Stiglitz: Capitalist Fools
Capitalist Fools
Behind the debate over remaking
policy will be a debate over who's to blame. It's
crucial to get the history right, writes a Nobel-
laureate economist, identifying five key mistakes-
under Reagan,
by Joseph E. Stiglitz
Vanity Fair - January 2009
http://www.vanityfair.com/magazine/2009/01/stiglitz200901
There will come a moment when the most urgent threats
posed by the credit crisis have eased and the larger
task before us will be to chart a direction for the
economic steps ahead. This will be a dangerous moment.
Behind the debates over future policy is a debate over
history-a debate over the causes of our current
situation. The battle for the past will determine the
battle for the present. So it's crucial to get the history straight.
What were the critical decisions that led to the
crisis? Mistakes were made at every fork in the road-we
had what engineers call a "system failure," when not a
single decision but a cascade of decisions produce a
tragic result. Let's look at five key moments. No. 1: Firing the Chairman
In 1987 the Reagan administration decided to remove
Paul Volcker as chairman of the Federal Reserve Board
and appoint Alan Greenspan in his place. Volcker had
done what central bankers are supposed to do. On his
watch, inflation had been brought down from more than
11 percent to under 4 percent. In the world of central
banking, that should have earned him a grade of A+++
and assured his re-appointment. But Volcker also
understood that financial markets need to be regulated.
Reagan wanted someone who did not believe any such
thing, and he found him in a devotee of the objectivist
philosopher and free-market zealot Ayn Rand.
Greenspan played a double role. The Fed controls the
money spigot, and in the early years of this decade, he
turned it on full force. But the Fed is also a
regulator. If you appoint an anti-regulator as your
enforcer, you know what kind of enforcement you'll get.
A flood of liquidity combined with the failed levees of
regulation proved disastrous.
Greenspan presided over not one but two financial
bubbles. After the high-tech bubble popped, in
2000-2001, he helped inflate the housing bubble. The
first responsibility of a central bank should be to
maintain the stability of the financial system. If
banks lend on the basis of artificially high asset
prices, the result can be a meltdown-as we are seeing
now, and as Greenspan should have known. He had many of
the tools he needed to cope with the situation. To deal
with the high-tech bubble, he could have increased
margin requirements (the amount of cash people need to
put down to buy stock). To deflate the housing bubble,
he could have curbed predatory lending to low-income
households and prohibited other insidious practices
(the no- documentation-or "liar"-loans, the interest-
only loans, and so on). This would have gone a long way
toward protecting us. If he didn't have the tools, he
could have gone to Congress and asked for them.
Of course, the current problems with our financial
system are not solely the result of bad lending. The
banks have made mega-bets with one another through
complicated instruments such as derivatives, credit-
default swaps, and so forth. With these, one party pays
another if certain events happen-for instance, if Bear
Stearns goes bankrupt, or if the dollar soars. These
instruments were originally created to help manage
risk- but they can also be used to gamble. Thus, if you
felt confident that the dollar was going to fall, you
could make a big bet accordingly, and if the dollar
indeed fell, your profits would soar. The problem is
that, with this complicated intertwining of bets of
great magnitude, no one could be sure of the financial
position of anyone else-or even of one's own position.
Not surprisingly, the credit markets froze.
Here too Greenspan played a role. When I was chairman
of the Council of Economic Advisers, during the
administration, I served on a committee of all the
major federal financial regulators, a group that
included Greenspan and Treasury Secretary Robert Rubin.
Even then, it was clear that derivatives posed a
danger. We didn't put it as memorably as
Buffett-who saw derivatives as "financial weapons of
mass destruction"- but we took his point. And yet, for
all the risk, the deregulators in charge of the
financial system-at the Fed, at the Securities and
Exchange Commission, and elsewhere-decided to do
nothing, worried that any action might interfere with
"innovation" in the financial system. But innovation,
like "change," has no inherent value. It can be bad
(the "liar" loans are a good example) as well as good.
No. 2: Tearing Down the Walls
The deregulation philosophy would pay unwelcome
dividends for years to come. In November 1999, Congress
repealed the Glass-Steagall Act-the culmination of a
$300 million lobbying effort by the banking and
financial-services industries, and spearheaded in
Congress by Senator Phil Gramm. Glass-Steagall had long
separated commercial banks (which lend money) and
investment banks (which organize the sale of bonds and
equities); it had been enacted in the aftermath of the
Great Depression and was meant to curb the excesses of
that era, including grave conflicts of interest. For
instance, without separation, if a company whose shares
had been issued by an investment bank, with its strong
endorsement, got into trouble, wouldn't its commercial
arm, if it had one, feel pressure to lend it money,
perhaps unwisely? An ensuing spiral of bad judgment is
not hard to foresee. I had opposed repeal of Glass-
Steagall. The proponents said, in effect, Trust us: we
will create Chinese walls to make sure that the
problems of the past do not recur. As an economist, I
certainly possessed a healthy degree of trust, trust in
the power of economic incentives to bend human behavior
toward self-interest-toward short-term self-interest,
at any rate, rather than Tocqueville's "self interest
rightly understood."
