Joseph Stiglitz
Lost in the analysis of our economic crisis is any perspective that what we face is a system failure. Almost every article, every television report and every op ed piece blames people for the mess. This psychology is a marked change from the Great Depression when people tended to blame themselves.
Today an attitude of “it’s not my fault” pervades our society. Take the mortgage crisis. You rarely hear someone take responsibility for a bad decision. Instead you hear people blaming the mortgage companies for duping them or even lying to them (which some of them did). Still, I have yet to hear a mortgage-holder–just as I have yet to hear a CEO–ruefully admit their own greed had something to do with the situation.
Consumers bought more house than they could really afford by seeking out mortgages with liberal terms and few requirements. CEOs have yet to acknowledge that in their zeal to maximize profits (and their own stock options) they were also guilty of seeking out dubious investment schemes that promised high returns.
We live in a pass-the-buck era where every problem is someone else’s fault. Right now Americans are blaming Detroit for building too many gas-guzzling cars, forgetting that these beasts clogged the highways because people bought them. At the top of the list is the Bush Administration which replaced Harry Truman’s “The Buck Stops Here” desk ornament with one saying “Not Here.”
The Blame Game”
Pass-the-Buck has become the new national pastime, the Blame Game. Behind all the finger-pointing lies a belief that someone else is responsible for the mess. In this view, the economic crisis is a people problem, a bad decision problem, a greed run amok problem. In short, we are in this mess because of the failures of other people. As usual, the Republicans blame the Democrats and the Democrats blame the Bush Administration.
But when the failures are so widespread, so massive and so pervasive that is precisely a sign that it is NOT a people problem, but a system problem. We have always had greedy CEOs and consumers looking to save a buck, but we have not experienced a crisis like this for over half a century.
Whenever you have a crisis of this magnitude it should be a warning sign that something is wrong with the system. If just a few people experienced foreclosures or a few companies faced bankruptcy you might blame it on circumstances or bad decisions, but we face something deeper and far more disturbing than a few bad decisions. Nobel Prize-winning economist Joseph Stiglitz began his recent testimony before the House Financial Services Committee by stating:
Our financial system has failed us.
What Went Wrong
If the system failed, what in it failed? In systems terms the answer to that question can be reduced to one word: feedbacks. In systems thinking feedbacks is a term that refers to the ways a system tends to regulate itself.
The easiest way to think of this is the thermostat in your house. It is a computerized electrical device designed to maintain a constant temperature. The feedback is the thermometer in the thermostat. It is part of a feedback mechanism called an anticipator that senses when the temperature is starting to fall and then turns on the furnace so the temperature stays constant.
Without the feedback provided by the anticipator you would either have to pick a low point when you wanted the furnace to start running or turn it on yourself. Since people are not as reliable as the mechanism as an anticipator, your house temperature would jerk wildly back and forth as you tried to keep it the same.
In essence that is what happened in this current economic crisis: the anticipator broke down, the furnace did not kick in when it needed to and now we are in danger of being out in the cold.
Feedback Failure One: Concentration Inhibits Information
Contrary to the conventional wisdom that concentration promotes efficiency it can reach a point where there is too much concentration and the system actually becomes inefficient. To go back to the thermostat analogy, it would be as if the anticipator were set within such a narrow range that your furnace was constantly cycling on and off, which raises your utility bill because turning the furnace motor on and off too much wastes electricity.
The reason concentration can become counter-productive is because it lowers the number of feedbacks in the system. The fewer financial institutions there are, the fewer options the system has and the less information the system gets. With fewer options and less information there is obviously a greater potential for failure. That is one reason why centralized, planned economies such as that of the former Soviet Union tend to not be as productive as those of a more open market.
Economist Joseph Stiglitz terms the access to information “transparency” and his research on the impact of information on markets won him the Nobel Prize. Since he wrote the technical papers that won him the award, Stiglitz has been a forceful advocate for open information, pointing out the negative consequences of what he terms “information asymmetry,” which the Nobel Committee explained as follows:
Agents on one side of the market have much better information than those on the other side.
