Other posts in this occasional series.
Joseph Stiglitz, the 2001 Nobel Prize winner and the most cited economist in the world (according to Wikipedia) has an article aggressively titled “Capitalist Fools” in Vanity Fair that purports to identify five key decisions that produced the current economic crisis, but really lays out one more or less unified argument for what went wrong: free market ideology or, in his words, “a belief that markets are self-adjusting and that the role of government should be minimal.”
The five “decisions,” with Stiglitz’s commentary, are:
- Replacing Paul Volcker with Alan Greenspan, a free-market devotee of Ayn Rand, as Fed Chairman. (Incidentally, when I was in high school, I won $5,000 from an organization of Ayn Rand followers by writing an essay on The Fountainhead for a contest.) Stiglitz criticizes Greenspan for not using his powers to pop the high-tech and housing bubbles of the last ten years, and for helping to block regulation of new financial products.
- Deregulation, including the repeal of Glass-Steagall, the increase in leverage allowed to investment banks, and the failure to regulate derivatives (which Stiglitz accurately ascribes not only to Greenspan, but to Rubin and Summers as well).
- The Bush tax cuts. Stiglitz argues that the tax cuts, combined with the cost of the Iraq War and the increased cost of oil, forced the Fed to flood the market with cheap money in order to keep the economy growing.
- “Faking the numbers.” Here Stiglitz throws together the growth in the use of stock options – and the failure of regulators to do anything about it – and the distorted incentives of bond rating agencies – and the failure of regulators to do anything about it.
- The bailout itself. Stiglitz criticizes the government for a haphazard response to the crisis, a failure to stop the bleeding in the housing market, and failing to address “the underlying problems—the flawed incentive structures and the inadequate regulatory system.” (There’s regulation again.)
I have a lot of sympathy for the argument that deregulation was a significant cause of the crisis. Calling it “deregulation” is not entirely accurate, because there are not that many major regulations you can point to that were actually repealed. Glass-Steagall is one, but I’m not sure that was centrally important. Even if commercial banks and investment banks had not been allowed to combine, I still think commercial banks would have made foolish loans, and investment banks would have still bought them to package them into securities. Actually, a lot of the subprime lending was done by specialized mortgage lenders – not by the hybrid institutions created by Glass-Steagall – until they got bought up at the peak of the boom.
In addition to traditional deregulation, I think there was a failure to enforce existing regulations, and a failure to create new regulations to keep pace with innovation in the financial sector. On paper, federal bank regulators have a great deal of power already. For example, the Office of the Comptroller of the Currency, which regulates national banks, has the following powers (from their website):
- Examine the banks.
- Approve or deny applications for new charters, branches, capital, or other changes in corporate or banking structure.
- Take supervisory actions against banks that do not comply with laws and regulations or that otherwise engage in unsound banking practices. The agency can remove officers and directors, negotiate agreements to change banking practices, and issue cease and desist orders as well as civil money penalties.
- Issue rules and regulations governing bank investments, lending, and other practices.
The FDIC similarly has the power to examine banks, assessing issues such as capital adequacy, asset quality, and liquidity (those three concepts should be familiar to anyone following the crisis over the last three months). Now, it is true that most people failed to see the huge insolvency risks in the banking sector before they became frighteningly visible this fall. But most people aren’t bank regulators, either.
Perhaps more importantly, there was a failure to keep regulation up to date with changes in the financial sector. The event that has gotten the most attention is the passage of the Commodity Futures Modernization Act in December 2000, which, among other things, preempted any regulation of credit default swaps. Another example is the hands-off attitude that was taken toward hedge funds, even as they became a larger and larger part of the financial system, and even after the crisis caused by the near-collapse of Long-Term Capital Management in 1998. Another is the failure of regulators to adapt to the proliferation of new types of subprime lending, recounted in the New York Times article with the great title, “Fed Shrugged as Subprime Crisis Spread.”
What could better regulation have accomplished? It could have reduced the growth of exploding subprime loans that borrowers had no chance of paying off. It could forced credit default swaps onto exchanges. It could have required greater disclosure by financial institutions of off-balance sheet positions. It could have brought more of the “shadow banking system” into the light. It could have forced banks to increase their capital. It could have prevented AIG from taking huge unbalanced credit default swap positions. In summary, it could have slowed the growth of the bubble and made the systemic risk in the financial sector more visible.
Well, maybe. I don’t want to convey the impression that it’s possible to have a perfect level of regulation, and there certainly is such a thing as too much regulation. And any administration that tried to regulate the financial sector more closely would have faced bitter, vicious, well-financed opposition from the industry itself. The truth is we don’t know what the consequences of different regulations would have been. Also, even with better regulation, there still would have been trillions of dollars sloshing around, and lots of greedy people trying to divert it their way, and lots of bubble-prone investors. But in general I think Stiglitz is right that we have definitely erred on the side of too little regulation for quite a while now.
