A Response

Linda asked me in a comment to respond to a few articles that she has posted on her new blog. I haven't had time to read all of them, but the first one is a good one. I'll try to take his points in turn.

Capitalist Fools
by Joseph E. Stiglitz

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 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.

I have a lot of admiration for Paul Volcker. And Greenspan deserves some of the blame for the current problems, and the dot com boom-bust, but the article goes too far. People stretch the Ayn Rand connection. In fact, I'm pretty sure that a good Randian would be against loose monetary policy.

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 In November 1999, Congress repealed the Glass-Steagall Act—the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by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

I completely disagree with the Glass-Steagall analysis. Glass-Steagall itself was not the problem. In fairness, Stiglitz doesn't argue that it was the problem, but rather that the culture change implied in repealing the Chinese wall between commercial and investment banks was the problem. I disagree. I do agree, however, that bank "self-regulation is preposterous." To be clear my disagreement with Stiglitz is that he points to Glass-Steagall as the cause of a culture of risk-taking, and I argue that the culture of risk-taking had the effect of repealing Glass-Steagall. But I think Glass-Steagall, in the end, was and is a good thing. Universal banking is not in and of itself a bad thing. It's a good thing in my opinion. Europe has had it for centuries.

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.

I said as much here:

FLG is pro lowering taxes. However, the Republicans cannot have it both ways. They cannot argue that when times are good, then the government should give the people back their money, and, oh, by the way, when times are bad we need to cut taxes to stimulate the economy.

No. 4: Faking the Numbers

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 have been defended as providing healthy incentives toward good management, but in fact they are “incentive pay” in name only. If a company does well, the C.E.O. gets great rewards in the form of stock options; if a company does poorly, the compensation is almost as substantial but is bestowed in other ways. This is bad enough. But a collateral 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.

I want to disagree, but he has a point. I want there to be some way to use stock options as incentives for good management, but there are too many ways to game the system for a quarter or two, exercise the options, and then come clean the next quarter. However, what we are talking about here is a type of fraud. Providing distorted information should be prosecuted. Admittedly, it's hard to make a case that the information was willfully distorted, but nonetheless.

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 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.

Mistakes were made. Certainly. And economic historians will analyze every decision made. But these were unprecedented issues. I would forgive people for reacting poorly at first to frogs falling from the sky. It's just too unbelievable to comprehend at first, and that's kinda what happened here.