The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.

This means, presumably, that he thinks we may be about to enter a recession worse than the one in 1981 — and that it’s not going to end until house prices stop falling, which probably won’t be until 2010 or so. This is bad, right?

The rest of Greenspan’s piece is basically a convoluted way of saying that Wall Street never expects the good times to end, but when they (inevitably) do, all the computer models that worked when prices were going up suddenly seize up and die:

In line with the time-honoured observation that diversification lowers risk, computers crunched reams of historical data in quest of negative correlations between prices of tradeable assets; correlations that could help insulate investment portfolios from the broad swings in an economy. When such asset prices, rather than offsetting each other’s movements, fell in unison on and following August 9 last year, huge losses across virtually all risk-asset classes ensued.

….Over the past half-century, the American economy was in contraction only one-seventh of the time. But it is the onset of that one-seventh for which risk management must be most prepared. Negative correlations among asset classes, so evident during an expansion, can collapse as all asset prices fall together, undermining the strategy of improving risk/reward trade-offs through diversification.

In other words, all those risk management systems created by the rocket scientists weren’t designed to take into account the possibility that there was any actual risk in the system.

In any case, Greenspan alludes to the fact that traumatic events have become more common in the global economy over the past couple of decades, which is certainly true. Just to name a few, we’ve seen the run on the pound; the Mexican collapse; the Asian collapse; the LTCM smashup; the dotcom bust; and now the subprime debacle. The next big argument, I assume, is going to be between people like Greenspan, who essentially say there’s nothing we can do about this, and others who think that reining in the wild west of global finance a bit might be a useful thing to do. Count me in the latter camp.

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