Stiglitz also raises the issue of incentive structures, which I think is a special case of the issue of regulation. One of the cardinal principles of undergraduate economics is that firms are rational profit-maximizing actors. This is widely understood to mean that firms act in the best interests of the shareholders who own them. However, in the real world, firms are controlled by their senior executives, who are loosely controlled by the board of directors, who are partially controlled by the CEO and very tenuously controlled by large institutional investors. During bailout season, we’ve all heard the phrase “capitalizing the upside and socializing the downside” or something to that effect – shareholders get the profits and taxpayers get the losses. But there’s another version of this that applies even without a taxpayer bailout.
Stiglitz is right that stock option-based compensation provides disproportionate rewards to executives (relative to shareholders) when stock prices rise and underproportionate risks to executives when stock prices fall. Even though, in general, it’s better for everyone for the stock price to go up and worse for everyone for it to go down, the benefits (as a function of stock price) differ for the two groups. This induces executives to take excessive risks and to take steps to boost short-term profits at the risk of long-term losses. But I don’t think the solution is government regulation to ban certain forms of compensation, because I just think it won’t work; boards of directors can be very creative about finding ways to pay CEOs obscene amounts of money. This is basically a corporate governance problem, and the solution is some form of increased disclosure by companies and increased shareholder rights, so shareholders can more easily replace directors who are complicit in paying CEOs obscene amounts. Both of these things (disclosure and shareholder rights) probably require new regulations or legislation.
It’s also important to remember that the U.S. was not the only country that had a housing bubble, and there was plenty of other bubble-like activity around the world, such as huge amounts of lending by Western and Central European banks into Eastern Europe and Latin America. Right now those banks are being burned as much by their emerging market investments as they are by their purchases of U.S. mortgage-backed securities. So when we talk about regulation, we have to remember that we live in a global financial system, and even if there were a virtuous country out there – call it Perfectistan – it would still be hurting today as a result of the downturn of the global economy. But the U.S. is still at the center of it all, for better or for worse.
The Baseline Scenario 
Thanks for the thoughtful essay. Missmarketcrash was on the same tangent last night – hit the bottom of this essay if you are not the literary sort –
the solution (but only in a utopian system) is: Open source it.
http://missmarketcrash.blogspot.com/2008/12/enchantress-of-numbers.html
Kind regards,
Miss Marketcrash
Another great article James.
I was thinking about the powers and responsibilities that you mention in regards to the Comptroller and FDIC. Although these agencies have the power to monitor banking institutions, I don’t know where those powers align with their responsibilities. As far as government agencies go, most are underfunded and understaffed. If they have authorities or responsibilities that do not correlate to their primary function, it probably gets overlooked. Honestly, I don’t know if this applies to either of these agencies, but it could explain why their isn’t more done to monitor the banking industry. In some ways its a good thing, since they already have the regulatory power it might be as simple as defining a framework for utilizing those powers and reporting their findings on a regular basis.
Interesting. The deeper question is, therefore, why did free market ideology come to the fore.
And if, as you say in your class, regulators privately despair (54 in the US alone controlling huge institutions not merely US but global in scope), how is any more regulation going to make any difference?
So when are you going to return the $5000 you got for your Ayn Rand essay?
John Donohue
Pasadena, CA
A very informative post. From this post and after reading the article by Joseph Stiglitz, I think lack of regulation tops as the cause of turmoil. The bond rating agencies should have done an “on their toes” job, but they have not been objective. Liquidity river, when it was flowing, needed embankments. If the rating agencies did an active job, these guided stoppers could have been set up ahead of time, before the flood.
When markers, in terms of these agencies, are present, then all that is needed is to pay heed to those markers and things would be OK. The demand for government regulation arises out of the fact that people do things that are not good for them. Just like smoking. There is a warning sign on the box, but people smoke. However, if there is a ban on public smoking, then only you see a significant effect that really discourages people to smoke.
Warning signs in terms of bond rating are not enough. People need to be sent to prison for violating certain financial rules. Then only, we would see intelligent finance take hold.
It seems we need BETTER or more effective regulations, not more. Perhaps we need to figure out ways to better align CEO’s short term decisions with long-term results. Most stock options vest over a couple years and expire 3 months after retirement or termination. Perhaps for upper level management, they should vest over a longer period, and be excercisable/saleable only in retirement, with a limited amount, 10-20% per year perhaps, being excercisable per year. So if their decisions bring down the company after they leave, they will feel the pain along with the shareholders.
With the fall of the Soviet Union and the transition of China from communism to capitalism, there ought to be a large pool of planners looking for work out there we could tap for this task of accelerating the nationalization of America.
Hiring them would be a brave token of America’s willingness to put our economy onto the International regulatory stage. And diverse too!
They’re experienced. They’re rested. They’re ruthless. Go gettem Mr. Obama.
John Donohue
Pasadena, CA
I always find it difficult to sift through the partisan aspects of analsyis.
It seems that the Repbublican analysis always wants to say that Fannie/Freddie (democratic darlings to be sure) and their “mandate” to get lower income folks into homes of their own is the real root cause that dwars all others.
Democratic analysis seems to always want to pin the blame on deregulation and a lack of oversight (clipping republican devotion to free markets and smaller government.
