John Steele Gordon on the Financial Mess: Greed, Stupidity, Delusion — and Some More Greed

John Steele Gordon, an author who specializes in financial and business history, has a helpful pedigree: both his grandfathers held seats on the New York Stock Exchange. His 2004 book An Empire of Wealth: The Epic History of American Economic Power is a remarkably vivid chronicle of every boom and bust that our economic history has absorbed.

Last week, we asked two University of Chicago finance professors, Doug Diamond and Anil Kashyap, to explain the Lehman and A.I.G. meltdowns (and more) in lay terms. Now we’ve asked Gordon to put the current mess in historical perspective and give some further insights into its origins.

Greed, Stupidity, Delusion — and Some More Greed

By John Steele Gordon

A Guest Post

Looking just at the Friday closes, it was one of those ho-hum weeks in the stock market. The Dow had ended the previous week at 11,421.99, and last Friday it closed at 11,388.44 — down 33.55 points — a measly 0.29 percent.

To be sure, in between the two closes things got a tad volatile: down 504 points on Monday, up 141 on Tuesday, down 449 on Wednesday, up 410 on Thursday, and up 368 on Friday — all on huge volume (with a record on Thursday of 10.2 billion shares). And in this remarkable week, the landscape of American capitalism changed profoundly. Great names like Merrill Lynch and Lehman Brothers will disappear, and government responsibility for backing up the financial system will increase considerably as the administration asks Congress for $700 billion in borrowing authority to handle the situation.

What happened? Simple: panic. Vast amounts of assets in the financial system became unsellable as no one knew what they were worth, and thus they were useless as collateral for loans. As a result, highly sophisticated bankers refused to lend to other highly sophisticated bankers overnight; Ma and Pa Mainstreet rushed to take their money out of uninsured money-market funds and put it in Treasury bills paying practically nothing, and in gold, which pays nothing at all (and indeed costs money for storage or insurance).

The world’s financial system came perilously close to seizing up — like an engine without oil. Had that happened, the consequences would have been very nasty indeed. Let us hope that the market’s bets on Thursday and Friday are a sign that the government is getting a handle on things.

But the first thing to do in a panic is … don’t panic! “If you can keep your head when all about you are losing theirs,” you’ll be fine.

There have been headlines that this is the worst economic crisis since the Great Depression. No. It is a financial crisis.

The underlying American economy is not in bad shape. Unemployment is at 6 percent; that’s a little high by the standards of the last decade or so, but not by longer-term standards (unemployment reached 10.8 percent as recently as 1982). In 1933, it was over 25 percent (and actually far higher, with many working part time). In 1933, G.D.P. was little more than half of what it had been in 1929.

G.D.P. has grown smartly in the last five years, even in 2008. Farm mortgages were being foreclosed at the rate of 20,000 a month in 1933. The nation’s farmers have never been so prosperous as they are today. When F.D.R. was inaugurated on March 4, 1933, banks were entirely closed in 38 states and restricted in the other 10. Over 5,000 banks had already failed by then, and had taken the savings of millions with them. Today, millions of families have substantial savings, retirement funds, and equity in real estate. In 1933, exports were one-fifth of what they had been in 1929. American exports are booming today.

In 1933, we were a country of haves and have-nots; today, we are largely a country of haves and have-mores. The poverty of the sort seen in the immortal photographs of Walker Evans simply does not exist today.

How we will get out of this mess is becoming clearer, and Congress will have to act very quickly. But the members of Congress stared into the abyss along with the rest of us last week, so my guess is that even they will act responsibly for once.

But there is no doubt at all about how we got into this mess.

To be sure, there is plenty of blame to go around. Greed, as it periodically does when traders and bankers forget the lessons of the past, clouded judgments. Some very smart people talked themselves into believing in the repeal of one of the fundamental laws of economics: risk will always equal potential reward. The idea that risk can be eliminated and high yields guaranteed is as idiotic as the idea that gravity can be suspended. Remember Long-Term Capital Management? Ten years ago it figured out how to eliminate risk using highly sophisticated computer programs and rolled up annual returns averaging 40 percent — until it collapsed in a heap.

Credit ratings agencies such as Moody’s and Standard and Poor’s gave good credit ratings to securities they didn’t understand.

But at the heart of the problem is Congress and its deeply corrupt relationship with Fannie Mae and Freddie Mac. Congress was equally at the heart of the savings and loan disaster 20 years ago and, obviously, learned nothing from it. (For a history of what led to the savings and loan collapse, see here.)

Fannie and Freddie, two of the largest publicly traded financial institutions on earth, are headquartered in Washington, D.C., where the next-largest non-governmental financial institution is probably a local credit union. Big financial companies are headquartered in New York and other cities where capitalism is practiced. That should tell you a lot about Freddie and Fannie: they were political to their fingertips.

Being “government sponsored entities,” they were able to borrow at lower interest rates than other profit-seeking companies, had less regulation, had lower capital requirements, and had an “implied” guarantee on their huge debts. This was supposed to translate into more money available for mortgages, but was used instead to roll up big profits and, not so incidentally, big bonuses for their top management — which came not from the financial world but from the political one.

