alan Greenspan stands out as the most competent—arguably the only competent—helmsman of U.S. monetary policy since creation of the Federal Reserve System. As Milton Friedman observed on Greenspan’s retirement, “For the first 70 years after it opened in 1914, the Fed did far more harm than good, presiding over inflation in two World Wars, converting a moderate recession into the great depression, and then, in the 1970s, producing the most serious peacetime inflation in our nation’s history.” By contrast, Greenspan’s “performance has indeed been remarkable.”

Greenspan oversaw relatively low and stable inflation and ushered in a striking decline in the volatility of real gross domestic product. Although defenders of macroeconomic intervention often suggest that government policies after World War II dampened business cycles, the truly significant change should be dated at 1987, the year Greenspan assumed office. The current fuss about a recession that, according to standard indicators, still is no worse than the minor recessions of 1990 and 2001 testifies to how high his legacy has raised the bar. Until a year or so ago many observers had therefore credited Greenspan with being the best at reading the economic tea leaves. But as we will demonstrate, the source of Greenspan’s apparent success has little to do with monetary discretion.

Freezing Total Reserves

Recently-converted critics are now charging Greenspan with having carried on an excessively expansionary monetary policy, particularly following the recession of 2001 and possibly during the dot-com boom that preceded it. But an objective examination of his record of nearly two decades shows that he did not. Instead, however unintentionally and unwittingly, he came close to freezing the domestic monetary base and deregulated the broader monetary aggregates.

Why do people now believe Greenspan was an “inflationist”? For one main reason: They note how low interest rates were from 2002 through 2004. But interest rates have never proved an adequate gauge of what the Fed is doing—not during the Great Depression, when rates were very low despite a collapsing money stock; not during the Great Inflation of the 1970s, when rates were high despite an expanding money stock; and not under Greenspan. A focus on interest rates ignores the simple fact that interest rates can change as a result of real factors involving supply and demand and are not simply “set” by the Fed.

The market ultimately determines interest rates. While central banks are big enough players in the loan market (and the quintessential noise traders to boot) that they can push short-term rates up or down somewhat, that ability is increasingly diminished—even fora major central bank like the Fed—as globalization integrates world financial markets. In defending his actions, Greenspan is correct in attributing the unusually low interest rates early this decade mainly to a massive flow of savings from emerging Asian economies and elsewhere.

A better, although now unfashionable, way to judge monetary policy is to look at the monetary measures: MZM, M2, M1, and the monetary base (see chart, p. 36). From 2001 to 2006 the annual year-to-year growth rate of MZM fell from over 20 percent to nearly 0 percent. During that same time M2 growth fell from over 10 percent to around 2 percent and M1 growth fell from over 10 percent to negative rates. Admittedly the Fed’s control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base since 2001 fell from 10 percent to below 5 percent in 2006. When all these measures agree, it suggests that monetary policy was not all that expansionary during 2002 and 2003 under Greenspan despite the low interest rates.

The key to what was really going on is the monetary base, which the Federal Reserve controls directly. The base consists of reserves held by the banks and other depositories, either in their accounts at the Fed or as vault cash, plus currency in circulation among the general public. Between December 1986—eight months before Greenspan became Fed chairman—and December 2005, the monetary base rose by a hefty amount, from $248 billion to $802 billion (no figures are seasonally adjusted). True, that doesn’t sound like a freeze. But virtually the whole increase was in currency in circulation. (See the graph of the monetary base and its two components on p. 37.) During that same time total bank reserves grew from $65 billion to $73 billion, for an average annual growth rate of a mere 0.65 percent. (These figures are unadjusted for any changes in reserve requirements and—unlike the somewhat misleading reserve totals reported by the Fed’s Board of Governors—include all vault cash, clearing balances, and float.) In some years aggregate reserves rose; in others they fell, with the major bump surrounding Y2K, when the accumulation of reserves by banks appears to have induced the Fed to accommodate a 40 percent jump followed by a 30 percent drop. Total reserves are also the one monetary measure whose growth rate shows a slight uptick into 2003, when interest rates were down. But that is thin backing for the extravagant accusations that “easy Al” was conducting an exceptionally expansionary monetary policy.

Currency in Circulation

During the same 19 years, currency in circulation exploded faster than the monetary base—at an annual rate of 7.54 percent. Before this explosion currency was less than three-quarters of the total monetary base; by the end of Greenspan’s tenure it was over 90 percent. In a period when debit cards and possibly ATMs were reducing currency demand, analysts were aware that all this new cash was not bulging in the wallets and purses of the average American. It was going abroad as a stable dollar evolved into an international currency. These growing foreign holdings of Federal Reserve notes became an additional factor increasing money demand and keeping U.S. inflation in check during the 1990s.

