Alan Greenspan came out yesterday and, confronted by the obvious, admitted he was wrong about the markets’ capability to police themselves:

Oct. 19, 2004: “Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.”

Yesterday: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.”

We’re in one of those “holy cow!” moments that, in retrospect, makes you wonder not just whether Greenspan himself had a lick of common sense, but how all the politicians, public and private institutions, and collective suppositions arrayed around him for so long could have been so spectacularly off-base.

For one, it should have been obvious to Greenspan, who coined the phrase “irrational exhuberance,” that markets are not perfect information-processing systems. They’re subject to bubbles, to panics, to general craziness. That goes double in this case, when the chain of ownership of mortgage-based securities grew very opaque, often deliberately so. There simply wasn’t enough information to evaluate the financial risks, and the hard information that existed was often deliberately downplayed or obscured. When everybody’s making money, the market incentives push participants to make even more; there’s not much to be gained by sussing out out information that may bring the whole edifice down.

In some ways what’s happened is a classic “tragedy of the commons” problem. In the original scenario, outlined in Garrett Hardin’s 1968 article, cowherders share pastureland. Each one believes it’s in his own short-term interest to expand his own herd, and none has an incentive to pay attention to the long-term consequences – a pasture without grass and a lot of starving cows:

Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit–in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

In this case, the “commons” is the unregulated marketplace itself. This is a basic problem of human nature – one that Greenspan, Congress and successive presidents should have taken into account.

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