This imbalance can be potentially dangerous, which is why Stiglitz has argued forcefully for open information by both government and corporations. In perhaps one of his most cogent defenses of open information Stiglitz notes:
To me, the most compelling argument for openness is the positive Madisonian one:meaningful participation in democratic processes requires informed participants. Secrecy reduces the information available to the citizenry, hobbling their ability to participate meaningfully.
In his testimony Stiglitz explained just how this operated in the current financial crisis:
The success of a market economy requires not just good incentive systems but good information—transparency…More recent research has shown that markets often fail to produce efficient outcomes (let alone fair or socially just outcomes) when information is imperfect or asymmetric—but information imperfections and asymmetries are at the center of financial markets…And we should be clear—this non-transparency is a key part of the credit crisis that we have experienced over recent weeks.
Before the repeal of the Glass-Steagall Act in 1999, there was less concentration in the financial world. All of us can verify that from a personal point of view: once we had several banking options or our bank was a local or regional institution rather than a national one. In essence what happened in banking is what has happened in retail stores, hardware stores, and even specialized niches such as office supply.
Of course, trusting your personal impressions can be dangerous. According to 2008 FDIC data:
The number of commercial banks and savings & loans in the United States has fallen in the past 20 years to 8,451 as of June, compared to 16,574 in 1988.
In 2004 the FDIC pointed out:
At the end of 2003, the 25 largest insured banks and savings institutions held 56 percent of total industry assets, with the 10 largest holding almost 44 percent, up from 19 percent in 1984.
MSNBC reports three “superbanks”–Bank of America, JPMorgan Chase and Wells Fargo–now control 32.7% of the financial market, so much that all three exceed the current law that says that no bank can have more than 10 percent of the domestic deposit market. Currently there are no plans to take action against any of the three. Third-ranked Morgan’s share of the market is almost triple that of fourth-ranked Citigroup.
In an uncanny statement supporting the feedback theory, Amar Bhide, a professor at the Columbia Business School notes:
Large institutions are impossible to manage prudently, let alone regulate.
Stiglitz explains how concentration made the feedbacks associated with mortgages more complex:
In the old days, those originating mortgages held on to them; banks knew the families to whom they had lent money. When there was a problem in repayment, they could understand its nature and work with the family on a payment plan.
Feedback Failure Two: Deregulation
With deregulation, especially the repeal of Glass-Steagall, came a redefining of the information financial institutions had to share with the government and the public. Stiglitz testified:
There is always going to be some circumvention of regulations. However, that doesn’t mean that one should abandon regulations. A leaky umbrella may still provide some protection on a rainy day. No one would suggest that because tax laws are often circumvented, we should abandon them. Yet, one of the arguments for the repeal of Glass-Steagall was that it was, in effect, being circumvented. The response should have been to focus on the reasons that the law was passed in the first place, and to see whether those objectives, if still valid, could be achieved in a more effective way.
The FDIC zeroes in particularly on Gramm-Leach-Bliley, the bill that gutted much of Glass-Steagall:
The Gramm-Leach-Bliley Financial Services and Modernization Act of 1999 (GLB) allowed the largest banking organizations to engage in a wide variety of financial services, acquiring new sources of noninterest income and further diversifying their earnings.
Here now we begin to see the impact of deregulation for not only did it not erase government oversight and hence transparency, it allowed the creation of complex financial arrangements that even the most sophisticated economists have trouble understanding. This creates a feedback loop with negative consequences: complicated financial arrangements inhibit understanding, lack of understanding limits transparency, lack of transparency makes it more difficult to determine the impact of these new financial instruments, which finally makes it all but impossible to regulate them.
