Causes of the Crisis

Texas Obervers Editor's note: These remarks were delivered to a meeting of the
Texas Lyceum in Austin on April 3, at a debate between University of
Texas professor James Galbraith, an
Observer contributing
writer, and former Majority Leader Richard Armey, chief instigator of
the recent Astroturf "tea party" protests. Armey had begun his remarks
by noting that his rule in life was "never trust anyone from Austin or
Boston," and proceeded to declare his allegiance to the "Austrian
School" of economics, a libertarian view that regards public
intervention in private markets as socialism.

It is of course a pleasure to be with you today. I was
born in Boston, and I am proud of it. And I have lived 24 years in
Austin-and I'm proud of that.

Leader Armey spoke to you of his admiration for Austrian economics.
I can't resist telling you that when the Vienna Economics Institute
celebrated its centennial, many years ago, they invited, as their
keynote speaker, my father [John Kenneth Galbraith]. The leading
economists of the Austrian school-including von Hayek and von
Haberler-returned for the occasion. And so my father took a moment to
reflect on the economic triumphs of the Austrian Republic since the
war, which, he said, "would not have been possible without the
contribution of these men." They nodded-briefly-until it dawned on them
what he meant. They'd all left the country in the 1930s.

My own economics is American: genus Institutionalist; species: Galbraithian.

This is a panel on the crisis. Mr. Moderator, you ask what is the root cause? My reply is in three parts.

First, an idea. The idea that capitalism, for all its considerable
virtues, is inherently self-stabilizing, that government and private
business are adversaries rather than partners; the idea that freedom
without responsibility is a viable business principle; the idea that
regulation, in financial matters especially, can be dispensed with. We
tried it, and we see the result.

Second, a person. It would not be right to blame any single person
for these events, but if I had to choose one to name it would be a
Texan, our own distinguished former Senator Phil Gramm. I'd cite
specifically the repeal of the Glass-Steagall Act-the
Gramm-Leach-Bliley Act-in 1999, after which it took less than a decade
to reproduce all the pathologies that Glass-Steagall had been enacted
to deal with in 1933. I'd also cite the Commodity Futures Modernization
Act, slipped into an 11,000-page appropriations bill in December 2000
as Congress was adjourning following Bush v. Gore. This
measure deregulated energy futures trading, enabling Enron and
legitimating credit-default swaps, and creating a massive vector for
the transmission of financial risk throughout the global system. When
the Washington Post caught up with me at an airport in
Parkersburg, West Virginia, a year ago to ask for a comment on Gramm's
role, I said very quickly that he was "the sorcerer's apprentice of
financial instability and disaster." They put that on the front page. I
do have to give Gramm some credit: When the Post called him up and read
that to him, he said, "I deny it."

Third, a policy. This was the abandonment of state responsibility
for financial regulation: the regulation of mortgage originations, of
underwriting, and of securitization. This abandonment was not subtle:
The first head of the Office of Thrift Supervision in the George W.
Bush administration came to a press conference on one occasion with a
stack of copies of the Federal Register and a chainsaw. A chainsaw.
The message was clear. And it led to the explosion of liars' loans,
neutron loans (which destroy people but leave buildings intact), and
toxic waste. That these were terms of art in finance tells you what you
need to know.

Subprime securities are inherently unsafe and should never have been
permitted. They are based on loans to borrowers who cannot document
their income and who may have bad credit histories, and they are
collateralized by houses with fraudulently inflated appraisals, rated
by agencies that did not examine the loan files. Writing in The Washington Post, Richard Cohen described one case, of Marvene Halterman of Avondale, Arizona:

At age 61, after 13 years of uninterrupted unemployment and at
least as many of living on welfare, she got a mortgage. She got it even
though at one time she had 23 people living in the house (576 square
feet, one bath) and some ramshackle outbuildings. She got it for
$103,000, an amount that far exceeded the value of the house. The place
has since been condemned. ... Halterman's house was never exactly a
showcase-the city had once cited her for all the junk (clothes, tires,
etc.) on her lawn. Nevertheless, a local financial institution with the
cover-your-wallet name of Integrity Funding LLC gave her a mortgage,
valuing the house at about twice what a nearby and comparable property
sold for. ... Integrity Funding then sold the loan to Wells Fargo &
Co., which sold it to HSBC Holdings PLC, which then packaged it with
thousands of other risky mortgages and offered the indigestible
porridge to investors. Standard & Poor's and Moody's Investors
Service took a look at it all, as they are supposed to do, and
pronounced it 'triple-A.'"

The consequence of tolerating this and like behavior is a collapse
of trust, a collapse of asset values, and a collapse of the financial
system. That is what has happened, and what we have to deal with now.

Can "stimulus" get us out?

As a matter of economics, public spending substitutes for private
spending. It provides jobs, motivates useful activity, staves off
despair. But it is not self-sustaining in the absence of a viable
private credit system. The idea that we will be on the road to full
recovery and returning to high employment in a year or so therefore
seems to me to be an illusion. And for this reason, the emphasis on
short-term, "shovel-ready" projects in the expansion package, while
understandable, was a mistake. As in the New Deal, we need both the
Works Progress Administration, headed by Harry Hopkins, to provide
employment, and the Public Works Administration, headed by Harold
Ickes, to rebuild the country.

The desire for a return to normal is very powerful. It motivates
both the ritual confidence of public officials and the dry numerical
optimism of business economists, who always see prosperity just around
the corner. The forecasts of these people, like those of official
agencies such as the Congressional Budget Office, always see a
turnaround within a year and a return to high employment within four or
five years. In a strict sense, the belief is without foundation.
Liquidation of excessive debt is now, and will remain for a time, the
highest priority of American households. That is in part because for
the moment they want to hold on to cash, and therefore they do not wish
to borrow, and in part because with the collapse of house values, they
no longer have collateral to borrow against. And so long as that is the
case, there can be no strong recovery of private spending or business

The risk we run, in public policy, is not inflation. It is lack of
persistence, a premature reversal of direction, and of course the fear
of large numbers. If deficits in the trillions and public debt in the
tens of trillions scare you, this is not a line of work you should be

The ultimate goals of policy are not measured by deficits or debt.
They are measured by the performance of the economy itself. Here Leader
Armey and I agree. He spoke with approval, in his remarks, of the goals
of 3 percent unemployment and 4 percent inflation embodied in the
Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978.
Which, as a 24-year-old member of the staff of the House Banking
Committee in 1976, I drafted.

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