Reading the American Past: Printed Page 332

DOCUMENT 31–4

Joseph Stiglitz Describes Capitalist Fools' Responsibility for the Economic Crisis

In 2007–2008, financial institutions such as banks, Wall Street investment firms, and insurance companies precipitated the most severe economic crisis in American history since the Great Depression. The crisis prompted the federal government to bail out failing financiers and auto companies with hundreds of billions of taxpayer dollars. The crisis and its aftermath lingered for years, causing citizens to lose trillions of dollars in savings, millions of Americans to lose their jobs as the unemployment rate soared and stayed high, and state and municipal governments to cut funding for basic services such as education, health care, and public safety. According to an article, excerpted below, written in the midst of the crisis by Nobel Prize–winning economist Joseph E. Stiglitz, the seeds of the economic meltdown were planted by what he called “capitalist fools” who believed that financial markets should regulate themselves rather than be subject to government oversight.

Capitalist Fools, December 11, 2008

What were the critical decisions that led to the [economic] 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. ... 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. ...

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. ...

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. ...

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. ...

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 risk-taking. ...

[T]he 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. ...

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 Fed ... engineered the bailout of Long-Term Capital Management, a hedge fund whose trillion-dollar-plus failure threatened global financial markets. But [President Clinton's] Secretary of the Treasury Robert Rubin, his deputy, Larry Summers, and Greenspan were adamant — and successful — in their opposition [to regulating derivatives]. 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 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 ... 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. ... 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 [Bush] 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 [President Bush's ] 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. ...

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.

From Joseph E. Stiglitz, “Capitalist Fools,” Centre for Research on Globalization, GlobalResearch.ca, December 11, 2008.

Questions for Reading and Discussion