Why Economists Are in Need of Some Greek Tragedy

This week, Alan Greenspan, the man who held the world's purse strings in his hands from 1987 to 2006 as Chairman of the Federal Reserve, admitted to a congressional committee that his hands-off, free market ideology was beginning to spring leaks. His words make for fascinating reading. Asked by Congressman Henry Waxman "Were you wrong?", Greenspan replied:

Partially...I made a mistake in presuming that the self-interest of organisations, specifically banks, is such that they were best capable of protecting shareholders and equity in the firms...I discovered a flaw in the model that I perceived is the critical functioning structure that defines how the world works. The overall view I take of regulation is, I took an oath of office when I became Federal Reserve chairman. I'm here to uphold the laws of the land passed by Congress, not my own predilections.

What's really surprising about Greenspan's admission to the House of Representatives is just how flimsy his basic dogma seems in the wake of recent developments. Conventional economics has always treated people and organisations as rational actors who will always act in their own self-interest. The absurd presumptiousness of this position, even its silliness, should be clear to any layperson. Most people would surely concur with Jonathan Swift, writer of Gulliver's Travels, when he wrote to his friend, the poet Alexander Pope, of "the falsity of that Definition animale rationale, and to show it should be only animale rationis capax." Put simply: man is not a rational actor, merely capable of rationality.

People do things all the time that are damaging to their self-interest: abuse drugs or alcohol, sleep with an unsuitable person, fail to control their temper or emotions. The Greek's even bequeathed us a word for it - cacoethes, defined by Chambers Dictionary as "a bad habit or itch; an uncontrollable urge or desire". Shock horror, driven by greed or just a desire to continually create and open up new markets rather than shore up existing ones, bankers might not always act in the interests of their banks or clients. They are fallible, not acting for our best interests in the best of all possible worlds.

Still, given that ideology is so unfashionable in both American and British politics at present, Greenspan's words seemed almost otherworldly, as he presented his realization of "flaws" as a kind of religious doubt, a wavering of his faith in complete deregulation. When Congressionman Waxman pressed: "You found that your view of the world, your ideology, was not right, it was not working?", Greenspan essentially agreed: "That's precisely the reason I was shocked because I'd been going for 40 years or so with considerable evidence that it was working exceptionally well."

So how has the media responded to Greenspan's bombshell? Jim Randel at the Huffington Post applauds Greenspan's forthcomingness "in acknowledging that he miscalculated the events which have led to the worst financial crisis in the United States since the Great Depression." Randel paints the former Fed Reserve Chairman as an ideologue living in the "Washtington bubble", blind to the anarchic reality that deregulation has created.

This airy attitude to risk does seem to characterise Greenspan's tenure in the Federal Reserve. For instance Greenspan was an enthusiastic backer of deriatives, the chopped-up parcels of saleable debt that brought inter-bank lending to a standstill. As Greenspan told the Senate Banking Committee in 2003:

"What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so. We think it would be a mistake to more deeply regulate."

Come the credit crunch, Greenspan was left floundering: "Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity, myself especially, are in a state of shocked disbelief. Such counter-party surveillance is a central pillar of our financial market's state of balance."