In recent weeks, Joseph Stiglitz has repeatedly vocalized his take on the causes of the current financial crises. In a series of articles and appearances in Vanity Fair, MSNBC and Bloomberg (upon which this article is based), the former Nobel Prize winner has outlined 5 key mistakes that lead to global economic catastrophe.
Replacing Paul Volcker with Alan Greenspan
Despite the success of the “Volcker Shock”, which brought domestic inflation down from 11 to 4%, the Reagan administration replaced Paul Volcker as Chairman of the Federal Reserve Board with Alan Greenspan. The cause of this substitution was Volcker’s ardent support of financial regulation.
In the words of Stiglitz, “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.” Instead, Stiglitz says that Greenspan should have fought the dot-com bubble by increasing margin requirements, and curbed predatory lending to deflate the housing bubble.
Stiglitz believes it was “unreasonable” to refuse to regulate the nascent credit-default swap and derivatives markets for fear of interfering with “financial innovation”. As a result, the financial system hinged on a series of massively interwoven gambles of which “no one could be sure of the financial position of anyone else – or even of one’s own position”. Not surprisingly, Stiglitz declared on MSNBC, the credit markets froze.
Repealing the Glass-Steagall Act
In 1999, Congress repealed the Glass-Steagall Act, which separated commercial banks (which lend and borrow) from investment banks (which underwrite the sale of securities). Glass-Steagall was borne from the ashes of the Great Depression, and attempted to restrain conflicts of interest in the financial markets. The Acts’ backers argued that a bank’s commercial division is inherently pressured to lend money to an ailing company their investment banking division had underwritten.
Stiglitz argues this repeal set an infectious precedent. Commercial banks, which hold civilian deposits, are supposed behave conservatively. Investment banks, Sitglitz claims, “manage rich people’s money – people who can take bigger risks in order to get better returns”. When Glass-Steagall was repealed, Stiglitz suggests that the Investment-bank culture won out, and increased depository risk became acceptable. This trend was continued in 2004 when the SEC authorized the investment banks to increase their debt-to-capital ratio from 12:1 to over 30:1. This enabled the banks to purchase more mortgage-backed securities, which further inflated the housing bubble, and jeopardized the savings of ordinary Americans.
More death, less taxes.
Stiglitz argues that the failure of the Bush tax cuts to stimulate the economy resulted in the Fed offering unprecedented low-interest rates and liquidity. As the war in Iraq drove up oil prices, and Americans ended up spending “several hundred billion more to purchase oil” rather than U.S. goods, the Fed fought to avoid a repeat of the 1970s slowdown. However, Stiglitz claims that “the Fed met the challenge in the most myopic way imaginable… (making) money readily available in mortgage markets, even to those who would not be able to borrow”. While this tactic did stave off economic slowdown, American debt to GDP levels skyrocketed, household savings plummeted to zero, and the housing market rapidly inflated.
Additionally, Stiglitz suggests that the Bush tax cuts had an even more pernicious outcome. By cutting the tax rate on capital gains, Bush increased the incentive for average Americans to leverage their assets, as interest was tax deductible. This resulted in Americans increasing the leverage rates on their most valuable and stable asset – their home – to purchase stock. In doing so, the interest they paid would be fully deductible every year, and they would pay exceptionally low rates in their capital gains. This further decreased household savings, increased consumer leverage, and a blew more air into housing bubble.
The Incentive Structure of the Rating Agencies
Rating agencies such as Moody’s and Standard & Poor’s are paid by the company they are supposed to grade. As a result “they have every reason to give companies high ratings… and believed in financial alchemy – that F-rate toxic mortgages could be converted into products that were safe enough to be held by commercial banks and pension funds”. Stiglitz draws a parallel to the Asia crisis of the 1990s, when high ratings caused a deluge of cash into the region, which immediately evaporated when the ratings reversed – ultimately devastating the region. The introduction of Basel II, which set legal reserve capital requirements based on agency ratings, intensified the damage done.
Haemophilia
Stiglitz claims that both the Federal Reserve and Bush administration acted like “the bad news was just a blip, and that a return to growth was just around the corner”. This attitude led to an inconsistent approach to economic stabilization, which creatied chaos and worsened investor/lender confidence. Some institutions (Bear Stearns) were bailed out; some were not (Lehman Brothers). Some shareholders were saved, some were not. No one knew the rules of the game.
Stiglitz goes on to argue that the original bailout package failed to address the underlying reasons for the loss of confidence. The banks had made too many bad loans; their balance sheets were too poor; and no one knew who was exposed to what. “The bailout package was like a massive transfusion to a patient suffer from internal bleeding – and nothing was being done about the source of the problem, namely all those foreclosures”. Stiglitz continues, “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.”
“I have found a flaw”
As you might expect, the ESA is a strong advocate for the principals of the free market. However, the global financial crisis has dutifully illustrated the need for diligent regulation of the financial industry. Self-regulation is practically incapable of identifying the systemic risks in the financial market. In Stiglitz’ words, “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.”