Capitalist Fools

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.

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.

No. 2: Tearing Down the Walls

The deregulation philosophy would pay unwelcome dividends for years
to come. 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. For instance, without separation, if a company
whose shares had been issued by an investment bank, with its strong
endorsement, got into trouble, wouldn't its commercial arm, if it had
one, feel pressure to lend it money, perhaps unwisely? An ensuing
spiral of bad judgment is not hard to foresee. I had opposed repeal of
Glass-Steagall. The proponents said, in effect, Trust us: we will
create Chinese walls to make sure that the problems of the past do not
recur. As an economist, I certainly possessed a healthy degree of
trust, trust in the power of economic incentives to bend human behavior
toward self-interest-toward short-term self-interest, at any rate,
rather than Tocqueville's "self interest rightly understood."

The most important consequence of the repeal of Glass-Steagall was
indirect-it lay in the way repeal changed an entire culture. Commercial
banks are not supposed to be high-risk ventures; they are supposed to
manage other people's money very conservatively. It is with this
understanding that the government agrees to pick up the tab should they
fail. Investment banks, on the other hand, have traditionally managed
rich people's money-people who can take bigger risks in order to get
bigger returns. When repeal of Glass-Steagall brought investment and
commercial banks together, the investment-bank culture came out on top.
There was a demand for the kind of high returns that could be obtained
only through high leverage and big risktaking.

There were other important steps down the deregulatory path. One was
the decision in April 2004 by the Securities and Exchange Commission,
at a meeting attended by virtually no one and largely overlooked at the
time, 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. In agreeing to this measure, the S.E.C. argued for the virtues
of self-regulation: the peculiar notion that banks can effectively
police themselves. Self-regulation is preposterous, as even Alan
Greenspan now concedes, and as a practical matter it can't, in any
case, identify systemic risks-the kinds of risks that arise when, for
instance, the models used by each of the banks to manage their
portfolios tell all the banks to sell some security all at once.

As we stripped back the old regulations, we did nothing to address
the new challenges posed by 21st-century markets. The most important
challenge was that posed by derivatives. In 1998 the head of the
Commodity Futures Trading Commission, Brooksley Born, had called for
such regulation-a concern that took on urgency after the Fed, in that
same year, engineered the bailout of Long-Term Capital Management, a
hedge fund whose trillion-dollar-plus failure threatened global
financial markets. But Secretary of the Treasury Robert Rubin, his
deputy, Larry Summers, and Greenspan were adamant-and successful-in
their opposition. Nothing was done.

No. 3: Applying the Leeches

Then along came the Bush tax cuts, enacted first on June 7, 2001,
with a follow-on installment two years later. The president and his
advisers seemed to believe that tax cuts, especially for upper-income
Americans and corporations, were a cure-all for any economic
disease-the modern-day equivalent of leeches. 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. Normally this would have led to an economic slowdown, as it had
in the 1970s. But the Fed met the challenge in the most myopic way
imaginable. 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. But it should have
been clear that we were living on borrowed money and borrowed time.

The cut in the tax rate on capital gains contributed to the crisis
in another way. It was a decision that turned on values: those who
speculated (read: gambled) and won were taxed more lightly than wage
earners who simply worked hard. But more than that, the decision
encouraged leveraging, because interest was tax-deductible. If, for
instance, you borrowed a million to buy a home or took a $100,000
home-equity loan to buy stock, the interest would be fully deductible
every year. Any capital gains you made were taxed lightly-and at some
possibly remote day in the future. The Bush administration was
providing an open invitation to excessive borrowing and lending-not
that American consumers needed any more encouragement.

No. 4: Faking the Numbers

Meanwhile, on July 30, 2002, in the wake of a series of major
scandals-notably the collapse of WorldCom and Enron-Congress passed the
Sarbanes-Oxley Act. The
scandals had involved every major American accounting firm, most of our
banks, and some of our premier companies, and made it clear that we had
serious problems with our accounting system. Accounting is a
sleep-inducing topic for most people, but if you can't have faith in a
company's numbers, then you can't have faith in anything about a
company at all. Unfortunately, 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. If a
company does well, the C.E.O. gets great rewards in the form of stock
options; if a company does poorly, the compensation is almost as
substantial but is bestowed in other ways. This is bad enough. But 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.
Agencies such as Moody's and Standard & Poor's are paid by the very
people they are supposed to grade. As a result, they've had every
reason to give companies high ratings, in a financial version of what
college professors know as grade inflation. The rating agencies, like
the investment banks that were paying them, believed in financial
alchemy-that F-rated toxic mortgages could be converted into products
that were safe enough to be held by commercial banks and pension funds.
We had seen this same failure of the rating agencies during the East
Asia crisis of the 1990s: high ratings facilitated a rush of money into
the region, and then a sudden reversal in the ratings brought
devastation. But the financial overseers paid no attention.

No. 5: Letting It Bleed

The final turning point came with the passage of a bailout package
on October 3, 2008-that is, with the administration's response to the
crisis itself. We will be feeling the consequences for years to come.
Both the administration and the Fed had long been driven by wishful
thinking, hoping that the bad news was just a blip, and that a return
to growth was just around the corner. As America's banks faced
collapse, the administration veered from one course of action to
another. Some institutions (Bear Stearns, A.I.G., Fannie Mae, Freddie
Mac) were bailed out. Lehman Brothers was not. Some shareholders got
something back. Others did not.

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. 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.

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.