Joseph Stiglitz dissects the economic crisis

Stiglitz says the 2001 and 2003 tax cuts "put the burden" of responding to the tech bubble on "monetary policy."

A couple months ago, ex Federal Reserve Bank chairman Alan Greenspan, in testimony before Congress confessed he had found a flaw in his philosophy of managing markets. Mr. Greenspan, like many others, believed markets are self regulating and government intrusion should be minimal.

Congressman Henry Waxman pushed him, responding, “In other words, you found that your view of the world, your ideology, was not right; it was not working.” “Absolutely, precisely,” Greenspan said.

It must have been a difficult admission for Mr. Greenspan. The much admired, highly praised ex Fed chair was admitting some culpability in the current financial meltdown in the U.S. And while it may be painful and embarrassing for some, Nobel Prize winning economist Joseph Stiglitz (who, inexplicably, is not a part of the Obama economic team) argues, in a Vanity Fair article, the wrong decisions, the bad moves leading up to our economist crisis needs to be well understood so as not to be repeated.

Mr. Stiglitz argues the collapse was a "system failure", but five key events are chiefly responsible:

The first is Ronald Reagan's replacement of Fed Chairman Paul Volcker with Alan Greenspan in 1987.

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.

Breaking down the barriers between commercial and investment banks and allowing commercial banking to increase debt to equity ratios were the components of the second key event.

The most important consequence of the repeal of Glass-Steagall (in 1999) was indirect—it lay in the way repeal changed an entire culture. Commercial banks are not supposed to be high-risk ventures; they are supposed to manage other people’s money very conservatively. It is with this understanding that the government agrees to pick up the tab should they fail. Investment banks, on the other hand, have traditionally managed rich people’s money—people who can take bigger risks in order to get bigger returns. When repeal of Glass-Steagall brought investment and commercial banks together, the investment-bank culture came out on top. There was a demand for the kind of high returns that could be obtained only through high leverage and big risktaking.

The third key event were the Bush tax cuts.

The tax cuts played a pivotal role in shaping the background conditions of the current crisis. Because they did very little to stimulate the economy, real stimulation was left to the Fed, which took up the task with unprecedented low-interest rates and liquidity. The war in Iraq made matters worse, because it led to soaring oil prices. With America so dependent on oil imports, we had to spend several hundred billion more to purchase oil—money that otherwise would have been spent on American goods.

Normally this would have led to an economic slowdown, as it had in the 1970s. But the Fed met the challenge in the most myopic way imaginable. The flood of liquidity made money readily available in mortgage markets, even to those who would normally not be able to borrow.

The accounting scandals early in the decade and the subsequent failure of Sarbanes-Oxley to address the issue of stock options prompted the continued fudging of the books for many corporations. The failure of regulators to address these kinds of conflicts of interest is Stiglitz's fourth key event.

Accounting is a sleep-inducing topic for most people, but if you can’t have faith in a company’s numbers, then you can’t have faith in anything about a company at all.

But a collateral problem with stock options is that they provide incentives for bad accounting: top management has every incentive to provide distorted information in order to pump up share prices.

And, finally, Mr. Stiglitz calls the $700B Congressional bailout the fifth key event. The bailout finally passed by Congress was without any means to force the banks to begin lending again, and some banks chose to use the federal funds to pay shareholders, prop up their balance sheets and provide management bonuses.

The other problem not addressed involved the looming weaknesses in the economy. The economy had been sustained by excessive borrowing. That game was up. As consumption contracted, exports kept the economy going, but with the dollar strengthening and Europe and the rest of the world declining, it was hard to see how that could continue. Meanwhile, states faced massive drop-offs in revenues—they would have to cut back on expenditures. Without quick action by government, the economy faced a downturn. And even if banks had lent wisely—which they hadn’t—the downturn was sure to mean an increase in bad debts, further weakening the struggling financial sector.