Reprinted from Freefall by Joseph Stiglitz. Copyright (c) 2010 by Joseph E. Stiglitz. Used with permission of the publisher, W.W. Norton & Company, Inc.
The entire series of efforts to rescue the banking system were so flawed, partly because those who were somewhat responsible for the mess--as advocates of deregulation, as failed regulators, or as investment bankers--were put in charge of the repair. Perhaps not surprisingly, they all employed the same logic that had gotten the financial sector into trouble to get it out of it. The financial sector had engaged in highly leveraged, non-transparent transactions, many off balance sheet; it had believed that one could create value by moving assets around and repackaging them. The approach to getting the country out of the mess was based on the same "principles." Toxic assets were shifted from banks to the government--but that didn't make them any less toxic. Off-balance sheet and non-transparent guarantees became a regular feature of the Treasury, Federal Deposit Insurance Corporation, and Federal Reserve. High leverage (open and hidden) became a feature of public institutions as well as private.
Worse still were the implications for governance. The Constitution gives Congress the power to control spending. But the Federal Reserve was undertaking actions knowing full well that if the collateral that it was taking on proved bad, the taxpayer would bail it out. Whether the actions were legal or not is not the issue: they were a deliberate attempt to circumvent Congress, because they knew that the American people would be reluctant to approve more largesse for those who had caused so much harm and behaved so badly.
The U.S. government did something worse than trying to re-create the financial system of the past: It strengthened the too-big-to-fail banks; it introduced a new concept--too-big-to-be- financially-resolved; it worsened the problems of moral hazard; it burdened future generations with a legacy of debt; it cast a pallor of the risk of inflation over the U.S. dollar; and it strengthened many Americans' doubts about the fundamental fairness of the system. Central bankers, like all humans, are fallible. Some observers argue for simple, rule-based approaches to policy (like monetarism and inflation targeting) because they reduce the potential for human fallibility. The belief that markets can take care of themselves and therefore government should not intrude has resulted in the largest intervention in the market by government in history; the result of following excessively simple rules was that the Fed had to take discretionary actions beyond those taken by any central bank in history. It had to make life and death decisions for each bank without even the guidance of a clear set of principles.
Several commentators have referred to the massive bailouts and government interventions in the economy as socialism with American characteristics, something akin to China's march to what it calls "a market economy with Chinese characteristics." But, as one Chinese friend pointed out, the description is inaccurate: socialism is supposed to care about people. Socialism American-style didn't do that. Had the money been spent on helping those who were losing their homes, it might have been a correct characterization. As it was, it was just an expanded version of Corporate Welfarism American-style.
The current crisis has seen the government assume a new role--the "bearer of risk of last resort." When the private markets were at the point of meltdown, all risk was shifted to the government. The safety net should focus on protecting individuals; but the safety net was extended to corporations, in the belief that the consequences of not doing so would be too horrific. Once extended, it will be difficult to withdraw: firms will know that if they are sufficiently big and their failure represents a sufficient threat to the economy--or if they are sufficiently politically influential--the government will bear the risk of failure. That is why it will be critical to prevent banks from growing so big.
There is, still, a chance for the American political system to restore a modicum of confidence in itself. Yes, Wall Street has used its power and money to buy deregulation, followed swiftly by the most generous bailout in the history of mankind. Yes, the government has failed to restructure the financial system in ways which would reduce the likelihood of a similar crisis, and which strengthened those parts of the financial system that were actually doing what they were supposed to be doing--managing risk and allocating capital. But, still, there is the chance to re-regulate, to correct the mistakes of the past. It is imperative that that be done quickly: for while one side in the struggle, ordinary taxpayers who had to bear the brunt of the cost of the financial sector's failure, might lose interest as the economy recovers, the other side, the banks, have every incentive to continue to fight to ensure that they have as much freedom to make profits as they can get. But because both the structure of the financial system has been made worse and the way the bailouts have been conducted has worsened the problem of moral hazard, the need for re-regulation is all the greater.
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