Sunday, November 4, 2012

Freefall Critique

Freefall published in 2010 by liberal economist, Joseph E. Stiglitz, is his analysis of the cause of the Great Recession of 2008, and the lessons he feels we should take from this catastrophic event and its aftermath. This is not a standard economics book. It is more like a newspaper article from a journalist with a strong viewpoint that he wants to spread. One of the key points Professor Stiglitz sets out to make in his book is that the Great Recession proves that the so-called self-correcting function of a market economy does not work: "One might have thought that with the crisis of 2008, the debate over market fundamentalism--the notion that unfettered markets by themselves can ensure economic prosperity and growth--would be over." (xiii) As somewhat of a student and victim of the Great Recession and Housing meltdown I find this conclusion off point. I believe the Housing meltdown as the acknowledged cause of the Great Recession is not about why markets did not self-correct, but what happens to markets when government mandates (HUD Affordable Housing Policy) require 50% of housing loans be made to marginal borrowers. The Great Recession is not about self-correcting markets. It is about government interference into markets to enforce an unrealistic social policy. Professor Stiglitz is trying to make the opposite point: he wants to show an economy in private hands doesn't work. He does that by seeking to find a private sector entity to blame for the crisis. Stiglitz chooses the banking system in his blame game.  He tries by accusation and through a circumstantial case to convict the banking system or at least to suggest a strict home monitoring system. The primary purpose of this effort is to make the case that the economy should be under the control of government, an idea first proposed by Keynes.

To make his case, Stiglitz creates his own reality. He repeatedly refers to the "financial system" as a "self-regulating apparatus." (xiv) As an ex-banker I know, for a fact, the banking industry is probably the most regulated activity in society. Nuclear energy has modest regulation by comparison. The Congressmen in control of the financial industry are household names to most Americans. Ask an American who the head of the Atomic Energy Commission is and they would not have a clue.  Ask them if they know who Ben Bernacke, Senator Dodd or Barney Frank are and people will explain their role in the financial crisis, and know some of the common accusations against them for complacency in the development of meltdown.

Stiglitz also creates his own history. He accuses believers in the market economy of arguing the financial crisis was the result of a few "rotten apples." (xix) I was in the middle of the financial crisis and I do not recall any traditional economist placing the blame on a few individuals. I do recall President Obama and Stiglitz blaming the financial industry for the crisis. Nevertheless, in this book Stiglitz is arguing the cause is "systemic." (xix) I am sure many traditional economists would agree with that assessment. They would argue the systemic failure was not in the private sector, but due to excessive regulation by the government housing agencies and specifically HUD. Stiglitz has the opposite view. He states it is government that saved "markets from their own mistakes." (xx)

When the book opens Stiglitz puts much of the blame for the crisis on a "deregulated market awash in liquidity." (1) The actual precipitating events of the Great Recession were just the opposite, a heavily regulated industry trying to comply with HUD requirements for subprime lending that reached 50% of a bank's portfolio in 2007, and a fear by other banks and lenders providing liquidity that these loans would not be viable. History would certainly prove their caution was justified, and that government mandates were unwise and the primary factor in magnifying risk. Stiglitz continues his attack on the financial industry by accusing them of developing residential loan products for "maximizing their returns," (5) when the truth is variable rate interest loans were first developed in Europe and that the bonds sold by Wall Street followed SEC regulations to the letter. The problem was not the types of loans, but the fact HUD regulations made it necessary to lower lending standards to serve the subprime borrower. The result was when the economy faltered these marginal borrowers could not refinance their loans or escape their obligation. Stiglitz also accuses the financial industry of "promoting securitization" (6) when the reasons large packages of loans were securitized was to sell them to Fannie Mae and Freddie Mac. The GSEs did not want to fuss with small bond packages. The government mandated the size of the securitized loan packages. The government was the main destination for most of these securitized packages.

