In a comprehensive study (PDF) presented to the Brookings Institution on Friday, former Chairman of the Federal Reserve and noted laissez-faire economist Alan Greenspan traces the roots of the global economic downturn back many years, arguing that because the savings rate of the developed world soared in the decade preceding it and intentions to invest were fewer, real long-term interest rates dropped, allowing a housing boom to take shape.

As housing became an interesting investment, “financial firms,” according to Greenspan, “starting in late 2003, began to accelerate the pooling and packaging of subprime home mortgages into securities.” Another factor contributing to the surge in demand, he notes (and I have previously opined that it was in fact the foremost factor), “was the heavy purchases of subprime securities by Fannie Mae and Freddie Mac,” the so-called government-sponsored enterprises. They were “pressed,” writes Greenspan, “by the Department of Housing and Urban Development and the Congress to expand ‘affordable housing commitments,'” and “they chose to meet them by investing heavily in subprime securities.” Between 2003 and 2004, their share of subprime securities grew fivefold, “implying that a significant proportion of the increased demand for subprime mortgage backed securities during the years 2003-2004 was effectively politically mandated.”

By the first quarter of 2007, subprime mortgage securities outstanding totaled over $900 billion; more than six times the size they had been in 2001. Unsurprisingly, as Greenspan puts it, “a classic euphoric global bubble took hold.”

Why didn’t people see it coming? The former central banker suspects that the relative shallowness of earlier busts led investors to believe “that future contractions would also prove no worse than a typical postwar recession.” Even the IMF, as late as April 2007, professed that global economics risks had declined compared to the year before. All regulators, including the Federal Reserve, “failed to fully comprehend the underlying size, length, and impact of the negative tail of the distribution of risk outcomes that was about to be revealed as the post-Lehman crisis played out.” The vast, and sometimes virtual indecipherable complexity of specific financial products, was “only modestly less of a problem.”

Greenspan likes to point out that he “raised the specter of ‘irrational exuberance'” as early as 1996 and stressed again in 2002 that the “extraordinary housing boom” could not go on indefinitely. But even he may have underestimated just how imminent the threat of collapse really was.

“In the context of financial reform,” the question must be answered whether the growth of the financial sector’s share of the economy in recent years was happenstance, “or evidence that [it] was required to intermediate an ever more complex division of labor,” writes Greenspan.

The great free-market economist is obviously struggling with his commitment to capitalism and the wish to achieve economic stability. “Inhibiting irrational behavior when it can be identified, through regulation,” can be stabilizing, he notes, yet “there is an inevitable cost of regulation in terms of economic growth and standards of living when it imposes restraints beyond containing unproductive behavior.”

“The elusive point of balance between growth and stability has always been a point of contention,” and Greenspan still has difficulty identifying it.

He recommends in the first place to “significantly increase capital requirements” for banks, meaning that they must hold more assets in reserve in order to better cushion a future contraction.

On another major shortcoming of the current financial system, the “too big to fail” problem, Greenspan suggests to push for contingent capital bonds to allow failing banks to either be rescued or go under without imperiling the whole of the market. If they prove insufficient however, “we should allow large institutions to fail,” he stresses, “and if assessed by regulators as too interconnected to liquidate quickly, be taken into a special bankruptcy facility.”

I assume that some of the newly created firms would survive, and others fail. If, after a fixed period of time (one month?), no viable exit from bankruptcy appears available, the financial intermediary should be liquidated as expeditiously as feasible.

In the end, Greenspan decides that “the notion of an effective ‘systemic regulator’ as part of a regulatory reform package would be ill advised. “The current sad state of economic forecasting,” he warns, “should give governments pause on the issue.”