What Caused the Financial Crisis

4. The Anatomy of a Murder: Who Killed the American Economy?

Chapter 4 The Anatomy of a Murder: Who Killed America’s Economy? JOSEPH E. STIGLITZ The search is on for whom to blame for the global economic crisis. It is not just a matter of vindictiveness; it is important to know who or what caused the crisis if one is to prevent another, or perhaps even to fix this one. The notion of causation is, however, complex. Presumably, it means something like, ‘‘If only the guilty party had taken another course of action, the crisis would not have occurred.’’ But the consequences of one party changing its actions depend on the behavior of others; presumably the actions of other parties, too, may have changed. Consider a murder. We can identify who pulled the trigger. But somebody had to sell that person the gun. Somebody may have paid the gunman. Somebody may have provided inside information about the whereabouts of the victim. All these people are party to the crime. If the person who paid the gunman was determined to have the victim shot, then even if the particular gunman who ended up pulling the trigger had refused the job, the victim would have been shot: someone else would have been found to pull the trigger. There are many parties to this crime—both people and institutions . Any discussion of ‘‘who is to blame’’ conjures up names like Robert Rubin, co-conspirator in deregulation and a senior official in one of the two financial institutions into which the American govern- 140 Joseph E. Stiglitz ment has poured the most money. Then there was Alan Greenspan, who also pushed the deregulatory philosophy, who failed to use the regulatory authority that he had, who encouraged homeowners to take out highly risky adjustable mortgages, and who supported President George W. Bush’s tax cut for the rich,1 —making lower interest rates, which fed the bubble, necessary to stimulate the economy. But if these people hadn’t been there, others would have occupied their seats, arguably doing similar things. There were others equally willing and able to perpetrate the crimes. Moreover, the fact that similar problems arose in other countries—with different people playing the parts of the protagonists—suggests that there were more fundamental economic forces at play. The list of institutions that must assume considerable responsibility for the crisis includes the investment banks and the investors; the credit-rating agencies; the regulators, including the SEC and the Federal Reserve; the mortgage brokers; and a string of administrations, from Bush to Reagan, that pushed financial-sector deregulation. Some of these institutions contributed to the crisis in multiple roles— most notably the Federal Reserve, which failed in its role as regulator, but which also may have contributed to the crisis by mishandling interest rates and credit availability. All of these—and some others discussed below—share some culpability. The Main Protagonists But I would argue that blame should be centrally placed on the banks (and the financial sector more broadly) and the investors. The banks were supposed to be the experts in risk management. They not only didn’t manage risk, they created it. They engaged in excessive leverage. At a 30-to-1 leverage ratio, a mere 3 percent change in asset values wipes out one’s net worth. (To put matters in perspective, as of March 2009, real-estate prices had fallen some 20 percent and were expected to fall at least another 10–15 percent.) The banks adopted incentive structures designed to induce short-sighted and excessively risky behavior. The stock options that they used to pay some of their senior executives, moreover, provided incentives The Anatomy of a Murder 141 for bad accounting, including incentives to engage in extensive offbalance -sheet accounting. The bankers seemingly didn’t understand the risks being created by securitization—including those arising from information asymmetries . The originators of the mortgages did not end up holding onto them, so the originators didn’t bear the consequences of any failure at due diligence. The bankers also misestimated the extent of correlation among default rates in different parts of the country—not realizing that a rise in the interest rate or an increase in unemployment might have adverse effects in many parts of the country—and they underestimated the risk of real-estate price declines. Nor did the banks assess with any degree of accuracy the risks associated with some of the new financial products...