“The Future of Banking: The Evolving Role of Commercial Banks in U.S. Credit Markets,” a 2004 FDIC report, notes how with deregulation has come a profound shift in the financial markets. The term used by those in the banking industry for these changes is that the system became “securitized.” The FDIC explained there has been:
A dramatic increase in the extent to which lending to households and businesses became securitized—that is, standardized, pooled, and funded by the issue of securities.
In their summary report on “The Future of Banking” the FDIC pointed out how securitization has changed the market:
Asset securitization (the pooling of loans and their funding by the issuing of securities) has allowed loans that used to be funded by traditional intermediaries, including banks, to be funded in securities markets.
The first report discusses the impact of this on banks:
Thus, although commercial banking’s on-balancesheet activity has declined as a piece of the credit-market pie, the industry’s off-balance-sheet activities are a growing source of income.
Stiglitz explained the consequences of this in his Congressional testimony:
Some of the “innovations” in the market, e.g. securitization and derivatives, in recent years have made these problems worse. Securitization has created new asymmetries of information…Mortgage originators didn’t have to ask, is this a good loan, but only, is this a mortgage I can somehow pass on to others. Our financial markets have not only exploited these information asymmetries, but they have often also exploited the uninformed and the poorly educated.
Even the experts at the FDIC admit these new financial arrangements have caused problems:
The funding of loans through private securities markets and the additional layers involved in modern credit flows have made it more difficult for researchers to track the flow of funds between primary lenders and primary borrowers.
At the same time, the commoditization of credit markets—that is, the standardization, unbundling, and repackaging of payments and risks associated with credit flows—makes it harder to measure the importance of banks as well as other intermediaries in providing credit-related services.
Now if the FDIC stated four years ago that not even researchers can track money in this crazy system that has evolved since the repeal of Glass-Steagall and that they can’t even do something as simple as measuring the impact of banks and others on credit, what are ordinary citizens or even people in Congress going to do? This isn’t information transparency it is an information nightmare.
The 2004 summary report made it clear:
Large, complex banking organizations may pose difficult supervisory issues.
In 2004 the FDIC all but laid out the scenario for what would occur in the following years, although it wrote that such developments were unlikely:
Bank failures would be few in number and idiosyncratic in nature—typically caused by managerial and internal control weaknesses, excessive risk taking, or fraud, rather than by broader economic forces.
However, the economy is not immune to speculative bubbles like those occurring in the energy, commercial real estate, and agriculture sectors in the 1980s.
Feedback Failure Three: Too Big to Fail
As I have written before, included in Gramm-Leach-Bliley was the infamous “too big to fail” clause. This created additional feedback problems because, to use Stiglitz’s language, it made them immune from any attempts at transparency. These institutions became big black holes into which no one could see, but which sucked into them all sorts of strange financial objects that never emerged again to see the light.
“Too big to fail” took these institutions out of any feedback loops in the system. Curiously, the FDIC all but recognized the impact of this on the system back in 2004:
Some studies have also concluded that banks may seek growth in an attempt to be regarded by the market as too big to fail. According to this view, the funding costs of a bank would be lower if holders of uninsured deposits, bonds, and other credits assumed they would be protected if the bank failed.
The emergence of megabanks has raised the possibility, however remote, that failures could deplete the deposit insurance funds, require large premium increases that place a heavy burden on the remaining banks, disrupt financial markets, and undermine public confidence. Financial and technological risks arise partly from the problems of monitoring and controlling multiple business lines, geographically dispersed operations, and complex corporate structures. Furthermore, the diversification of large banks into new financial areas exposes these institutions to new reputational risks.
I have been writing about the financial crisis for some time, so I have become somewhat numb to reading the latest doom-and-gloom scenario, but nothing I have read in this entire two-year investigation has floored me as much as the second paragraph. It all but proves the FDIC and hence the Bush Administration and Congress knew that there was a possibility that all this deregulation and concentration would backfire on them.
