How much of the blame for the financial crisis lies with current Chairman of the Federal Reserve Ben Bernanke and his predecessor, Alan Greenspan?

By: Anna Collins

Back in 1999, Congress was busy setting up the United States for failure. In that year, they repealed the Glass-Steagall Act of 1933 without a substitute safeguard. The Act’s purpose was to protect the financial system by insulating commercial banks and other forms of risk by maintaining separation between groups prone to competing interests. With no replacement, many observers predicted that a large-scale financial crisis would inevitably result, perhaps not immediately but certainly once the market stopped growing at such a hurried pace.

How right they were. The current financial crisis, rooted in deregulation and a massive asset bubble, could have easily been prevented had authorities, such as former Chairman of the Federal Reserve Alan Greenspan and current Chairman Ben Bernanke, not shamelessly refused to acknowledge the ever-burgeoning problem. Conservative politicians and economists are also to blame for failing to understand that growing inequality--a product of the Washington Consensus that allowed the rich to get richer as the wages of low- and moderate-income workers stagnated--never leads to universally positive consequences. However, now is not the time for counter-productive finger pointing or senseless blame games. Now is the time to understand the steps leading up to the market collapse of 2008 and what our country can do to preclude another downturn.

At the center of the problem was market instability, caused in large part by the ability to create new lines of credit that gradually dried up the flow of money, slowed new economic growth, and curtailed the buying and selling of assets. These developments negatively impacted both individuals and businesses, and many financial institutions found themselves in the possession of mortgage-backed assets that dropped so precipitously in value that they could no longer bring enough money to pay the loans. As a natural consequence, the banks’ already insufficient reserve capital became restricted or disappeared, as did their credit and ability to negotiate new loans. In the time leading up to the crisis, banks displayed enormous irresponsibility and indiscretion by facilitating mortgages for people who could not afford them.

During the years of the housing bubble, mortgage brokers earned their money simply by issuing mortgages, giving them an incentive to favor inflated appraisals over accurate ones. When the housing bubble began to unravel after prices peaked in 2006, a rapid rise in default rates ensued, especially in the subprime market, and subprime mortgages, widely held by financial firms, lost most of their value. This led to a large decline in the monetary reserves of many banks and made the infamous tax-payer funded bailouts necessary.

While the Fed was right to worry that the failure of the world’s largest and most interconnected businesses would have disastrous consequences for world financial markets, the bailout process inevitably encourages careless and erratic risk-taking.

Another contributing factor to market instability was cheap credit, which made it much easier for people to buy houses or make other investments based purely on speculation. Recall that it was a speculative stock frenzy, the product of artificially low interest rates and an unsustainable credit-driven boom, that preceded the Great Depression—something the composers of the Glass-Steagall Act fully comprehended. Put simply, cheap credit created more money in the system and, acting accordingly, people tried to spend that money. Unfortunately, people all wanted to buy the same asset (houses), which shifted demand outward and resulted in inflation. Private equity firms leveraged billions of dollars of debt to purchase companies and created hundreds of billions of dollars in wealth simply by shuffling paper without creating anything of real value. Adding to the problem of inflation was speculation in oil prices and rising unemployment.

We must also consider why, during the peak years of the housing bubble, financial institutions were counter-intuitively willing to make loans that would never be paid off. The answer is an incentive structure that places an enormous premium on short-term profits, often at the expense of long-term profits or even long-term corporate survival. Rather than rewarding long-term performance or patiently awaiting the long-term impact of bankers’ actions, employers customarily honored short-term, fleeting profit through “guaranteed bonuses.” These created perverse incentives for excessive risk taking that could be well worse the incentives rather than straight salary. Regrettably, even as French President Nicolas Sarkozy threatened to storm out of the September G-20 summit meeting in Pittsburgh if the assembling countries do not agree to tough curbs on bonus payments for overly daring bankers, the U.S. continues to voice reservations about reforming our distorted bonus culture.

Eager to protect major financial centers in the City of London and Wall Street, our country seems to consider bonuses a non-subject, unaware or in denial of a practice that is altogether improper and cynical. Company managers need to set long-term policies while holding pressures for short-term profits in check as they do in Germany. This is enforced by their stake-holder, rather than share-holder, model of capitalism where, for instance, worker representatives sit on boards of directors and unionization rates remain high.

Clearly some significant changes need to be made. The financial meltdown of 2008 need not be interpreted as the collapse of market fundamentalism or the downfall of capitalism, but as a clear opportunity to reform our financial system. Middle- and lower-income Americans need to be given more buying power through an increase in wages so most of what is earned in America does not continue to go exclusively to the richest five percent. Whereas the rich are more likely to invest their earnings wherever around the world they can get the highest return, low- and moderate-income Americans are more likely to buy and stimulate the American economy.

Stronger unions are also necessary in order to better protect the local service sector from global competition. Moreover, corporations should be made legally answerable to not only shareholders, but also their employees and community, which would first require a basic change in the composition of corporate boards. Finally, while it may seem like a radical solution, the government should temporarily nationalize the banking institutions, replace failed management, refresh the balance sheets, and then sell them back to the private sector once all underlying problems are thoroughly addressed. This way banks are forced to acknowledge the extent of their problems and to resolve them immediately. On a related note, major banks considered “too big to fail,” those that disproportionately influence public policy, must be broken up by the government. Even banks that remain in private hands should be subject to size limitations. In short, if we as a country want to disqualify the possibility of another massive economic slump, we need to recognize and then forcefully shatter the unacceptable banking oligarchy.