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Tuesday, December 09, 2008

"Capitalist Fools"

What caused the crisis? Joe Stiglitz says it was “system failure” based upon a single, incorrect belief:

Capitalist Fools, by Joseph E. Stiglitz, Vanity Fair: There will come a moment when the ... task before us will be to chart a direction for the economic steps ahead. ... Behind the debates over future policy is a debate over ... the causes of our current situation. ... 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 ... understood that financial markets need to be regulated. Reagan wanted someone who did not believe any such thing... Greenspan['s] flood of liquidity combined with the failed levees of regulation proved disastrous. ...

No. 2: Tearing Down the Walls: The deregulation philosophy would pay unwelcome dividends... In November 1999, Congress repealed the Glass-Steagall Act... The most important consequence ... lay in the way repeal changed an entire culture. Commercial banks 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 ... 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.

There were other important steps down the deregulatory path. One was ... to allow big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher)... 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. ... Nothing was done.

No. 3: Applying the Leeches: Then along came the Bush tax cuts... 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... 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 flood of liquidity made money readily available in mortgage markets... 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... [T]he decision encouraged leveraging, because interest was tax-deductible. ... The Bush administration was providing an open invitation to excessive borrowing and lending...

No. 4: Faking the Numbers: ...[I]f 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 ... a fundamental underlying problem: stock options. ...[A] 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...

No. 5: Letting It Bleed: The final turning point came with the passage of a bailout package... As America’s banks faced collapse, the administration veered from one course of action to another. Some institutions ... were bailed out. Lehman Brothers was not. Some shareholders got something back. Others did not.

The original proposal by ... Henry Paulson ... 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 ...—and nothing was being done about the source of the problem, namely all those foreclosures. Valuable time was wasted... 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. ...

The other problem not addressed involved the looming weaknesses in the economy. ... Without quick action by government, the economy faced a downturn. ...

Was there any single decision which, had it been reversed, would have changed the course of history? ... 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.  ... 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.

    Posted by on Tuesday, December 9, 2008 at 12:51 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (66)

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