Plunder and Blunder; How the 'Financial
Experts' Keep Screwing You
by Dean Baker, PoliPoint Press
www.alternet.org, february 7,
[An excerpt from Plunder and Blunder:
The Rise and Fall of the Bubble Economy by Dean Baker, published
by PoliPoint Press, 2009]
The stock market and housing bubbles were
the central features of the U.S. economy over the last 15 years.
The stock bubble propelled the strongest period of economic growth
since the late 1960s. The housing bubble lifted the economy from
the wreckage of the stock bubble and sustained a modest recovery,
at least through 2007. However, financial bubbles by definition
aren't sustainable, and when they collapse, they cause enormous
social and economic damage.
The economy had no problem with financial
bubbles during its period of strongest and most evenly shared
growth, the years from 1945 to 1973. It only became susceptible
to bubbles after the pattern of growth had broken down_ -- when
most workers no longer shared in the benefits of productivity
growth, and businesses no longer routinely invested to meet increased
demand based on growing consumption. We don't have enough evidence
to say that bubbles are a direct outgrowth of inequality, but,
again, we do know that bubbles weren't a problem when income was
more evenly distributed.
The bubbles were allowed to grow only
because the people in a position to restrain them failed in their
duties. The leading villain in this story is Alan Greenspan. Greenspan
mastered the art of currying the favor of the rich and powerful
and held top economic positions under five presidents of both
political parties. He also managed to gain a near cult-like following
among the media. As a result, most of the public is largely unaware
of how disastrous the Fed's policies under his tenure were for
the economy and the country.
Most of the economics profession went
along for the ride, somehow managing to miss a $10 trillion stock
bubble in the 1990s and an $8 trillion housing bubble in the current
decade. If leading economists had recognized these bubbles and
expressed concern about the inherent risks, they could have alerted
the public and forced a serious policy debate on the problem.
Instead, the leading voices in the profession joined the chorus
of Greenspan sycophants, honoring him as potentially the greatest
central banker of all time.
The financial industry proved to be more
incompetent and corrupt than its worst critics could have imagined.
Did people who manage multi-billion dollar portfolios in the late
1990s really believe that price-to-earnings ratios would continue
rising, even when they already exceeded 30 to 1? Or did these
highly paid fund managers believe that PE ratios no longer mattered_
-- as though people bought up shares of stock because the stock
certificates were pretty?
It's hard to understand how anyone who
managed money for a living could have justified keeping a substantial
portion of their funds in the ridiculously overvalued markets
of 1999 and 2000. You could play the bubble, riding the wave up
and dumping stock before the crash. But a buy-and-hold strategy
in 1999 and 2000 was a guaranteed loser. In the late 1990s, Warren
Buffet famously commented that he didn't understand the Internet
economy, and thus he pulled much of his portfolio out of the market.
Buffet understood the Internet economy very well. He recognized
a hugely overvalued stock market that was certain to crash. Why
didn't fund managers?
The financial industry's conduct in the
housing bubble was even worse. House prices had sharply diverged
from a 100-year trend without any explanation. Furthermore, vacancy
rates were at record highs and getting higher. In introductory
economics, we teach students about supply and demand. If the excess
supply keeps growing, what will happen to the price? Furthermore,
inflation-adjusted rents weren't rising through most of the period
of the housing bubble. There will always be a rough balance between
sales price and rent. When sales prices diverge sharply from rents,
some owners become renters, reducing the demand for housing. Similarly,
some owners of rental units convert them to ownership units, increasing
the supply of housing.
Decreased demand and increased supply
lowers the price; what part of that reality did the highly compensated
analysts fail to understand? How could the CEOs of the country's
two huge mortgage giants, Fannie Mae and Freddie Mac, have been
surprised by the housing bubble? The Wall Street wizards at Merrill
Lynch, Citigroup, Bear Stearns, and elsewhere were probably even
worse. Did they really have no idea that the bubble would burst
and that a large amount of mortgage debt, especially subprime
mortgage debt, would become nearly worthless? Did they think that
this junk could be made to disappear through complex derivative
Wall Street sold these instruments to
pension funds and other institutional investors. It also persuaded
state and local governments to pay them billions of dollars in
fees for issuing auction rate securities and for buying credit
default swaps and other exotic financial instruments. In addition,
many of the same institutional investors lost billions of dollars
by holding the stock of companies like Merrill Lynch, Citigroup,
and Bear Stearns, the value of which was driven into the ground
by very highly paid executives.
The real problem is that the public, including
many of the pension fund managers who were taken for a ride, still
don't understand what has happened. Perhaps the main reason for
this confusion has been the quality of economic reporting. The
media relied almost exclusively on the folks who got it wrong.
The industry bubble-pushers and the bubble-deniers in policy positions
were almost the only sources for economic reporting during the
bubble years. The vast majority of the people who follow the news
probably never heard anyone argue that the economy was being driven
by a stock bubble in the 1990s or a housing bubble in the current
decade. Such views simply were not permitted. (The New York Times
deserves special mention as a media outlet that actively sought
alternative voices, especially during the housing bubble.)
Knowingly or not, these outlets have covered
up the extraordinary incompetence and corruption that allowed
these bubbles to grow. For example, in a recent three-part series
on the housing bubble, the Washington Post reported a claim from
Alan Greenspan that he first became aware of the explosion in
subprime mortgage lending as he was about to leave his post as
Fed chair in January of 2006. According to the article, Greenspan
said he couldn't remember if he had passed this information on
to his successor, Ben Bernanke.
This article makes it sound as though
the explosion in subprime lending was an obscure piece of data
only available to a privileged few. In reality, the explosion
in subprime lending was a widely discussed feature of the housing
market during the bubble years. If Greenspan was implying that
he was unaware of this explosion, he was unbelievably negligent
in his job as Fed chair. The notion that Greenspan would have
to pass this information on to his successor_ -- as though an
economist of Bernanke's stature could be unaware of such an important
development in the economy_ -- is equally absurd. In other words,
the Post article helped Greenspan present a remarkably straightforward
development_ -- namely, the massive issuance of bad loans_ --
as complex and confusing.
In the same vein, the Wall Street Journal
provided cover for Treasury Secretary Henry Paulson by explaining
how the collapse of Fannie Mae and Freddie Mac caught him by surprise.
These two financial institutions hold almost nothing except mortgages
and mortgage-backed securities. What did Mr. Paulson think would
happen to them in a housing crash?
The secret of these two bubbles is that
there is no secret. Anyone with common sense, a grasp of simple
arithmetic, and a willingness to stand up against the consensus
could have figured out the basic story. The details of the accounting
scandals in the stock bubble and the convoluted financing stories
in the housing bubble required some serious investigative work,
but the bubbles themselves were there in plain sight for all to
The public should demand a real accounting.
Why does the Fed grow hysterical over a 2.5 percent inflation
rate but think that $10 trillion financial bubbles can be ignored?
Where was the Treasury Department during the Clinton and Bush
administrations? What about congressional oversight? Did no one
in Congress think that massive bubbles might pose a problem? Why
do economists worry so much more about small tariffs on steel
and shirts than about gigantic financial bubbles? What exactly
do the people who get paid millions of dollars by Wall Street
financial firms do for their money? And finally, why don't the
business and economic reporters ask any of these questions?
The stock and housing bubbles have wreaked
havoc on the economy and will cause enormous pain for years to
come. We can't undo the damage, but we can try to create a system
that will prevent such catastrophes from recurring and that ensures
that people responsible for these preventable events are held
accountable. That would be a huge step forward.