- Back in 1987 Reagan replaced the world class central banker Paul Volker with the Ayn Randian Libertarian gold bug and free- unregulated- financial market apostle Alan Greenspan. Throughout his nearly two decades as Federal Reserve Chairman Greenspan ran a loose money low interest policy that created excess of liquidity, and he combined this with his belief that financial markets were self-regulating, so he did not provide the banks with the regulations they needed. This led directly to two financial bubbles followed by the current financial freeze-up.
- In 1999 the bankers and financial industry succeeded in removing the Depression era Glass-Steagall Act. The Glass-Steagall Act had separated the commercial banks which made loans from the Investment banks that organized the sale of stocks and bonds. The intent was to keep the bank which sold the equity or bonds of an organization from pressuring its lending arm to loan money to the organization if that organization was getting into financial trouble. The difficulty is that combining the two kinds of banks causes commercial banks - which are supposed to conservatively invest other people's money - are sucked into the high-risk highly-leveraged financial operations of the investment banks. The entire American banking system became a great deal more risky and less able to deal with economic downturns.
Then in 2004 the SEC "... allow[ed] big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process." This was based on the assumption that the big banks were capable of regulating themselves. The results show that they were not. Among other problems, no one bank is capable of identifying the systemic risks that exist when numerous banks all operate similar computer models to manage their portfolios. There is no control that prevents them all from selling the same stock at the same time, an even sure to cause a financial disaster in the market. - Then there were the two separate tax cuts aimed primarily at the rich in 2001 and 2003. They were supposed to stimulate the economy, but actually did very little stimulation. The economy was primarily stimulated by Greenspan's low interest rates and enlarged money supply, which worked through inflating the housing bubble.
The tax cuts also lowered the capital gains tax but there was no tax on interest. This encouraged investors to borrow money from the home equity to invest and deduct the interest each year on their taxes. The capital gains were not taxed until the investment was sold, sometime far in the future. The already excessive borrowing and lending was being encouraged by the Bush tax cuts. - Two additional items were the exclusion of stock options from consideration in company's financial reporting and the incentive of the companies selling bonds and mortgage back bonds paying the rating agencies to rate the financial instruments. Stock options were used to pay executives when the market was going up and other payments were used to pay them when the market did not go up.
But the fact that rising markets increased the value of stock options led a lot of companies to fudge the financial reports to increase the value of the options. The fact that the rating agencies were paid by the sellers of the rated financial instruments meant that the rating agencies competed to see who would rate each issue the highest. Both of these factors led to less accurate financial reports. Everyone knows not to trust them. - The most recent problem has been the bail-out package to preserve Wall Street. The initial package demanded from Congress consisted of three pages that amounted to a demand by Secretary of the Treasury Paulson for $700 billion to be spent in any way he saw fit with no oversight. It amounted to a demand to Congress "Gimme tons of money and I'll take care of the Wall Street banks." (It's no real surprise, with Paulson's attitude, that the Detroit auto makers attempted the same strategy on Congress a few weeks ago.)
When a slightly improved bill was passed right before the election, Paulson then did not know what to do with it. His original plan to buy up bad loans quickly was abandoned as the massive insurer AIG failed and had to be rescued, but nothing that Paulson attempted was directed at the real underlying problems causing the economy and the markets to collapse. No surprise, because the Bush administration and Wall Street all operated on the Neo-Hooverian philosophy that the markets were self-correcting. Stiglitz describes the administration's efforts to turn the economy around with the bail-out this way:...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, namely all those foreclosures. 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. He even allowed the banks to pour out money to their shareholders as taxpayers were pouring money into the banks.
The other problem not addressed involved the looming weaknesses in the economy. The economy had been sustained by excessive borrowing. That game was up. As consumption contracted, exports kept the economy going, but with the dollar strengthening and Europe and the rest of the world declining, it was hard to see how that could continue. Meanwhile, states faced massive drop-offs in revenues-they would have to cut back on expenditures. Without quick action by government, the economy faced a downturn. And even if banks had lent wisely-which they hadn't-the downturn was sure to mean an increase in bad debts, further weakening the struggling financial sector.
The administration talked about confidence building, but what it delivered was actually a confidence trick. If the administration had really wanted to restore confidence in the financial system, it would have begun by addressing the underlying problems-the flawed incentive structures and the inadequate regulatory system.
Was there any single decision which, had it been reversed, would have changed the course of history? Every decision-including decisions not to do something, as many of our bad economic decisions have been-is a consequence of prior decisions, an interlinked web stretching from the distant past into the future. You'll hear some on the right point to certain actions by the government itself-such as the Community Reinvestment Act, which requires banks to make mortgage money available in low-income neighborhoods. (Defaults on C.R.A. lending were actually much lower than on other lending.) There has been much finger-pointing at Fannie Mae and Freddie Mac, the two huge mortgage lenders, which were originally government-owned. But in fact they came late to the subprime game, and their problem was similar to that of the private sector: their C.E.O.'s had the same perverse incentive to indulge in gambling.In short, it is as I have been writing since this Recession started, we are living out the predictable results of the Reagan Revolution put into place by the conservative movement.
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.
Any time the financial sector is deregulated the result will always be a series of booms and busts, each larger than the previous one. Markets are NOT self-adjusting, and they can only be protected from themselves by appropriate government regulation.
Addendum December 11, 2008 11:42 am CST
Digby also posted on this Stiglitz article and she makes a really important point.
Democrats are working very hard to discredit the very concept of ideology in favor of technocratic competence. And I would guess most Americans find that to be something of a relief by now. But I think it's as much a mistake to sweep this under the rug as it is to let bygones be bygones on the torture regime. There is ideology and then there is ideology and people should know the difference. These dogmatic deregulators and market fundamentalists ran a decades long experiment that failed on an epic scale. If the country doesn't understand what went wrong here -- if they get confused by complexity and propaganda --- there is every reason that the free lunch mentality these ideologues promoted will make a comeback the minute we see the light at the end of the tunnel. Ideology matters.
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