Franklin Raines, Fannie C.E.O. from 1999 to 2004, had been budget director in the Clinton White House. He cooked the books at Fannie to increase his compensation (more than $50 million). Jamie Gorelick, vice C.E.O., was number two at the Clinton Justice Department before going to Fannie Mae. She made $26 million. Jim Johnson, a perennial Washington big-foot, was chairman from 1991 to 1998. He too, according to an official government report, cooked the books to increase his compensation and failed to publicly reveal how much he received.

The Wall Street Journal editorial page has been giving chapter and verse for years on why this was a disaster waiting to happen (Pulitzer Prize judges, please note). The Bush administration tried way back in 2003 to change the system. It got nowhere. Alan Greenspan, then the chairman of the Federal Reserve, frequently noted the danger of Fannie and Freddie’s weak capitalization. He was ignored. Congressman Mike Oxley, then chairman of the House Financial Services Committee, introduced a bill in 2005 to correct the situation. Lobbyists from Fannie and Freddie succeeded in gutting it to the point that Rep. Oxley pulled the bill.

Why were Fannie and Freddie so successful at maintaining the status quo? Check it out.

Senator Chris Dodd — formerly ranking member and now chairman of the Senate Banking Committee, with oversight over Freddie and Fannie — recently said on Bloomberg Television: “I have a lot of questions about where was the administration over the last eight years.”

Excuse me? Just where the hell were you, Senator? Oh, right. You were standing in line at the bank in order to deposit the political contributions Fannie and Freddie were lavishing upon you. At least they got their money’s worth — until the party ended and the American people got the bill.

Members of Congress — aided and abetted by their many waterbearers in the media — wonder why their collective approval rating is about on par with colon cancer’s. The reason is simple enough: Congress is the sick man of Washington; a textbook example of the truism that institutions tend to evolve in ways that benefit their elites, at the expense of the people they were created to serve.

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  1. donna says:

    Anyone who thinks poverty doesn’t exist in this country doesn’t know where to look. It may not look like the 30s, but it’s there.

    We’re fortunate to have what we do, and hopefully, it won’t get as bad as the 30s did. But the inequality is more extreme than ever.

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  2. Scott Baker says:

    The president will have to assume FDR-like powers to solve the derivative collapse.

    He should declare all derivatives placed outside of legally regulated markets (90% of them) null and void. These “bets” – worth $180 trillion according the U.S. Office of the Comptroller of the Currency in America alone, and up to $450 trillion worldwide – could not have been made in regulated markets, because the players had insufficient collateral.

    If the parties object to the elimination of their derivative bets, they should be reminded of the penalty for fraud; it is inconceivable they did not know they were establishing positions far beyond their ability to repay.

    For every buyer there is a seller, so the amounts lost would zero out and no party would gain an advantage. We would just get to reset the clock. This is as fair as things can be made, given where we are.

    What is causing the panic in the markets right now is the realization that the losers have insufficient money to pay the winners. The domino effect of multiple collapses cannot be stemmed by any government, even by running the printing press overtime. The only solution is to wipe the underlying derivatives off the books and ensure these bets are never made again by creating laws to send those who make them in the future to jail.

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  3. The Outspoken New Yorker says:

    You may be an economist sir, however, you fail to realize: everyone hates the Congress, but everyone loves their Congressman.

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  4. roseann says:

    It has to do with reconditioning an ‘Spend Spend attitude’ problem in America – The wealth of any nation is the savings capital of its’ populist.

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  5. Ken says:

    Donna, the post doesn’t say there isn’t inequality. But it is correct — we are now Haves and Have Mores (sometimes, a LOT more). The problem is not poverty, it’s envy.

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  6. Gene says:

    This apologist for the Bush administration overlooks the fact that the congress has given in at every turn.

    Don’t forget the administration’s habit of skirting or breaking the law when it suited its agenda.

    Let’s dry our crocodile tears for this amateur administration’s incompetence.

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  7. mark says:

    Yes, Bush and Greenspan tried so hard to keep this all from happening, but the Democrats tied their hands. And the poor investment banks were taken down by panic caused by Fannie and Freddie. This is either the most idiotic, or the most fraudulent assessment of the current crisis I have seen. How could someone allegedly knowledgeable about US economic history be so ridiculously wrong about present events? I will not be buying your book, and I look forward to not seeing guest posts by Mr. Gordon in the future!

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  8. Drew in NC says:

    “Greed, Stupidity, Delusion” should be the blurb for the article as well. A partisan attack on Democrats and Fanny and Freddy that conveniently forgets the repealing of the Glass-Steagall Act. Nice work Mr. Gordon. It’s nice to see that the “have mores” are still on that attack and unwilling to accept responsibility for themselves. You even got in some bonus historical revisionism and a Bush Admin defense along the way.

    When will you greedy fools take responsibility for yourselves? Apparently, not even after the disaster occurs. As Colin Powell said before the war that your boys screwed-up “If you break it, you own it”.

    Hope you enjoy your new toy.

    Too bad you screwed up the country for the rest of us who are just trying to get by.

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