Stiglitz blames the mortgage companies, banks and rating agencies for the financial crisis, but never mentions HUD's role in manipulating the system. If it is a systemic failure like he asserts we should look at the system architect and not at the carpenters. Some of Stiglitz's arguments against the banks and the mortgage originators are just simply untrue: "The banks jumped into subprime mortgages--an area where, at the time, Freddie Mac and Fannie Mae were not making loans--without any incentives from the government." (10) The banks were middlemen between the mortgage lenders and the GSEs, Fannie and Freddie. The banks assembled bonds to feed the GSE's appetite.  Fannie and Freddie were also victim's of HUD. Just like the banks they were mandated by HUD to have a certain percentage of subprime loans (35% starting in 1992 with passage of the GSE Act). Stiglitz is correct it was not an incentive, it was a mandate. Everyone involved made subprime loans since the government mandated the GSEs and banks finance a specific percentage of subprime loans each year. Failure to comply meant the GSEs and banks could not make prime loans. This was the main business of both entities.

This gets us to the "too big to fail argument." Stiglitz asserts that banks knowing "they were too big to fail provided incentives for excessive risk-taking." (15) Let's evaluate this common statement of liberal academic economists. Bankers make money by making loans that return a profit. Why would they push it to a point where the government takes over their business and kicks them out? They would not. "Excessive risk" is not appealing when the risk is losing your career, and your retirement investment in a company that has provided your livelihood. Mortgage bankers did not take on "excessive risk," because of a big annual bonus. They were forced into a no win situation by a government that required they make loans to people likely not to repay them (GSE & CRA Acts). Why did they make those loans? Loaning to subprime borrowers was a precondition of making loans to the most lucrative real estate segment, prime borrowers. The conflict between Stiglitz's argument that insufficient regulation is the cause of the Great Recession and the evidence that over regulation is the cause of the housing meltdown is not explained in Freefall.

Stiglitz clearly states the cause of the Great Recession is "the reckless lending of the financial sector, which had fed the housing bubble, which eventually burst." (27) I would suggest lending that the government required for participation in the prime market segment is not properly characterized as "reckless," but better described as a mandated risk.

Stiglitz indicates the solution to the Great Recession is a monetary stimulus coming from the government. Sitting here in 2012 it is clear that after two and a half monetary stimulus attempts this antiquated economic concept works no better today than it did in 1933. He argues a government stimulus provides a 1.5 multiplier while a bailout provides no stimulus: "Spending money to bail out the banks without getting something in return gives money to the richest Americans and has almost no multiplier." ( 62) Stiglitz provides no explanation for his comment, "gives money to the richest Americans," but whatever Bill Gates and Warren Buffet did with their "gift," I am sure it will spent on people in need throughout the world.

Eventually, Stiglitz admits the borrowers may have had a role in the financial crisis: "many of these borrowers were financially illiterate and did not understand what they were getting into." (78) This begs the question of where were the regulators hired to prevent such situations? It also brings us back to asking why HUD required banks and the GSEs to make such loans. Such logic misses Stiglitz as he continues to hurl vindictive and hyperbole at the baking industry: "The securitization process supported never-ending fees, the never-ending fees supported unprecedented profits, and the unprecedented profits generated unheard-of bonuses, and all of this blinded the bankers." (79) If the Great Recession made banks so wealthy, why did they cancel dividends, layoff thousands and let their share price slip to 30 year lows. Obviously, the stock market saw something entirely different from Joseph Stiglitz.

