From Vanity Fair:
The Economic Crisis
Capitalist Fools
Behind the debate over remaking U.S. financial policy will be a debate over who’s to blame. It’s crucial to get
the history right, writes a Nobel-laureate economist, identifying five key mistakes—under Reagan, Clinton,
and Bush II—and one national delusion.
by Joseph E. Stiglitz January 2009
Treasury Secretary Henry Paulson and former Federal Reserve Board chairman Alan Greenspan bookend
two decades of economic missteps.
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.
How did we land in a recession? Visit our archive, “Charting the Road to Ruin.” Illustration by Edward Sorel.
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.
