In a brilliant article in Vanity Fair, Nobel Prize Winning Economist Joseph E. Stiglitz gives us a remarkably clear and clear-headed review of the multiple bad decisions that have led us to our present mess, starting with Reagan’s decision to fire Paul Volcker from his position as Chairman of the Fed and replace him with the radically anti-regulation Ayn Rand worshipper Alan Greenspan.
Stiglitz lists five key mistakes, decisions that were made in the administrations of Reagan, Clinton and Dubya. Mistakes cascade – each bad decision makes it more difficult to undo the negative results of the last bad decision. So, Greenspan was the first mistake; Stiglitz points out that Greenspan presided over not one but two bubbles: the high-tech bubble of 2000-2001 and the subsequent housing bubble.
He [Greenspan] had many of the tools he needed to cope with the situation. To deal with the high-tech bubble, he could have increased margin requirements (the amount of cash people need to put down to buy stock). 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. If he didn’t have the tools, he could have gone to Congress and asked for them.
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. Not surprisingly, the credit markets froze.
Greenspan ran the Fed through the course of the next three mistakes that Stiglitz identifies: the tearing down of the walls that separated commercial banks from investment banks and the consequent pressure on the commercial banks to take on riskier investments; the Bush Administration’s many actions that, in Stiglitz’s words, seemed to be based on the belief “that tax cuts, especially for upper-income Americans and corporations, were a cure-all for any economic disease—the modern-day equivalent of leeches”; and the breakdown, throughout the first decade of this century, of ratings agencies as adequate arbiters of the financial soundness of the companies they rated (and from whose ranks they came).
The final mistake was the bailout of the banks:
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. 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
The conclusion Stiglitz comes to is radical and, to my mind, right on:
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.
The article is not all that long, and Stiglitz’s majestic command of the facts and their implications make his story most convincing. Let’s hope that the Democratic majority has the good sense and that President-Elect Obama has the leadership skills to restore a role for government in the creation and maintenance of an economic system that will be equitable, transparent, and productive of widely shared prosperity and well-being.