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is not entirely accurate, because there are not that many major regulations you can point to that were actually repealed.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.