The truth is probably both. What disappoints me is when smart folks (like James) fail to incorporate or respond to the best arguments of other positions. If Fannie/Freddie were critical (as Rebpublicans like to say), how can a thoughtful analysis not even addrees them?
The fact that the U.S. government stepped in to partially nationalize a company like AIG should be repugnant to all. Yet, not to have done so, apparently risked a total collapse of the financial system.
The government is not without blame on this. The silly ideology of the goodness of the unfettered market far too long dominated even in the Congress. This led to poor oversight and lax regulation of the market. In the end, the government had to intervene to save Wall Street from itself. The alternative would have been a devastating depression.
While the partial nationalization of a number of large companies is clearly a temporary but extreme measure, I would hate to contemplate the situation now if the government had simply taken a hands off approach. Those “purists” who argue for such a hands off approach are clearly living in a fantasy world.
Even without stock options, CEOs (and other leaders) have an incentive for excessive risk taking and bold moves.
Many top executives are already very comfortable financially, and motivated by a desire for recognition as “great leaders”. Such recognition tends not to go to the leaders who employ sound but conservative strategies. Instead, we celebrate the leaders who in a “visionary” way set a business or a country upon a new path and succeeded. Never mind if it was a crazy risk ex ante.
Was it excessive deregulation and excessive free market idealogy that caused Rep. Barney Frank (D-Mass.) and other Democrats to prevent reigning in Fannie Mae and Freddy Mac as these government-sponsored enterprises guaranteed mortgages against default? Housing prices wouldn’t have gone so high in Las Vegas, Miami, Phoenix, the Inland Empire of California, and other overvalued markets at the height of the housing bubble if it was not for these guarantees. And for over two decades, both Republicans and Democrats in Congress and the White House opposed the expensing of employee stock options. Countries with more interventionist governments have had stock- and housing-market bubbles, too (think Japan in the 1980s). A problem for regulators is that when stock or housing prices begin to get overvalued, there is enormous pressure put on the regulators to not engage in policies that would cause a drop in prices. For example, as the housing bubble inflated in the U.S. this decade, all of the government policies were aimed at boosting demand. Most of the private sector failed to see how risky many of the mortgage loans had become, but so did government regulators and elected officials.
The idea that Fannie and Freddie caused the housing crisis is pretty much a myth. See Econbrowser for example. The idea that Democrats somehow prevented John McCain and the Republicans from “reining in” Fannie and Freddie is complicated by the fact that the Republicans controlled both houses of Congress for most of the last fourteen years and controlled the House (where Barney Frank sits) from 1994 to 2006.
Fannie and Freddie were by no means perfect. They lobbied both sides of the aisle heavily and had powerful allies on both sides. They took excessive risks in order to juice returns and therefore executive compensation, knowing that they had an implicit government guarantee. They had a major accounting scandal. But they didn’t cause the housing crisis.
Business cycles always end with the banking system having overgorged in some asset class. Diversification is one of the credit basket, Making lots of loans judged to be of low quality can have only one result; lots of losses. Hence the sub prime loan binge had only one predictable end; it would blow up. That it did then, is no surprise. The only surprise was the timing, which is not really predictable. Mr Prince’s “dancing” comment was a reflection of the times; all of those with some control of the process had abdicated responsibility.
A balkanized regulatory structure supported by diverse political interests, led to turf wars which inhibited proper regulatory oversight. Overleveraing and inadequate credit controls were the main factors leading the current crisis.
That Fannie and Freddie were not the cause of the crisis is clear. They are the poster children of all that went wrong. Political interference over their affairs led to improper regulatory oversight. This allowed them to overlever (bigtime) and put too many low quality assets on their books. Twenty % of their assets are sub prime and with their inadequate capital base, they are toast. FHA appears to be walking in their footsteps.
Very little attention has been paid to the role played by investors in all of this. They are as culpable as those who created the investment products. The apparent lack of investment products led investors to reach for yield which the dealers were only too happy to provide. (Complex derivatives are an example here) This was too much money chasing too few goods. Sounds like a form of inflation to me. The causes of this are pretty complex but probably had it’s genesis from the lack of a true consumer led recession in 2001. Most economists (and certainly all politicians) were terrified that with consummers levered as they were, a “real” recession should be avoided at all costs. Mr. Greenspan was only too happy to oblige. And here we are today.
Complex derivatives are a problem as no normal mortal can understand them. This is another example of inadequate regulatory supervision (not to mention management and investor stupidity).
Perhaps this all argues for a benign dictator at the top of the financial pyramid, who will take away the punch bowl at the appropriate time?
Cute. I doubt that the free marketers who gave me the $5000 would think they had a claim to get it back. The purpose of the contest was clearly to get high school students who would not otherwise have read Ayn Rand to try her out. They got their money’s worth, and I got mine.
There are high school kids who don’t like Rand? I was only able to appreciate her from the ages of 15 to 17.
“the transition of China from communism to capitalism”
This is a dangerous myth. China is still Communist in the worst sense of the word.