Greenspan believed a lending institution's self interest in protecting shareholder equity would prevent the institution from taking on risk that would damage that equity. But he implicitly made two theoretical assumptions that the markets have now proven wrong.
The first was assuming that the self interested behaviour of agents in the marketplace could never lead to a systemic financial collapse. Underlying this assumption was the belief that the agent's self interest in protecting shareholder equity would prevent bet the farm behavior that could lead to financial collapse. But the present crisis presents a prime example of marketplace agents self interested behavior leading to a financial collapse. And while the actions of individual marketplace agents in this case did not necessarily endanger business entities on their micro economic level, the sum of the self interested behavior has led us to our present financial collapse on the macroeconomic level. The sum is greater than the whole in this instance.
Most of the agents in the marketplace, acting out of self interest, bought insurance in the credit default swap market (CDS) on their risky bets and then went on to engage in even riskier behaviour because they thought their previous risky behavior was hedged. But because so many agents thought they were hedged against losses and then went on to engage in riskier behavior that didn't pan out, the trouble started. The failure of the agents' riskiest bets led to the collapse of the agents' previous hedging strategies, which resulted in a lot of market players going into a financial tailspin. What Greenspan didn't count on was self interested agents thinking they had hedged their bets when in reality they were engaging in willful blindness as to the risks they had incurred. Very few CDS market players inquired into the liabilities their insurers were carrying and what would happen if there were large scale defaults that required the insurers to pay out more than they had bargained for. And the insurers did not count on large scale defaults occurring. See AIG. Something similar happened in the securitized mortgage market. Thus the failure of marketplace agents riskiest bets led to a failure, or at least the perception of a possible failure (after all a lot of this crisis is a crisis of faith), and behavior that was previously believed to be hedged became suspect.
Greenspan's second and worse theoretical mistake was anthropomorphizing business entities through inapplicable metaphors. Inanimate objects do not have self interests, no matter how useful it may be to sometimes speak as if they do. And it is quite often convenient and harmless to talk as if inanimate objects like banks intentionally do things such as entering into contracts. But this is just a convenient short hand for discussing the behavior of the human agents who actually control the business entity in question, and it is a mistake to think that somehow the business entity has intentional psychological states that only belong to conscious animals. To say a bank's self interest will mitigate its risk taking is to attribute an intentional psychology to an inanimate object.
In terms of analyzing the self interest of agents in a marketplace a better place to start is with the agents who have the real psychological intentional states, the humans that run the entity. Once you start to look at the self interests of the intentional agents you can see how those self interests may cause them to make the entity take actions not in the entity's best interest. Stock options provide incentives to pump up stock prices and executive pay packages often include perverse incentives for the executive to act against the company's best interest. This is nothing new, but there seems to be a naive belief with many free marketers that business entities have intentional states such as self interest that exist independently of the human agents that run the entities, and this leads the free marketers to be shocked at behavior that is obvious to anyone who just takes a look around them.
