Friday, October 3, 2008

Who Caused the Economic Crisis? blames McCain advisers. He blames Obama and Democrats in Congress. Both are wrong.

A Political Action ad plays the partisan blame game with the
economic crisis, charging that John McCain’s friend and former
economic adviser Phil Gramm “stripped safeguards that would have
protected us.” The claim is bogus. Gramm’s legislation had
broad bipartisan support and was signed into law by President Clinton.
Moreover, the bill had nothing to do with causing the crisis, and
economists – not to mention President Clinton – praise it
for having softened the crisis.

A McCain-Palin ad, in turn, blames Democrats for the mess. The ad says
that the crisis “didn’t have to happen,” because
legislation McCain cosponsored would have tightened regulations on
Fannie Mae and Freddie Mac. But, the ad says, Obama "was notably
silent" while Democrats killed the bill. That’s oversimplified.
Republicans, who controlled the Senate at the time, did not bring the
bill forward for a vote. And it’s unclear how much the
legislation would have helped, as McCain signed on just two months
before the housing bubble popped.

In fact, there’s ample blame to go around. Experts have cited
everyone from home buyers to Wall Street, mortgage brokers to Alan

Congress wrestled with a $700 billion rescue for Wall Street's
financial crisis, partisans on both sides got busy – pointing
fingers. Political Action on
Sept. 25 released
a 60-second TV ad called "My Friends’ Mess," blaming Sen. John
McCain and Republican allies who supported banking deregulation. The
McCain-Palin campaign released its own 30-second TV spot Sept. 30,
saying "Obama was notably silent" while Democrats blocked reforms
leaving taxpayers "on the hook for billions." Both ads were to run

And both ads are far wide of the mark.

Blame the Republicans!

The Political Action ad blames a banking deregulation bill
sponsored by former Sen. Phil Gramm, a friend and one-time adviser to
McCain's campaign. It claims the bill "stripped safeguards that would
have protected us."

That claim is bunk. When we contacted spokesman Trevor
Fitzgibbons to ask just what "safeguards" the ad was talking about, he
came up with not one single example. The only support offered for the
ad's claim is one line in one newspaper article that reported the bill
"is now being blamed" for the crisis, without saying who is doing the
blaming or on what grounds.


The bill in question is the Gramm-Leach-Bliley Act,
which was passed in 1999 and repealed portions of the Glass-Steagall
Act, a piece of legislation from the era of the Great Depression that
imposed a number of regulations on financial institutions. It's true
that Gramm authored the act, but what became law was a widely accepted
bipartisan compromise. The measure passed the House 362
- 57, with 155 Democrats voting for the bill. The Senate passed the bill by a vote of 90 - 8.
Among the Democrats voting for the bill: Obama's running mate, Joe
Biden. The bill was signed into law by President Clinton, a Democrat.
If this bill really had "stripped the safeguards that would have
protected us," then both parties share the blame, not just "John
McCain's friend."

The truth is, however, the Gramm-Leach-Bliley Act had little if
anything to do with the current crisis. In fact, economists on both
sides of the political spectrum have suggested that the act has
probably made the crisis less severe than it might otherwise have been.

Last year the liberal writer Robert Kuttner, in a piece in The American Prospect, argued
that "this old-fashioned panic is a child of deregulation." But even he
didn't lay the blame primarily on Gramm-Leach-Bliley. Instead, he
described "serial bouts of financial deregulation" going back to the
1970s. And he laid blame on policies of the Federal Reserve Board under
Alan Greenspan, saying "the Fed has become the chief enabler of a
dangerously speculative economy."

What Gramm-Leach-Bliley did was to allow commercial banks to get into investment banking. Commercial
banks are the type that accept deposits and make loans such as
mortgages; investment banks accept money for investment into stocks and
In 1998, regulators had allowed
Citicorp, a commercial bank, to acquire Traveler's Group, an insurance
company that was partly involved in investment banking, to form
Citigroup. That was seen as a signal that Glass-Steagall was a dead
letter as a practical matter, and Gramm-Leach-Bliley made its repeal
formal. But it had little to do with mortgages.

Actually, deregulated banks were not the major
culprits in the current debacle. Bank of America, Citigroup, Wells
Fargo and J.P. Morgan Chase have weathered the financial crisis in
reasonably good shape, while Bear Stearns collapsed and Lehman Brothers
has entered bankruptcy, to name but two of the investment banks which
had remained independent despite the repeal of

Observers as diverse as former Clinton Treasury official and current Berkeley economist Brad DeLong and George Mason University's Tyler Cowen, a libertarian, have praised Gramm-Leach-Bliley has having softened the crisis. The deregulation allowed Bank of America and J.P. Morgan Chase to acquire Merrill Lynch and Bear Stearns. And Goldman Sachs and Morgan Stanley have now converted themselves into unified banks to better ride out the storm. That idea is also endorsed by
former President Clinton himself, who, in an interview with Maria Bartiromo published in the Sept. 24 issue of Business Week, said he had no regrets about signing the repeal of Glass-Steagall:

Bill Clinton (Sept. 24):
Indeed, one of the things that has helped stabilize the current
situation as much as it has is the purchase of Merrill Lynch by Bank of
, which was much smoother than it would have been if I hadn't
signed that bill. .
know, Phil Gramm and I disagreed on a lot of things, but he can't
possibly be wrong about everything. On the Glass-Steagall thing, like I
said, if you could demonstrate to me that it was a mistake, I'd be glad
to look at the evidence. But I can't blame [the Republicans]. This
wasn't something they forced me into.

