The ghosts of Greenspan's past stalk Obama financial plan

Regulatory Tension

In unveiling his regulatory plan Wednesday, Obama noted that there is always tension between those who favor the market's “invisible hand” and those who favor “the guiding hand of government.”

He rightly added that such tension isn't always a bad thing. Yet in recent years, the invisible hand ruled.

Under Greenspan's laissez-faire approach, markets would police themselves and risk would be spread far and wide. The theory was that losses would be more easily absorbed if a broad base of investors, rather than a few banks, held risk.

Even as cracks began to gape in the financial system in early 2007, Geithner continued to hew to this view. While acknowledging in his speech at the time that problems with subprime mortgages may signal a gathering storm, he said that credit-market innovations should help ease any pain: “If risk is spread more broadly, shocks should be absorbed with less trauma.”

Hidden Risks

It didn't work out that way. Rather than dispersing risk, many of the policies espoused during the Greenspan era simply caused risks to regroup out of investors' and regulators' sight.

This meant that investors couldn't know who was holding what types of assets, which ultimately led them to stop trading with one another. Credit markets began to freeze.

Greenspan and his followers also trumpeted financial engineering, hailing the creation of exotic securities that would supposedly help to disperse risk. In the end, much of the innovation - like structured investment vehicles or CDOs - proved ephemeral.

Even those who weren't Greenspan disciples, such as Fed Chairman Ben Bernanke, failed to challenge the prevailing orthodoxy. Bernanke has been reluctant to abandon the financial- innovation theme promoted by his predecessor.

In a speech this April, Bernanke acknowledged that financial innovation is currently “perceived as the problem.” That said, the Fed chairman rose to its defense, saying that, “Innovation, at its best, has been and will continue to be a tool for making our financial system more efficient and more inclusive.”

Given that so many regulators and political leaders sipped from the Greenspan Kool-Aid cup, it will take time to see if the financial crisis has sobered them up.

If not, Obama can play with regulatory organizational charts all he wants, and it won't make much difference.

David Reilly is a Bloomberg News columnist. The opinions expressed are his own.

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