Unintended market consequences

If only Alan Greenspan had read John Locke more attentively. The 17th-century philosopher, who doubled as a brilliant economist, was among the earliest exponents of the law of unintended consequences. It is one of the most powerful lessons economics has to teach, yet one the former US Federal Reserve chairman conspicuously failed to heed.

To understand why hedge-fund whizz-kids have spent the past few weeks tearing their hair out, and why Greenspan is largely to blame, let us take a trip back to 1692. That year, Locke wrote with passion against a parliamentary bill that proposed to cut interest rates. Its supporters wanted to help the poor; but Locke realised that government intervention would be worse than doing nothing. Paradoxically, he argued, it would hurt hardest those it sought to help — ‘widows, orphans and all those who have their estates in money’ — by curtailing the supply of credit.

Fast-forward to 2001, the year in which Greenspan slashed US interest rates from 6 per cent to 1.75 per cent (they eventually fell all the way to 1 per cent). He was desperately and laudably trying to fight the twin effects of the collapse of the dotcom bubble and the fallout from 9/11. But while he succeeded beyond all expectations, staving off recession and covering himself in glory in the process, his actions also triggered a borrowing bonanza, a house-price boom and deeply imprudent attitudes to risk, laying the seeds of the current turmoil in financial markets.

Vast numbers of mortgages were extended to US borrowers with poor credit ratings, on the absurd assumption that interest rates would always remain low. Now that Fed rates are back up to 5.25 per cent, tens of thousands of sub-prime borrowers have started to default.