The most important consequence of the repeal of Glass-
Steagall was indirect-it lay in the way repeal changed
an entire culture. Commercial banks are not supposed to
be high-risk ventures; they are supposed to manage
other people's money very conservatively. It is with
this understanding that the government agrees to pick
up the tab should they fail. Investment banks, on the
other hand, have traditionally managed rich people's
money- people who can take bigger risks in order to get
bigger returns. When repeal of Glass-Steagall brought
investment and commercial banks together, the
investment-bank culture came out on top. There was a
demand for the kind of high returns that could be
obtained only through high leverage and big risktaking.
There were other important steps down the deregulatory
path. One was the decision in April 2004 by the
Securities and Exchange Commission, at a meeting
attended by virtually no one and largely overlooked at
the time, to allow big investment banks to increase
their debt-to-capital ratio (from 12:1 to 30:1, or
higher) so that they could buy more mortgage-backed
securities, inflating the housing bubble in the
process. In agreeing to this measure, the S.E.C. argued
for the virtues of self-regulation: the peculiar notion
that banks can effectively police themselves. Self-
regulation is preposterous, as even Alan Greenspan now
concedes, and as a practical matter it can't, in any
case, identify systemic risks-the kinds of risks that
arise when, for instance, the models used by each of
the banks to manage their portfolios tell all the banks
to sell some security all at once.
As we stripped back the old regulations, we did nothing
to address the new challenges posed by 21st-century
markets. The most important challenge was that posed by
derivatives. In 1998 the head of the Commodity Futures
Trading Commission, Brooksley Born, had called for such
regulation-a concern that took on urgency after the
Fed, in that same year, engineered the bailout of Long-
Term Capital Management, a hedge fund whose trillion-
dollar- plus failure threatened global financial
markets. But Secretary of the Treasury Robert Rubin,
his deputy, Larry Summers, and Greenspan were adamant-
and successful-in their opposition. Nothing was done.
No. 3: Applying the Leeches
Then along came the Bush tax cuts, enacted first on
June 7, 2001, with a follow-on installment two years
later. The president and his advisers seemed to believe
that tax cuts, especially for upper-income Americans
and corporations, were a cure-all for any economic
disease- the modern-day equivalent of leeches. The tax
cuts played a pivotal role in shaping the background
conditions of the current crisis. Because they did very
little to stimulate the economy, real stimulation was
left to the Fed, which took up the task with
unprecedented low-interest rates and liquidity. The war
in
oil prices. With
we had to spend several hundred billion more to
purchase oil-money that otherwise would have been spent
on American goods. Normally this would have led to an
economic slowdown, as it had in the 1970s. But the Fed
met the challenge in the most myopic way imaginable.
The flood of liquidity made money readily available in
mortgage markets, even to those who would normally not
be able to borrow. And, yes, this succeeded in
forestalling an economic downturn;
saving rate plummeted to zero. But it should have been
clear that we were living on borrowed money and borrowed time.
The cut in the tax rate on capital gains contributed to
the crisis in another way. It was a decision that
turned on values: those who speculated (read: gambled)
and won were taxed more lightly than wage earners who
simply worked hard. But more than that, the decision
encouraged leveraging, because interest was tax-
deductible. If, for instance, you borrowed a million to
buy a home or took a $100,000 home-equity loan to buy
stock, the interest would be fully deductible every
year. Any capital gains you made were taxed lightly-and
at some possibly remote day in the future. The Bush
administration was providing an open invitation to
excessive borrowing and lending- not that American
consumers needed any more encouragement.
No. 4: Faking the Numbers
Meanwhile, on July 30, 2002, in the wake of a series of
major scandals-notably the collapse of WorldCom and
Enron-Congress passed the Sarbanes-Oxley Act. The
scandals had involved every major American accounting
firm, most of our banks, and some of our premier
companies, and made it clear that we had serious
problems with our accounting system. Accounting is a
sleep-inducing topic for most people, but if you can't
have faith in a company's numbers, then you can't have
faith in anything about a company at all.