The Smoking Gun that Signals Systemic Failure
To prevent this the FDIC, to its credit, recommended the following actions in 2004:
Among these are the assessment provision of the systemic-risk exception for large-bank failures, the authority for the FDIC to create different premium systems for large and small institutions, and the authority for bank regulators to require more capital based on risk.
None of these was implemented. Had Congress, the Administration or the Federal Reserve instituted even one, the crisis might have been averted or its impact muted. I put that statement in bold because it may well be the smoking gun in this entire mess. If only the third one had been implemented we would not have needed a bailout bill.
Note that virtually all of these recommendations are feedback–”transparency”–solutions: more assessment of “systemic risk,” recognition of the transparency problems of large institutions, and the requirement of carrying more capital based on risk.
So Gramm-Leach-Bliley created the unintended consequence of encouraging financial institutions to consolidate and grab a bigger share of the market because the bigger they grew the more likely the government would rescue them. The way you grow bigger, of course, is to gobble up other banks and to increase your assets by engaging in questionable activities.
It may have been the biggest rigged game in the history of the American economy: you get too big to fail by enlarging your holdings any way possible, all the time knowing that even if such activity turned out to be questionable the government would rescue you. And so it has, with a lion’s share of Treasury Dictator Paulson’s “bailout” going to the biggest institutions, which have used them to buy more banks.
Systemic Versus Personal Failure
At this point, if not long before, some of you have probably said, “So it was a people problem and not a system problem.” The FDIC gave us warning and even proposed measures that might have prevented the crisis, but people chose to ignore them. The final paragraph of the 2004 FDIC report proved prophetic:
The existing regulatory structure appears to be increasingly out of alignment with the rapidly changing financial products and markets. The nature of the safety net itself may need to be reexamined to ensure that it effectively accommodates an industry characterized by a few megabanks alongside thousands of community banks.
To some extent the systemic versus individuals question is a chicken-and-egg issue, people, after all a part of systems. They are feedback mechanisms, they can change the system. But the system also neutralizes people. One way it does that is by having insufficient feedback mechanisms. Trying to regulate the current financial mess is like trying to keep your house warm without a thermostat or even a thermometer to help you.
In a way nothing more clearly demonstrates that the system failed than the FDIC report itself. This essay has more quotes than usual because I felt it was important for readers to see what the experts have been saying. In a way it is my own way of shopwing transparency and providing you with feedbacks you can follow to make up your own mind about the crisis.
This evidence shows that by 2004 all the pieces for systemic failure were in place for the crisis and all of them involved feedbacks. To return to the thermostat analogy, it was as if the financial system’s thermostat had broken and the furnace quit running and had us all wondering if we would freeze to death.
Conclusion
If we think merely changing the people in charge will be enough or prosecuting those who may be guilty of causing this crisis, then we will have missed the point. What is required is for us to reform the system in such a way that lessens the possibility that someone can screw things up. Gramm-Leach-Bliley and “too big to fail” were like invitations to disaster.
By removing regulations, encouraging concentration and allowing financial institutions to get into markets they had no business being in, they removed all the feedbacks that might have prevented the crisis. Financial institutions became less transparent as they grew larger and more complex, the less transparent they became the easier the system made it for them to become even bigger and more difficult to regulate. GLB took the anticipator, the regulator out of our financial system.
In the end it does not matter which institution or which person took advantage of this severing of the feedbacks because the way GLB was written someone would have. By 2004 when the FDIC issued its recommendations the systemic forces had become too strong. So some people literally did get put out into the cold.
A coming essay will propose a radical solution to the crisis, one that differs greatly from what both Congress and the Treasury Dictator have in mind. In the end the final word goes to Stiglitz:
In this sense, the fall of Wall Street is for market fundamentalism what the fall of the Berlin Wall was for communism — it tells the world that this way of economic organization turns out not to be sustainable. In the end, everyone says, that model doesn’t work. This moment is a marker that the claims of financial market liberalization were bogus.
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