http://www.vanityfair.com/magazine/2009/01/stiglitz200901
The Economic Crisis
Capitalist Fools
Behind the debate over remaking U.S. financial policy will be a debate
over who’s to blame. It’s crucial to get the history right, writes a
Nobel-laureate economist, identifying five key mistakes—under Reagan,
Clinton, and Bush II—and one national delusion.
by Joseph E. Stiglitz January 2009
Treasury Secretary Henry Paulson and former Federal Reserve Board
chairman Alan Greenspan bookend two decades of economic missteps. Photo
illustration by Darrow.
There will come a moment when the most urgent threats posed by the
credit crisis have eased and the larger task before us will be to chart
a direction for the economic steps ahead. This will be a dangerous
moment. Behind the debates over future policy is a debate over history—a
debate over the causes of our current situation. The battle for the past
will determine the battle for the present. So it’s crucial to get the
history straight.
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.
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.
How did we land in a recession? Visit our archive, “Charting the Road to
Ruin.” Illustration by Edward Sorel.
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.
Of course, the current problems with our financial system are not solely
the result of bad lending. The banks have made mega-bets with one
another through complicated instruments such as derivatives,
credit-default swaps, and so forth. With these, one party pays another
if certain events happen—for instance, if Bear Stearns goes bankrupt, or
if the dollar soars. These instruments were originally created to help
manage risk—but they can also be used to gamble. Thus, if you felt
confident that the dollar was going to fall, you could make a big bet
accordingly, and if the dollar indeed fell, your profits would soar. The
problem is that, with this complicated intertwining of bets of great
magnitude, no one could be sure of the financial position of anyone
else—or even of one’s own position. Not surprisingly, the credit markets
froze.
Here too Greenspan played a role. When I was chairman of the Council of
Economic Advisers, during the Clinton administration, I served on a
committee of all the major federal financial regulators, a group that
included Greenspan and Treasury Secretary Robert Rubin. Even then, it
was clear that derivatives posed a danger. We didn’t put it as memorably
as Warren Buffett—who saw derivatives as “financial weapons of mass
destruction”—but we took his point. And yet, for all the risk, the
deregulators in charge of the financial system—at the Fed, at the
Securities and Exchange Commission, and elsewhere—decided to do nothing,
worried that any action might interfere with “innovation” in the
financial system. But innovation, like “change,” has no inherent value.
It can be bad (the “liar” loans are a good example) as well as good.
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