Interesting article in Vanity Fair, Capitalist Fools, by Nobel prize winning economist Joseph Stiglitz, traces our financial crisis to terribly flawed ideology — one that says markets are self-adjusting and that the role of government should be minimal. Stiglitz reports on Alan Greenspan’s testimony on Capital Hill this fall where, finally, Greenspan admits his ideology of unregulated markets was terribly wrong and the source of our financial crisis.
Stiglitz says that it is important to understand the history that brought us to our present crisis. He writes: “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.”
He says, “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,” and outlines five key developments in the history of the crisis:
No. 1: Firing the Chairman
Stiglitz writes, “In 1987 the Reagan administration decided to remove Paul Volcker as chairman of the Federal Reserve Board and appoint Alan Greenspan in his place. But Volcker 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. … 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.”
Stiglitz writes that regardless of the well known dangers of derivatives — Warren Buffett early on called them ‘financial weapons of mass destruction’ — “the deregulators in charge of the financial system decided to do nothing”
No. 2: Tearing Down the Walls
Stiglitz writes, “In November 1999, Congress repealed the Glass-Steagall Act—the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by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. … 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 risk taking. …
“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…. 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…. 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
Stiglitz writes, “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 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.
“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
Stiglitz writes, “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…. 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 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.”
No. 5: Letting It Bleed
Stiglitz writes, “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….
“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 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.”
Joseph E. Stiglitz, a Nobel Prize winning economist in 2001, is a professor at Columbia University. He was Chairman of the President’s Council of Economic Advisors from 1995 to 1997 for Bill Clinton. He is also the former Senior Vice President and Chief Economist of the World Bank.
