10
Dec
08

A single mistake

That’s how Nobel Prize-winning economist Joseph Stiglitz assigns culpability for our current economic meltdown, as encapsulated in a single, flawed belief:

that markets are self-adjusting and that the role of government should be minimal.

If you’re like me, you haven’t been keeping up with most economic analysis of our current crisis because it bores / confuses / depresses you.  But this Vanity Fair piece by Stiglitz clearly explains 5 major decisions since the Reagan era that got us to today.   Though I summarize them very briefly here, I highly recommend the whole article.

1.  Reagan’s firing of Fed Chairman Paul Volcker and hiring of Alan Greenspan

Volcker…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…

Greenspan presided over not one but two financial bubbles…

2.  Deregulation under Clinton (or as they say in New Orleans, les bon temps roulez!)

In November 1999, Congress repealed the Glass-Steagall Act—the culmination of a $300 million lobbying effort by the banking and financial-services industries, and spearheaded in Congress by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

When repeal of Glass-Steagall brought investment and commercial banks together, the [high leverage, high risk] investment-bank culture came out on top.

…in April 2004…the Securities and Exchange Commission…[decided] to allow 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. …the S.E.C. argued for the virtues of self-regulation: the peculiar notion that banks can effectively police themselves. Self-regulation is preposterous…and…can’t…identify systemic risks…

As we stripped back the old regulations, we did nothing to address the new challenges posed by 21st-century markets…In 1998 the head of the Commodity Futures Trading Commission, Brooksley Born, had called for [derivatives] regulation…But Secretary of the Treasury Robert Rubin, his deputy, Larry Summers, and Greenspan were adamant—and successful—in their opposition. Nothing was done.

3.  The Bush Tax Cuts & Iraq

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. The war in Iraq made matters worse, because it led to soaring oil prices. With America so dependent on oil imports, we had to spend several hundred billion more to purchase oil—money that otherwise would have been spent on American goods…The flood of liquidity made money readily available in mortgage markets, even to those who would normally not be able to borrow. And, yes, this succeeded in forestalling an economic downturn; America’s household saving rate plummeted to zero.

The cut in the tax rate on capital gains contributed to the crisis in another way…The Bush administration was providing an open invitation to excessive borrowing and lending—not that American consumers needed any more encouragement.

4.  Sarbanes-Oxley and Stock Options

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.

…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.

The incentive structure of the rating agencies also proved perverse.

5.  The Bailout Plan

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.

(Naomi Klein thinks one of Paulson’s major mistakes was submitting such a short proposal – the public actually read it and responded!)

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