December 12, 2008

Helpful Explanations Re- the Current Economic Crisis

(For an inspirational soundtrack for this post, click on the video in the post two below this one, titled "Human Anthem.")

In a recent Vanity Fair article, Nobel-laureate economist Joseph Stiglitz argues that we can't fix our problems unless we understand the causes. He identifies five crucial wrong turns taken during the last few decades:

1. Removing Walls Between Foxes and Henhouses. In 1999 Congress repealed the Glass-Steagall Act, which had been passed in the wake of the 1929 crash in order to help prevent the same thing from happening again. It worked. The Act separated commercial banks, which were supposed to accept deposits and make loans based on prudent underwriting principles, from investment banks, which engage in organizing sales of riskier investments such as stocks and bonds. Repealing the Act and allowing banks to engage in both kinds of activities at once inevitably meant they would be under greater temptation and pressure to subject ordinary deposits to the much greater risks of equity investments directly or indirectly underwritten by the bank.

2. Installing a Fed Chair Who Favored Deregulation and Liquidity Injections. In 1987 the Reagan administration replaced Paul Volcker with Alan Greenspan. Volcker understood the need for regulation of financial markets and had successfully brought inflation down from more than 11% to under 4%. Greenspan believed markets are self-regulating, turned the money spigot on, and helped set the stage for a series of increasingly catastrophic asset bubbles.

Two other important deregulatory mistakes were the rejection of a call in 1998 by Brooksley Born, head of the Commodity Futures Trading Commission, for government regulation of credit derivatives, and the decision in 2004 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, thereby further inflating the housing bubble.

Regarding our current bubble, bear in mind that the big problem isn't the bad mortgages; it's the credit derivatives. Even if derivatives were regulated like stocks or bonds, they are the kind of equity investment that depositary institutions probably should not be investing in. Warren Buffet has described derivatives as “financial weapons of mass destruction.” Greenspan consistently sided with those who argued that any kind of oversight might interfere with “innovation” in the financial system.

3. Injecting Money into the Wrong Bodies. Tax-cuts, touted as an economic cure-all, were repeatedly enacted that mainly benefitted the upper-upper class. When "trickle-down" failed, instead of admonishing Congress, Greenspan pumped the economy up by lowering interest rates and increasing the money supply.

4. Faking the Numbers. After the collapse of Worldcom and Enron revealed serious problems with corporate accounting, Congress enacted the Sarbanes-Oxley Act; but while corporations have complained that the Act is too burdensome, in fact it didn't go far enough. A main deficiency identified by Stiglitz is that it failed to rein in "incentive" options granted to executives, which rather than incentivizing better management performance, as claimed, proved to incentivize further distortions in accounting.

The incentives for the rating agencies such as such as Moody’s and Standard & Poor’s are similarly distorted, since the rating agencies are paid by the companies they're supposed to rate, with the predictable result that their ratings suffer "grade inflation" so long as things are going well, to be downgraded only after the problems become obvious anyway.

I'd add, the government itself has also taken steps to obscure if not "fake" economic realities, by jiggering the ways in which inflation and unemployment statistics are measured, by completely ceasing to publish M3 money supply statistics, and by widely-suspected, increasingly-frequent stock market manipulation by the President's "Plunge Protection Team."

5. The Bush Admin's Response to the Current Crisis. Stiglitz writes, "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. . . . 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."
Quoting Greenspan during Congressional hearings this fall, Stiglitz concludes by observing: "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."

In a recent piece on counterpunch, freelance writer Mike Whitney agrees, and further explores how past policies -- including both deregulation and the creation of excessive monetary and debt liquidity -- have enriched the highest-income citizens at the expense of middle- and lower-income citizens. The entire piece is well-worth the read; but to include just one quote: "The bottom line, is that financialization, which rests on the twin pillars of easy credit and ballooning debt, creates an inherently unstable system which is prone to wild swings and frequent busts. Bernanke is trying to restore this system ignoring the fact that workers -- whose personal balance sheets are already bleeding red -- can no longer support it. . . . There is a historic mismatch between supply and demand that cannot be reconciled by Bernanke's market meddling. Workers need a raise; that's how demand is created."

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