Inside Job

by Charles Ferguson

  But starting in the 1980s, all that began to change, and by the 2000s, both the structure of the financial sector and its compensation practices would have been unrecognizable to a banker of 1975. At every level from individual traders to CEOs to boards of directors to transactions between firms, people and companies were now rewarded immediately (and usually in cash) for producing short-term profits, with no corresponding penalties for producing subsequent losses. This was fatal. In finance, it is extremely easy to create transactions that are initially profitable, but are disastrous failures in the longer term. But by the 2000s, the bankers didn’t have to give any money back if that happened, so they didn’t care. In fact, they were actively incented to be destructive—to their customers, to their industry, to the wider economy, even frequently to their own firms.

  While the party lasted, it made banking look like paradise. During the bubble of the 2000s, financial sector profits soared to nearly 40 percent of all US corporate profits. The average pay of people working at US investment banks jumped from about $225,000—already an amazingly high number—to over $375,000, where it has stayed, even after the crisis. And that was just the cash; those numbers do not include stock options.

  And that’s the average. Consider what happened to the pay of “named executive officers”, or NEOs, the highest-paid senior officers (although in any given year, the hottest traders may make more). According to their 2008 proxy statement, the top five officers at Goldman Sachs averaged $61 million each in compensation in 2007. Pay levels like that disorient moral compasses; so did the private lifts, the private jets, the partners’ private dining rooms and personal chefs, the helicopters, the cocaine, the strip clubs, the prostitutes, the trophy wives, the mansions, the servants, the White House state dinners, the fawning politicians and charities, and the multimillion-dollar parties. There is no denying that in chasing all these things, many bankers not only destroyed the world economy but also sabotaged their own institutions and, in some cases, even themselves.

  Nor has financial sector compensation changed greatly since the crisis. In 2008, when all banks were gasping for their last breath, the average NEO compensation dropped back only to the 2005 level, and in January 2009, in the depths of the crisis that they had caused, the New York investment banks awarded their employees over $18 billion in cash bonuses.

  But the banks are also guilty of two other, even larger, crimes. The first of these is that they used their wealth to acquire and manipulate political power, to their own advantage but to our enormous, long-term detriment. It was in large measure the financial sector’s political activities (through lobbying, campaign contributions, and revolving-door hiring) that gave us deregulation, abdication of white-collar law enforcement, tax cuts for the wealthy, huge budget deficits, and other toxic policies.

  And the bankers’ final crime was that, far from channelling funds into productive uses, the financial sector has become parasitic and dangerous—a semicriminal industry that is a drag on the American economy. The banks have destabilized the financial system, wasted huge sums of money, plunged millions of people into chronic poverty, and crippled economic growth throughout the industrialized world for many years to come. The proper job of bankers is to allocate capital efficiently by assembling savings from households and businesses, and to place that money into the investments that produce the highest long-term returns for the economy. That is how the financial sector creates jobs and prosperity—or so economic theory says it should.

  But the housing boom of the 2000s, which was based on a combination of unsustainable consumption and outright fraud, brought no real economic improvement. The financial system deliberately shifted its focus toward people who were either bad credit risks or easy victims, creating new products to entice and defraud them.

  By the autumn of 2005, Merrill Lynch estimated that half of all US economic growth was related to housing—including new construction, home sales, furniture, and appliances. Much of the rest came from the Bush administration’s enormous deficit spending. America was living in a fake economy. Finally, in 2008 the banks ran out of victims, and the bubble collapsed.

  NONE OF THE FINANCIAL destruction wreaked by the bankers was an act of God. Nor was it unforeseen. Voices were raised in warning early in the 2000s, and in greater and greater volume, as the bankers plunged into ever more exotic universes of risk. Some of them are in my film Inside Job—Raghuram (Raghu) Rajan, Charles Morris, Nouriel Roubini, Simon Johnson, Gillian Tett, William Ackman, Robert Gnaizda, the IMF, even the FBI. They were all ignored, even ridiculed, by those who were profiting from the situation. To a great degree, of course, the outlines of this story are now known, and I will spend relatively little time on it. Most of this book is therefore devoted to two issues: first, the rise of finance as a criminalized, rogue industry, including the role of this criminality in causing the crisis; and second, an analysis of the wider growth of inequality in America.