Ideally we should adjust the monetary base and monetary aggregates downward to account for this drain abroad. Richard G. Anderson of the St. Louis Fed estimates that the proportion of U.S. currency held abroad doubled between 1986 and 2005, from 25 to nearly 50 percent. Although his estimates may be too low, the Fed makes no such adjustment. Doing so would reduce the average annual growth rate of the monetary base between December 1986 and December 2005 from 6.4 to 4.9 percent.

Furthermore, in a fully deregulated monetary system, private banks—not the Fed—would be the institutions issuing currency. Currency would become an additional bank liability like deposits and respond to market forces. In our current system, the public still determines how much of the base becomes currency in circulation by their decisions to withdraw and redeposit cash. The Fed controls only the total base whereas currency passively expands to accommodate people’s preferences. This suggests that a more meaningful approximation of the base would be simply to subtract all currency in circulation, leaving us with only aggregate reserves as our proxy. Thus the virtual freezing of reserves turns out to be the most salient yet ignored feature of Greenspan’s tenure. Interestingly, the late Milton Friedman had recommended in the 1980s something similar to what Greenspan did de facto: freeze the base.

Greenspan also helped deregulate the broader monetary aggregates: M2, MZM, and M3. The Depository Institutions Deregulation and Monetary Control Act of 1980 had begun phasing out interest-rate ceilings on deposits and modified reserve requirements in complex ways. Combined with later administrative deregulation under Greenspan through January 1994, these changes left all the financial liabilities that M2 adds to M1—savings deposits, small time deposits, money market deposit accounts, and retail money-market mutual fund shares—utterly free of reserve requirements and allowed banks to reclassify many M1 checking accounts as M2 savings deposits. M2 and the broader measures became quasi-deregulated aggregates with no legal link to the size of the monetary base.

A result noted by Milton Friedman in 2003 is that fluctuations in the velocity of M2 were offset by fluctuations in the amount of M2. Interestingly, this is similar to what monetary economists George A. Selgin and Lawrence H. White predicted would happen under free banking—or a market-determined monetary system void of government involvement. They argued that free banking would automatically adjust the quantity of money to changes in velocity. If velocity rose, signaling a fall in money demand, market mechanisms would cause banks to reduce the quantity of money they created. And if velocity fell, signaling a rise in money demand, banks would enlarge the quantity of money. The response of M2 to changes in velocity in the 1990s offers stunning confirmation of this claim. The result was that inflation was held in check.

Thus during the dot-com boom of the 90s the velocity of M2 rose as people shifted into stocks. But this was offset by the declining growth rate of M2, which fell to near zero between 1994 and 1996. Assorted Fed watchers reached opposite conclusions depending on which variable they chose to focus on. Some warned that Greenspan’s policies were deflationary. Others looked at the higher growth rates of the base and M1, which remains more closely tied to the base and more distorted by currency going abroad, and predicted higher inflation. Both were wide of the mark, of course, but not because of Greenspan’s miraculous central-bank discretion. The result was a product of the market process, and when the collapse of the dot-com boom burst the M2 velocity bubble it induced a new spike in M2 growth.

Why Any Inflation?

If Greenspan approximately froze total reserves, why was there any inflation at all during his tenure? Rather than averaging 2.5 percent annually, shouldn’t prices have remained constant or actually fallen? Indeed, in a thoughtful critique of an earlier version of this article, Selgin denied that the broader monetary measures were responding to changes in velocity, since productivity growth would have therefore generated just such a gradual deflation. The answer relates to the market’s extraordinary capacity for financial innovation. Until the recent, extraordinary changes in Fed operations, bank reserves in the United States paid no interest, giving banks a strong incentive to economize on their use and maximize lending. They figured out ways to do so even under reserve requirements, as amply illustrated by the origins and growth of the Federal funds market, where banks regularly lend each other excess reserves.

Financial deregulation gave the process an additional boost. From December 1986 to December 2005—the same period during which aggregate reserves remained almost constant—the aggregate de facto reserve ratio of the banking system as a whole backing M2 fell by half, from 2.52 percent to 1.23 percent. So the quantity of M2 deposits grew at a secular rate of 4.6 percent, enough to generate mild, sustained inflation. And the quantity of domestically held currency grew alongside at an accommodating rate.