I must admit I am not above blaming a group of people, like Stieglitz does, for some of our problems. In my case it is lawyers, so I was delighted when I came across this statement: "Besides, many of those in charge of the markets, though they might pride themselves on their business acumen and ability to appraise risk, simply didn't have the ability to judge whether the models were good or not. Many were lawyers, untrained in the subtle mathematics of the models." (84) Stiglitz in Chapter Four proposes a few new ideas that totally ignore five thousand years of financial development. One of these ideas is his proposal of separating housing debt from the home owner's wealth called a "homeowners' Chapter 11, (where) people wouldn't have to go through the rigmaroles of bankruptcy, discharging all of their debts. The home would be treated as if it were a separate corporation." (103) Maybe I am overly critical, but isn't this just allowing the homeowner to escape their liability? He does propose an interesting idea for a tax credit rather than a tax deduction for mortgage interest. (105) Another intriguing idea taken from Denmark that Stiglitz proposes is the idea that the mortgage originator bares the first loss on a default or resale. (106)

The biggest flaw of this book is putting the blame for the Great Recession on the bankers like this statement from page 109: "The bankers who got the country into this mess should have paid for their mistakes." The case for blaming the bankers is unclear. In fact, the bankers and homeowners bore the brunt of the financial loss, but the evidence of guilt during the crisis seemes to indicate it was HUD and their partner in the crime, the U.S. Congress. These government institutions required banks to lend to homeowners who "were financially illiterate" and encouraged market products that were financially not viable. Are the banks to blame, because they took this mandated medicine so they could make prime loans? Similarly, it seems ridiculous to blame "illiterate" homeowners. It seems correct to blame the government institutions that got us into this mess.

The argument of Freefall is further eroded when Stiglitz ventures into a lecture on what is morally correct behavior for an economy. At one point he states, "Capitalism can't work if private rewards are unrelated to social rewards." (110) This line of argument is way out there! Capitalism is not a reward for moral behavior. Heaven is a reward for moral behavior. Capitalism is a wealth creation system. Besides line of argument fallacies, I question the application and use of some of the factual statements included in the book like the following: "In the United States, the magnitude of guarantees and bailouts approached 80 percent of U.S. GDP, some $12 trillion." (110) This sum is only reached by double counting the investments of money market funds in U.S. Treasury Bills that the government guaranteed when they were originally purchased. Likewise, the following statement from the book is at least an unfair, if not an outright lie: "But by now, it is clear that there is little chance that the taxpayers will recover what has been given to the banks and no chance that they will be adequately compensated for the risk borne," (112) As a taxpayer I feel more than compensated for the "risk borne" knowing the world economy did not collapse, even if all I received in return was the face value of the funds the banks borrowed for a couple of years. Also, Stiglitz gives the impression the banks did not pay back the face value of the loans which is untrue.

It is not surprising Stiglitz's solution to the difficulties the banks went through is for the "shareholders (to) lose everything; bondholders become the new shareholders." (116) My only question is what did the shareholders do to deserve this punishment? Stiglitz argues the taxpayer should not bear the cost of the bailout. There is no cost to the taxpayers since the banks repaid the funds lent to them. Oh, I am forgetting the $3 trillion dollars of bailout funds. Following Stiglitz's logic: the liberal economists who encouraged the government to spend"stimulus" money on new office furniture for government buildings should repay the poorly invested stimulus funds. The banks repaid the money they borrowed to restore the banking system. It only seems fair the government should repay the stimulus money they borrowed that did not help to restore the economy. Both investments are equally bad. Since the plan directed by the liberal economists did not work. It seems like the government has a responsibility to recover those consulting fees paid to the liberal economists for advise that was clearly flawed.

Halfway through the book, Stiglitz turns his venom on the Fed, "The Fed played a central role in every part of this drama, from the creation of the crisis through lax regulation and loose monetary policies through the failure to deal effectively with the aftermath of the bursting of the bubble." ( 141) Stiglitz does not explain the role the Fed played in the "creation of the crisis." That is an unfortunate oversight on his part since it weakens his argument. To support his argument Stiglitz resorts to some of the most discredited economic theories, like the idea of "trade-offs between inflation and unemployment." (142) Finally, Stiglitz blames the computer programs written to evaluate the real estate products offered for sale: "Valuation of the complex products wasn't done by markets. It was done by computers running models that, no matter how complex, couldn't possibly embrace all of the relevant information." (160)