No, Blame the Democrats!

The McCain-Palin campaign
fired back with an ad laying blame on Democrats and Obama. Titled
"Rein," it highlights McCain's 2006 attempt to "rein in Fannie and
Freddie." The ad accurately quotes the Washington Post as
saying "Washington failed to rein in" the two government-sponsored
entities, the Federal National Mortgage Association ("Fannie Mae") and
the Federal Home Loan Mortgage Corporation ("Freddie Mac"), both of
which ran into trouble by underwriting too many risky home mortgages to
buyers who have been unable to repay them. The ad then blames Democrats
for blocking McCain's reforms. As evidence, it even offers a snippet of
an interview in which former President Clinton agrees that "the
responsibility that the Democrats have" might lie in resisting his own
efforts to "tighten up a little on Fannie Mae and Freddie Mac." We're
then told that the crisis "didn't have to happen."

It's true that key Democrats opposed
the Federal Housing Enterprise Regulatory Reform Act of 2005,
which would have established a single, independent regulatory body with
jurisdiction over Fannie and Freddie – a move that the
Government Accountability Office had recommended in a 2004 report. Current House Banking Committee chairman Rep. Barney Frank of Massachusetts opposed legislation to reorganize oversight
in 2000 (when Clinton was still president), 2003 and 2004, saying of
the 2000 legislation that concern about Fannie and Freddie was
"overblown." Just last summer, Senate Banking Committee chairman Chris
Dodd called a Bush proposal for an independent agency to regulate the two entities "ill-advised."

saying that Democrats killed the 2005 bill "while Mr. Obama was notably
silent"  oversimplifies things considerably. The bill made it out
of committee in the Senate but was never brought up for consideration.
At that time, Republicans had a majority in the Senate and controlled
the agenda. Democrats never got the chance to vote against it or to
mount a filibuster to block it.

By the time McCain
on to the legislation, it was too late to prevent the crisis anyway.
McCain added his name on May 25, 2006, when the housing bubble had
already nearly peaked.
Standard & Poor's Case-Schiller Home Price Index,
which measures residential housing prices in 20 metropolitan regions
and then constructs a composite index for the entire United States,
shows that housing prices began falling in July 2006, barely two months

The Real Deal

So who is
to blame? There's plenty of blame to go around, and it doesn't fasten
only on one party or even mainly on what Washington did or didn't do.
As The Economist magazine noted recently,
the problem is one of "layered irresponsibility ...
with hard-working homeowners and billionaire villains each
playing a role." Here's a partial list of those alleged to be at fault:

  • The Federal Reserve, which slashed interest rates after the dot-com bubble burst, making credit cheap.

  • Home buyers, who took advantage of easy credit to bid up the prices of homes excessively.

  • Congress, which continues to support a mortgage tax deduction that gives consumers a tax incentive to buy more expensive houses.

  • Real estate agents, most of whom work for the sellers rather than the buyers and who earned higher commissions from selling more expensive homes.

  • The Clinton administration, which pushed for less stringent credit and downpayment requirements for working- and middle-class families.

  • Mortgage brokers,
    who offered less-credit-worthy home buyers subprime, adjustable rate
    loans with low initial payments, but exploding interest rates.

  • Former Federal Reserve chairman Alan Greenspan, who in 2004, near the peak of the housing bubble, encouraged Americans to take out adjustable rate mortgages.

  • Wall Street firms,
    who paid too little attention to the quality of the risky loans that
    they bundled into Mortgage Backed Securities (MBS), and issued bonds
    using those securities as collateral.

  • The Bush administration, which failed to provide needed government oversight of the increasingly dicey mortgage-backed securities market.

  • An obscu
    re accounting rule

    called mark-to-market, which can have the paradoxical result of making
    assets be worth less on paper than they are in reality during times of

  • Collective delusion,
    or a belief on the part of all parties that home prices would keep
    rising forever, no matter how high or how fast they had already gone

U.S. economy is enormously complicated. Screwing it up takes a great
deal of cooperation. Claiming that a single piece of legislation was
responsible for (or could have averted) is just political
grandstanding. We have no advice to offer on how best to solve the
financial crisis. But these sorts of partisan caricatures can only make
the task more difficult.

–by Joe Miller and Brooks Jackson

Benston, George J. The Separation of Commercial and Investment Banking: The Glass-Steagall Act Revisited and Reconsidered. Oxford University Press, 1990.

Tabarrok, Alexander. "The Separation of Commercial and Investment Banking: The Morgans vs. The Rockefellers." The Quarterly Journal of Austrian Economics 1:1 (1998), pp. 1 - 18.

Kuttner, Robert. "The Bubble Economy." The American Prospect, 24 September 2007.

"The Gramm-Leach-Bliley Act of 1999." U.S. Senate Committee on Banking, Housing and Urban Affairs. Accessed 29 September 2008.

Bartiromo, Maria. "Bill Clinton on the Banking Crisis, McCain and Hillary." Business Week, 24 September 2008.

Standard and Poor's. "Case-Schiller Home Price History." Accessed 30 September 2008.

"Understanding the Tax Reform Debate: Background, Criteria and Questions." Government Accountability Office. September 2005.

Bianco, Katalina M. "The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown." CCH. Accessed 29 September 2008.

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