This steady, long-term decline of reserve ratios cannot easily be halted and confronts government fiat money with a fatal long-run problem. Re-tightening of reserve requirements would only burden banks with an implicit tax not faced by other financial institutions, encouraging the development of new, highly liquid money substitutes that effectively avoid the requirements. Congress has, moreover, moved in the opposite direction, permitting the Fed to eliminate all remaining reserve requirements in 2011, thereby bringing the United States into line with such countries as Australia, New Zealand, Canada, the United Kingdom, and Sweden, which have already done so. True, the Fed has now started paying interest on bank reserves, which has enormously increased demand for them in the short run. Nonetheless banks will still be able to earn greater interest on loans and securities under normal economic circumstances. Moreover, paying interest on reserves in effect transforms that portion of the monetary base into Treasury securities payable in fiat money, rather than genuine fiat money itself.

In short, the ongoing spread of electronic funds transfers and assorted cashless payments is essentially replacing money with a sophisticated network of computerized barter. The demand for fiat money will thus approach zero asymptotically. So long as the money base is built on a fiat foundation with no other source of demand, the price level will slowly but inexorably head toward infinity. Only a commodity base with a nonmonetary demand—say gold, although it could just as well be silver, some combination of the two, or a more complex basket of commodities or financial assets—will anchor the price level over the long haul. Under free banking, the expansion of monetary substitutes would drive down the demand for gold-as-money, but gold’s value can never drop below its commodity value. Gold would continue to provide the unit of account, the common numeraire in nearly all transactions, without ever needing to be used as a medium of exchange.

Greenspan cannot be held responsible for this ultimate unviability of fiat money, although his deregulation accelerated the inflationary bias. A steady, secular contraction of total reserves could in theory have offset the declining reserve ratio, delivering a constant price level or even secular deflation over the last two decades. But the continued fall of base-money demand is itself inevitable as long as developed economies wish to capture the enormous welfare gains of financial innovation and a more efficient allocation of savings.

An Ironic Legacy

So what did cause the current financial crisis? That is similar to asking what caused the minor recessions of 1990 and 2001. Unlike the cause of inflation, the cause of business cycles is not obvious, which is why economists still vigorously debate the question. Minor blips in total reserves under Greenspan may have played some poorly understood role in any of these three events. Because Greenspan only imperfectly implemented Friedman’s rule of freezing the monetary base, without intending to do so, his policy may have ended up slightly too discretionary. But that possibility hardly justifies the “asset bubble” hubris of those economic prognosticators who, only well after the fact, declaim with absolute certainty and scant attention to the monetary measures how the Fed could have pricked or prevented such bubbles.

The misunderstanding of Alan Greenspan’s management of the U.S. money stock has an ironic coda. Before his appointment the Federal Reserve had proved so palpably inept as to all but discredit discretionary monetary policy. Both monetarist rules and free banking were gaining adherents among economists. But today, despite the recent financial turmoil, most interpret Greenspan’s record as showing either that discretionary policy can be done right or that what is needed is some activist pseudo-rule such as that developed by John B. Taylor of Stanford University. Central bankers, after half a century or more of failure, have allegedly learned from their past mistakes. Finally, according to this view, they have the knowledge to plan the money stock properly.

In a review of Greenspan’s memoirs Harvard economist Benjamin Friedman claims that Greenspan was a practitioner par excellence of monetary discretion (despite paying lip service to laissez faire) and that Greenspan’s major failing was that he was not more of a regulator. Friedman is wrong on both counts. Greenspan, like the Wizard of Oz, was a lousy wizard—but he was a good deregulator. And that made all the difference. His success stemmed from weakening Fed discretion with the unintentional approximation of a rigid monetary rule and the very deregulation that Benjamin Friedman deplores. Rather than demonstrating that monetarist rules are obsolete and free banking unnecessary, Greenspan’s policies suggest that the more thoroughly either of those two objectives is implemented, the greater the macroeconomic stability our economy will enjoy.

Money Definitions

• M1: currency in circulation, travelers’ checks, and transaction deposits (accounts that permit unlimited checking).
• M2: M1 plus savings deposits, small time deposits, money-market deposit accounts, and retail money-market mutual fund shares.
• M3 (which the Fed ceased reporting in March 2006): M2 plus bank-issued repurchase agreements, Eurodollar deposits held by U.S. residents in foreign branches of U.S. banks, large certificates of deposit (over $100,000), and institutional money-market mutual fund shares.
• MZM (Money of Zero Maturity and reported only by the St. Louis Fed): M2 minus small time deposits plus institutional money-market mutual fund shares.