THE
ECONOMIC CRISIS
Capitalist Fools
by Joseph
E. Stiglitz
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.
© 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 Clintonadministration,
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 Iraqmade
matters worse, because it led to
soaring oil prices. With Americaso 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 Asiacrisis 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 Europeand 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 ColumbiaUniversity.
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