Events of the past two years have shaken many of the political and economic assumptions commonly held by journalists, politicians and policy-makers up to then. Probably the most famous change of mind has been that of Alan Greenspan, as discussed in the BBC2 show "The love of money", last week. At the height of the crisis last year, Greenspan went before Congress and said that he'd been wrong to believe that self-interest would be sufficient to make financial markets broadly self-regulating. In an interview for this BBC2 show, Greenspan expands upon his view. You can see him here, at 56.35. Here's what he said:
"Fundamental to the functioning of a market system is the fact that each individual economic entity works extraordinarily assiduously to preserve its solvency. It is such a critical part of the way a competitive free market system works. You have to have that as an essential ingredient in the marketplace, or it will not work."
Now this is a completely new one to me. I've heard of lots of economic theories in which firms seek to maximise profits, other theories in which they try to maximise expected shareholder value, and even of theories in which firms promote the interests of those that manage them rather than own them. But I've never heard of an economic theory in which firms, in general, make it their central goal to avoid becoming insolvent. How would that work? Wouldn't firms avoid risky new projects - risky new products or new production methods - preferring instead always to protect their solvency? Indeed, if a firm ever had any other option, wouldn't it always avoid taking on any new debt because to do so would increase the risk that, some day, it might become insolvent?
Is this some new school of economics that I've never heard of? (Perhaps readers can help me out?) Did Alan Greenspan really believe such an odd idea? One might think that he expressed himself badly on TV, but in his evidence to Congress (highlighted a minute or so earlier in the show) he seems to say much the same thing - he appears to believe that firms going insolvent represents some kind of failure of market processes, rather than being simply one of the ways in which market disciplines work. If he really did believe that in a well-functioning competitive market system no firm would ever go insolvent (or, at least, would never undertake a business strategy that would do otherwise than minimise its risk of going insolvent), how did someone with such eccentric beliefs ever get to hold such a significant position of economic management as Chairman of the Federal Reserve?
Update: It may be worth spelling a certain point out, since it may not be obvious to all readers. In almost no industry will it be the case that either the strategy that maximises expected profits or the strategy that maximises shareholder value will minimise the probability of insolvency. This is particularly the case in the finance industry, which intrinsically deals in risky activities. To maximise expected profits you need to take risks that might go bad. To minimise the probability of insolvency you need to avoid risks that might go bad. If Alan Greenspan really believed that firms aim to minimise insolvency, then he would have expected radically different patterns of behaviour from them than if he had believed (as per standard theory) that they maximise expected profits or shareholder value. That may not be obvious to all of you reading this piece, but few, if any, of you are governors of major central banks.
