[R-G] [BillTottenWeblog] Plunder and Blunder

Wed Mar 18 17:37:40 MDT 2009

How the 'Financial Experts' Keep Screwing You

by Dean Baker

AlterNet (February 07 2009)

Editor's Note: The following is 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 US
economy over the last fifteen 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 thirty to one? 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 hundred-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 instruments?

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 see.

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.

Click here to buy a copy of Plunder and Blunder: The Rise and Fall of
the Bubble Economy
http://www.powells.com/partner/32513/biblio/9780981576992
_____

Dean Baker is co-director of the Center for Economic and Policy Research.

http://www.alternet.org/story/125421/

TO POST A COMMENT, OR TO READ COMMENTS POSTED BY OTHERS, please click
on the word "comment" highlighted at the end of the version of this
essay posted at http://billtotten.blogspot.com/