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.
Capitalist Fools
By Joseph E. Stiglitz
Vanity Fair Magazine
January 2009
vanityfair.com
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. |
