Sunday, December 14, 2008

Stiglitz: Capitalist Fools

Stiglitz: Capitalist Fools


Capitalist Fools


     Behind the debate over remaking U.S. financial

     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, Clinton, and Bush II-and one national delusion.


by Joseph E. Stiglitz


Vanity Fair - January 2009


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 Clinton

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 Warren

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 Iraq made matters worse, because it led to soaring

oil prices. With America so dependent on oil imports,

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; America's household

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 East Asia crisis of the 1990s: high

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 America's banks faced collapse, the

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 America's taxpayers but failed to

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 Europe and the

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 America-and much of the rest of the world-of

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 Columbia University.


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