Sunday, March 29, 2009

Capitalist Fools

Recent Nobel laureates Joseph Stiglitz and Paul Krugman have long been known as left-liberal critics of conservative economic dogma. I offer here my own summary of Stiglitz's recent article in Vanity Fair , entitled "Capitalist Fools", both because it might benefit someone who doesn't have time to read the original article, and because it accords nicely with several of my own recent commentaries.

Stiglitz's column singles out five key mistakes by policy makers which contributed to our current malaise.

1. Firing the Chairman (Replacing Paul Volcker with Alan Greenspan)

In 1987, former president Ronald Reagan This meant replacing a noted pragmatist and believer in the need for financial regulation with an ideological follower of ultra-libertarian philosopher Ayn Rand. The timing of the appointment helped to obscure the fact that it was Volcker, not Greenspan, who had done most of the work in wringing inflation out of the economy.

No. 2: Tearing Down the Walls (The Deregulation Philosophy)

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 In November 1999, Congress repealed the Glass-Steagall Act—the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by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.

Stiglitz opposed the repeal of Glass-Steagall, for reasons that now seem obvious:

"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 (The Bush Tax Cuts)

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.

No. 4: Faking the Numbers (Dishonest Accounting)

The Sarbanes-Oxley Act that followed on the heels of the Enron scandal failed to deal with stock options; it also failed to deal with a collateral problem with stock options: 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. As Stiglitz puts it "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. "

NO. 5: Letting It Bleed (The Bush Bailout)

The crisis started when the US Treasury bailed out Bear Stearns--but then did not bail out Lehmann Brothers. "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. " But while the purpose of this act was to "restore" confidence" , how could it do that without addressing the cause for the lossof confidence--that too many bad loans had happened and too many foreclosures were happening.

The initial bailout plan was a failure. As Stiglitz puts it, "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."

Stiglitz concludes by saying that the fundamental problem was an ideological one: a naive faith in the Self -Regulating Market:

"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."

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