Stiglitz's solution to the Great Recession is more regulation and more government; "will require government taking on a larger role." (185) "Deregulation played a central role in the crisis, and a new set of regulations will be needed to prevent another crisis and restores trust in the banks." ( 216) Regulation is just policing. The issue is why did homeowners run the red light? More police does not alter the action of the inattentive driver. Logic insists that the cause of the Great Recession must be an action taken before the value of Residential Mortgage Bonds collapsed. The collapse was due to homeowners defaulting on their mortgages. Why did homeowners default? They could not pay the increasing cost of their mortgages. So the crisis comes down to who encouraged homeowners to purchase mortgages they could not afford. Even after Professor Stiglitz's explanation it still looks like HUD's reduced borrowing standards went too far. A policy to encourage expanded home ownership reduced all the standard economic safeguards.

Stiglitz expands his arguments into the absurb. At one point he declares that people do not make economic decisions in a "rational" manner: "The belief in rationality is deeply in grained in economics. Introspection--and even more so, a look at my peers-- convinced me that it is nonsense." (248) I personally have a hard time believing in an economic system not based on rationality. How could you model a person's expected response if you do not expect them to act rationally. I suppose life in an insane asylum would be a good model. I only hope that is not what Stiglitz is suggesting.

Let me end this  critique with a quote from Joseph Stiglitz since it aptly describes his book and his life: "The best ideas do not always prevail, at least in the short run." (274) Later he argues that "materialism" has "led to rampant exploitation of unwary and unprotected individuals and to an increasing social divide." (276) This 1920s liberalism is not a very potent argument in a world largely composed of a single middle class (the 99%). Stiglitz argues one of the probelms is the community defines our social structure by their choices in the marketplace. He is appalled that we "allowed markets to blindly shape our economy." In Stiglitz's preferred world the government makes those choices. Apparently, allowing consumers to influence the market is morally wrong. Since as Professor Stiglitz points out, "the unrelenting pursuit of profits and the elevation of the pursuit of self-interest may not have created the prosperity that was hoped, but they did help create the moral deficit." (278) It must be this "moral deficit" that caused bankers throughout the world to risk our economic prosperity for their personal pursuit of profits. I do not know about your personal banker, but mine is a guy who watches his kids play soccer on the week-end and mows his lawn with a push mower. If he is part of the moral deficit, he hides it very well. I should give Stiglitz a break.Part of his problem is his New Yorkcentric world view.

News blast: New York is not the center of the universe!

Stiglitz defines something he calls economic rights: "why should these economic rights--rights of corporations--have precedence over the more basic rights of individuals, such as the rights of access to health care or to housing or to education?" (287)  Stiglitz is confused over what a "right" is. Everyone has the freedom to obtain health care, housing or education. But, no one is entitled to receive these things without earning them. Being a human being is not an entitlement to an expensive education, housing or health care. These things like all products of society are a benefit of hard work.

Professor Stiglitz concludes his book by blaming particular segments of the private sector for manipulating our economic and social policy: "the special interest groups that shape American economic and social policy include finance, pharmaceuticals, oil and coal. Their political influence makes rational policy making all but impossible." (294) The only time I see industry representatives come before Congress is to be criticized and ridiculed. I am sure their message is delivered to Congress, but clearly employees of the government including Professor Stiglitz have much greater access and influence.

His entire book is an attempt to place blame on the bankers for the Great Recession. There is no tracing of events or causes that makes that argument persuasive. His arguments do not disprove that HUD caused the crisis by lowering lending standards and requiring an unrealistic large percentage of mortgage loans to be subprime. The book is simply a retelling of the events of the Great Recession, and then making a statement that the blame for these events lies at the feet of the banking system. Stiglitz's solution of more regulators and government power over the banking industry is not persuasive. In fact, Professor Stiglitz's shaky case adds credence to the opposite theory that the events of the Great Recession occurred because of government interference in the residential real estate market.