Nobel Laureate Joseph Stiglitz attributes the meltdown to five not-so-easy pieces:
(1) the replacement of Volcker with Greenspan, a non-regulator;
(2) the repeal of Glass-Steagall, which pushed "too-big-to-fail" banks into the high-risk world of investment banking;
(3) the Bush income and capital gains tax cuts of 2001 and 2003;
(4) the collapse in credibility of accounting firms and rating agencies;
(5) Paulson's mishandling of the October 2008 bailout.
I can get behind the Greenspan problem; (2) through (5) are unconvincing. Here we go, starting with Greenspan:
Greenspan played a double role. The Fed controls the money spigot, and in the early years of this decade, he turned it on full force. But the Fed is also a regulator. 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.
"A flood of liquidity combined with the failed levees of regulation" - where can I get his Metaphor Maker?
Greenspan presided over not one but two financial bubbles. After the high-tech bubble popped, in 2000–2001, he helped inflate the housing bubble. The first responsibility of a central bank should be to maintain the stability of the financial system. If banks lend on the basis of artificially high asset prices, the result can be a meltdown—as we are seeing now, and as Greenspan should have known. He 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.
After several years of complaints about a jobless recovery and a few good years of job growth, Greenspan was not going to reduce liquidity in 1999 just to see whether the fears of the Y2K bug were overblown. Hindsight is 20/20.
As to the housing bubble, c'mon - that was a good thing! Following the 2001 recession and the 9/11 attacks, there was general relief that the housing sector and the US consumer were keeping the US and world economies afloat. Greenspan's guiding philosophy has been that a recession tomorrow is better than a recession today. Obviously, its hard to judge that rule without knowing the relative severity of the recessions on offer today and tomorrow, but its not a bad rule.
That said, Greenspan's approach suggests a different metaphor - maybe Greenspan was making the same mistake as the Forest Service when it extinguished every fire, however small, at Yellowstone. Eventually the accumulated debris fueled a fire much hotter and more destructive than ever could have occurred naturally, proving that a (big) fire tomorrow is not better than a small fire today. Obviously, Greenspan and Co. made a bad call back in 2005 when the question of dealing with a possible housing bubble was mooted.
Here is Stiglitz on the repeal of Glass-Steagall:
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.
Along that line, Stiglitz ought to cite the 1998 bail-out of Long Term Capital Management. By demonstrating that a "never heard of 'em" hedge fund was too big to fail, Greenspan strongly reinforced the notion that banks and investment banks could count on a Fed lifeline. Lightly regulated and heavily supported - where was that going to lead?
I find Stiglitz utterly unconvincing on taxes, but I guess all earnest libs have to say this:
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.
I think long term structural tax cuts are entirely capable of stimulating the economy, but let me move on:
The cut in the tax rate on capital gains contributed to the crisis in another way. It was a decision that turned on values: those who speculated (read: gambled) and won were taxed more lightly than wage earners who simply worked hard. But more than that, the decision encouraged leveraging, because interest was tax-deductible. If, for instance, you borrowed a million to buy a home or took a $100,000 home-equity loan to buy stock, the interest would be fully deductible every year. Any capital gains you made were taxed lightly—and at some possibly remote day in the future. The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement.
Huh? Warren Buffet, a gambler? And the timing is backwards - we had a tech bubble and attendant speculation in equities back in 1999/2000, under the Clinton income and capital gain tax rates. Then, after Bush cuts the capital gains rate, global investors flocked to bonds backed by US home mortgages - that's an equity play?
As a bonus quibble, with lower income tax rates the value of the mortgage interest deduction is reduced, not increased.
If Stiglitz's point is that a reduction in the capital gains rate artificially inflated US equity prices, well, that would be controversial. Plenty of investors (e.g., pension funds and college endowments) are not subject to tax and it is far from clear that the marginal investor is driven by capital gains considerations. In any case, its a long leap from the stock market to sub-prime mortgages.
If his point is that a lower capital gains rate encouraged speculation in US houses (I don't think it is), well, most people can avoid capital gains on their primary residence most of the time. Baffling. [LATE UPDATE: I refer to the Bush capital gains cut; this 1997 elimination of capital gains on home sales may well have fueled the housing bubble but its hard to pin that cut on Bush.]
But the Bush tax cuts have to go (eventually) , so Stiglitz has added his voice to the chorus.
Here is Stiglitz on the rating agencies:
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. 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.
Well, for a century both Moodys and S&P endured that conflict and valued their reputation. Times change. But let's picture a different world.
Suppose the fifty state treasurers agreed fund a new rating agency paid for by investors, that, since between their various agencies and pension funds they owned all sorts of assets. That eliminates the incentive that Moodys and S&P had to play up to the issuer. But it also creates a new incentive, to wit, don't embarrass the investors. Will this new, Simon Pure Agency be immune to pressure to avoid embarrassing a powerful state treasurer caught holding bonds that are under review for a possible downgrade? You're sure? I am not - the question of who will guard the guardians is neither new nor simple.
On point (5), Stiglitz hammers Paulson for the proposed bailout. I would point to the decision to allow Lehman to fail as the more disastrous moment of the fall of '08. A snippet:
Valuable time was wasted as Paulson pushed his own plan, “cash for trash,” buying up the bad assets and putting the risk onto American taxpayers. 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.
How does one force banks to lend?
Stiglitz' Big Finish:
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.
I disagree with Stiglitz's characterization of the situation as "a belief that markets are self-adjusting and that the role of government should be minimal". Or, as a great American almost said, these markets cannot permanently endure half regulated and half free.
The fact is, investors did not act as if they expected the role of government to be minimal; they acted as if they expected the Fed to perform a miracle if times got tough, just as the Fed had done in 1998 and 2001. The US government, Democrats and Republicans, promoted the ownership society and the growth of the sub-prime market and the Fed's interest rate policy kept the housing market alive for years.
And why is the analysis so Amero-centric? Britain has been a major financial center for centuries, with a Labor government and a proud regulatory tradition - why are all their banks going down? What happened to Iceland, and why is that our fault? When the US takes Stiglitz's advice and hires more regulators, I hope we are also able to hire the smart ones. Or the prescient ones. But the odds are, we will hire people who will figure they can't get fired for saying "No" to everything.
Well. Now is not the time for the government to step back and watch everything burn. But looking back, it might have been helpful if the Fed had let a firm or two fail in 1998 as an inspiration to the others. And going forward, there may be a day when letting a big firm or two fail will be a very good thing.