Unfortunately, in the negotiations over what became
Sarbanes-Oxley a decision was made not to deal with
what many, including the respected former head of the
S.E.C. Arthur Levitt, believed to be a fundamental
underlying problem: stock options. Stock options have
been defended as providing healthy incentives toward
good management, but in fact they are "incentive pay"
in name only. If a company does well, the C.E.O. gets
great rewards in the form of stock options; if a
company does poorly, the compensation is almost as
substantial but is bestowed in other ways. This is bad
enough. But a collateral problem with stock options is
that they provide incentives for bad accounting: top
management has every incentive to provide distorted
information in order to pump up share prices.
The incentive structure of the rating agencies also
proved perverse. Agencies such as Moody's and Standard
& Poor's are paid by the very people they are supposed
to grade. As a result, they've had every reason to give
companies high ratings, in a financial version of what
college professors know as grade inflation. The rating
agencies, like the investment banks that were paying
them, believed in financial alchemy-that F-rated toxic
mortgages could be converted into products that were
safe enough to be held by commercial banks and pension
funds. We had seen this same failure of the rating
agencies during the
ratings facilitated a rush of money into the region,
and then a sudden reversal in the ratings brought
devastation. But the financial overseers paid no attention.
No. 5: Letting It Bleed
The final turning point came with the passage of a
bailout package on October 3, 2008-that is, with the
administration's response to the crisis itself. We will
be feeling the consequences for years to come. Both the
administration and the Fed had long been driven by
wishful thinking, hoping that the bad news was just a
blip, and that a return to growth was just around the
corner. As
administration veered from one course of action to
another. Some institutions (Bear Stearns, A.I.G.,
Fannie Mae, Freddie Mac) were bailed out. Lehman
Brothers was not. Some shareholders got something back.
Others did not.
The original proposal by Treasury Secretary Henry
Paulson, a three-page document that would have provided
$700 billion for the secretary to spend at his sole
discretion, without oversight or judicial review, was
an act of extraordinary arrogance. He sold the program
as necessary to restore confidence. But it didn't
address the underlying reasons for the loss of
confidence. The banks had made too many bad loans.
There were big holes in their balance sheets. No one
knew what was truth and what was fiction. The bailout
package was like a massive transfusion to a patient
suffering from internal bleeding-and nothing was being
done about the source of the problem, namely all those
foreclosures. Valuable time was wasted as Paulson
pushed his own plan, "cash for trash," buying up the
bad assets and putting the risk onto American
taxpayers. When he finally abandoned it, providing
banks with money they needed, he did it in a way that
not only cheated
ensure that the banks would use the money to re-start
lending. He even allowed the banks to pour out money to
their shareholders as taxpayers were pouring money into the banks.
The other problem not addressed involved the looming
weaknesses in the economy. The economy had been
sustained by excessive borrowing. That game was up. As
consumption contracted, exports kept the economy going,
but with the dollar strengthening and
rest of the world declining, it was hard to see how
that could continue. Meanwhile, states faced massive
drop- offs in revenues-they would have to cut back on
expenditures. Without quick action by government, the
economy faced a downturn. And even if banks had lent
wisely-which they hadn't-the downturn was sure to mean
an increase in bad debts, further weakening the
struggling financial sector.
The administration talked about confidence building,
but what it delivered was actually a confidence trick.
If the administration had really wanted to restore
confidence in the financial system, it would have begun
by addressing the underlying problems-the flawed
incentive structures and the inadequate regulatory system.
Was there any single decision which, had it been
reversed, would have changed the course of history?
Every decision-including decisions not to do something,
as many of our bad economic decisions have been-is a
consequence of prior decisions, an interlinked web
stretching from the distant past into the future.
You'll hear some on the right point to certain actions
by the government itself-such as the Community
Reinvestment Act, which requires banks to make mortgage
money available in low-income neighborhoods. (Defaults
on C.R.A. lending were actually much lower than on
other lending.) There has been much finger-pointing at
Fannie Mae and Freddie Mac, the two huge mortgage
lenders, which were originally government-owned. But in
fact they came late to the subprime game, and their
problem was similar to that of the private sector:
their C.E.O.'s had the same perverse incentive to indulge in gambling.
The truth is most of the individual mistakes boil down
to just one: a belief that markets are self-adjusting
and that the role of government should be minimal.
Looking back at that belief during hearings this fall
on Capitol Hill, Alan Greenspan said out loud, "I have
found a flaw." Congressman Henry Waxman pushed him,
responding, "In other words, you found that your view
of the world, your ideology, was not right; it was not
working." "Absolutely, precisely," Greenspan said. The
embrace by
this flawed economic philosophy made it inevitable that
we would eventually arrive at the place we are today.
Joseph E. Stiglitz, a Nobel Prize-winning economist, is a professor at
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