Stiglitz Explains The Meltdown (We Differ)

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.

Comments

[Jim Ryan]

Good post.

[Charlie (Colorado)]

You know, this is why I hate economics. The meaning of terms changes depending on the political orientation of the economist; the facts move to suit the theory; the "scientific results" seem clearly driven by the outcome they desire; and economists who are really doing empirical research don't become well known unless they're politically convenient.

There was another recent example that struck me, when the NBER declared there had been a recession for the last year. Now, if you look up recession, you'll find that old definition of two successive quarters of "negative growth", ie, reduction, in GDP. In other words, if GDP is G, then a recession starts when dG/dt < 0 and ends when dG/dt ≥ 0 again.

Look at the NBER report, and they define a recession as the time between when the rate of change of GDP changes downwards. and ends when it reverses. So to the NBER, a recession starts when d²G/dt² < 0 and ends when d²G/dt² ≥ 0.

In other words, the difference is between when you stop your car and put it into reverse, or when you're driving at 60 and start to slow down.

How can you make any decisions based on this nonsense?

[Neo]

BEIJING - CHINA may soon cut business tax as part of its efforts to prop up the slowing economy amid the global financial crisis, state media reported on Tuesday. The government is 'very likely' to soon cut the business tax for enterprises by one percentage point, the China Daily said, citing an unnamed source close to policymakers.

Meanwhile, "The One" is proposing public works projects that only unions would, and a commie should, love.

[Neo]

You say .. what about Fannie and Freddie ?

"Fannie Mae did not cause the current crisis," said Raines. "If anything, Fannie Mae played catch-up to the banks and investment banks who drove the securitization of the most toxic subprime mortgages."

Raines said that while Fannie and Freddie hold some responsibility for not appropriately managing their own credit risk, regulators must share in the blame. He argued that government officials -- he named the Federal Reserve, Federal Trade Commission, Department of Housing and Urban Development, among others -- were asleep at the switch. The regulators, he said, failed to use their authority to put a stop to extremely dangerous lending practices.

"While regulations did not force financial institutions to make bad loans, the absence of consumer protection regulation allowed many bad loans to be made to the detriment of consumers," he said.

Yeah, that's the ticket .. noone was there to tell Franklin Raines not to lend again.

[Neo]

The headline says it all ...Pay raise for judges tucked into bailout plan

[bad]

TM, someone needs to report on the Waxman hearings held yesterday regarding Fannie Mae/Freddie Mac. Don't let Blago/auto bailout distract you...

[Pofarmer]

How can you make any decisions based on this nonsense?

One would hope that the powers that be are making decisions based on other factors than what we are fed in the press.

[bgates]

tax cuts, especially for upper-income Americans and corporations...the modern-day equivalent of leeches.
I know how he means it, but it's quite easy to paint this as
money : blood,
government : sick person, and
productive Americans : leeches.

OT, I have the DVR set to record "Children of the Damned" today. That's the one where superbright multiethnic young people with creepy dead eyes band together and hypnotize everyone else into committing terribly destructive acts.
By which I mean, I think I know an alternative catchphrase for "Team of Rivals".

[cathyf]

"While regulations did not force financial institutions to make bad loans, the absence of consumer protection regulation allowed many bad loans to be made to the detriment of consumers," he said.

This is, quite simply, a baldfaced lie. It was the presence of regulations forcing financial institutions to make bad loans that forced them to make bad loans.

[Neo]

With Citigroup now on the government dole, exactly what qualified them to takeover the "Wacky Bank" weeks ago ?

[narciso]

Stiglitz has to balance this with his
admiration for Hugo Chavez, who rode another commodity bubble into the ground; with grave consequences for his country.
He was an occasionally perceptive economist
who went mad at some point; re Krugman.
Speaking of economic analysts who should properly be buried in peet moss, like the Vogons recommend. Someone gave Henry Blodget
the former Merrill Lynch tech analyst a blog; and in addition to his financial picks, he's going for a little Trig Trutherism ;following Sullivan's delusions
'out where the buses don't run'

[LindaK]

It is always a source of amazement to me when left leaning economists argue that taz increases are good in the face of the fact patterns since the 1930s of the negative consequences of raising corporate and personal income taxes. Europe is another good example: the countries with the lowest income tax rates have great GDP growth than countries with high tax rates. The US has very high corporate tax rates. One of the reasons for the loss of jobs and manufacturing is that capital seeks low tax zones.

[LindaK]

Wasn't he an advisor to John Edwards, the populist?

[Patrick R. Sullivan]

I wonder what Ken Rogoff has to say about this, given his admiration for Stiglitz as
expressed in this 2002 letter:

Joe, you may not remember this, but in the late 1980s, I once enjoyed the privilege of being in the office next to yours for a semester. We young economists all looked up to you in awe. One of my favorite stories from that era is a lunch with you and our former colleague, Carl Shapiro, at which the two of you started discussing whether Paul Volcker merited your vote for a tenured appointment at Princeton. At one point, you turned to me and said, "Ken, you used to work for Volcker at the Fed. Tell me, is he really smart?" I responded something to the effect of "Well, he was arguably the greatest Federal Reserve Chairman of the twentieth century" To which you replied, "But is he smart like us?" I wasn't sure how to take it, since you were looking across at Carl, not me, when you said it.

[JJ]

Good post. Got me reading article and response in detail.

[Thomas Esmond Knox]

Wells Fargo

[rrsafety]

<<"And going forward, there may be a day when letting a big firm or two fail will be a very good thing.">>

Like Lehman?

Ooops. Anybody but Lehman.

[reliapundit]

i'm a bit shocked neither you or stiglitz mentions OIL.

the oil bibble was one of the things whch burst the bubble.

i say 3 things caused the current recession:

oil; greenspan's 17 rate increases (cuz he feared inflation); and CRA/FANNIE MAE derivatives.

the current crisis REQUIRED all three. two would have been a far different matter.

these ae the three legs of the cirrents crisis's stool.

[Thomas Esmond Knox]

Wells Fargo.

What did they do right?

Was it patience?

Was it patience and other virtues?

Tell me.

[kim]

Oh, that's easy, they employ my daughter.
==========================

[sophy]

I do not know how to use the Hellgate gold ; my friend tells me how to use.