  The book therefore proceeds as follows: Chapter 2 offers a short history of the twenty-year period that led to the rise of a deregulated, concentrated, destabilizing financial sector, including the reemergence of financial crises and criminality.

  Next, I describe the available evidence about banking behaviour during the 2000s, including the role played by criminal behaviour in the bubble and crisis. Chapter 3 examines mortgage lending; chapter 4, investment banking and related activities; chapter 5, the coming of the crisis and the behaviour it produced. Chapter 6 surveys the rise of financial criminality, and the case for criminal prosecutions. Not all of the bankers’ actions were criminal, of course, but some were—especially if we apply the same standards that sent hundreds of savings and loan executives to prison in the 1990s, not to mention what happened to people not lucky enough to be working for major investment banks when they committed fraud or laundered criminal money.

  The last four chapters of the book are a wider analysis of America’s recent changes. Starting with financial services, and then turning to academia, other economic sectors, and the political system, I discuss America’s descent over the last generation into an economically stagnant, financially unstable, highly unequal society. I begin in chapter 6 by examining the financial sector’s transformation into a parasitic industry that increasingly confiscates, rather than creates, national wealth.

  In chapter 8, I turn to academia. Many viewers of Inside Job commented that the most surprising and shocking element of the film was its revelations about academic conflicts of interest. Here I provide a far more detailed and extensive examination of how the financial sector and other wealthy interest groups have corrupted American academia, changing its role from independent analysis to an additional tool for corporate and financial lobbying. In chapter 9, I consider the broader decline of the economic and political systems. Chapter 10 concludes the book with a discussion of the alternative futures facing the US and Europe, the large-scale policy changes required to reverse American decline, and finally the potential avenues for achieving these ends through social and political action.

  This last task will not be easy. The conduct of the Obama administration provides a painfully clear example. For reasons described in the final chapters of this book, a political duopoly is now highly entrenched in the US and it is resistant to change. Despite their populist pretensions, both American parties depend on the money that flows to them because they, and only they, control electoral politics, and both parties would fiercely resist any challenge to this arrangement.

  And there is a final problem. To some extent, it must sadly be admitted, this decline has been tolerated by the American people. Over the last thirty years Americans have become less educated, less inclined to save and invest for the future, and, understandably, far more cynical about participating in politics and other institutions. Consequently, it has proven disturbingly easy for the new oligarchy to manipulate large segments of the population into tolerating, even supporting, policies that worsen the world’s economy. And, of course, many young
people have simply given up on politics, particularly after numerous betrayals, including by the Obama administration; many are now profoundly disturbed that Obama turned out to be more of the same.

  To reverse this decline, it will first be necessary to reverse the consolidation of economic power now wielded by highly concentrated industries, the financial sector, and the extremely wealthy. In addition, it will be necessary to shift economic priorities towards education, saving, and long-term investment, and away from excessive reliance on cheap energy and, in the case of the US, military power. And finally, it will be necessary to profoundly change the role of money in politics—in campaign contributions, political advertising, revolving-door hiring, lobbying, and the enormous disparities between public and private sector salaries that have taken over the American system and threaten to take hold elsewhere.

  There are three alternative routes for achieving deep systemic reform, both in the US and farther afield: a successful insurgency in one of the existing political parties; a true third-party effort; and a nonpartisan social movement perhaps analogous to the civil rights or environmental movements of a generation ago. All of these paths are difficult. But we have done difficult things before, even when they faced powerful opposition. Often the most remarkable achievements come in part because of remarkable leaders who have been committed to remarkable goals. Let us hope we see such leaders again.

  CHAPTER 2

  * * *

  OPENING PANDORA’S BOX: THE ERA OF DEREGULATION, 1980–2000

  IT WAS IN THE 1970s that the US first encountered many of its current economic problems. But it was in the 1980s that America began to harm itself in earnest. The Reagan administration provided an eerie sneak preview of the Bush administration, complete with politically popular tax cuts, resultant budget deficits, widespread unemployment, and a sudden rise in economic inequality.

  It was in the 1980s that declining American industries and their complacent, outdated, but politically clever CEOs first noticed that paying off lobbyists, politicians, boards of directors, and academic experts was much less expensive, and much easier, than improving their actual performance. And it was also in the 1980s that America’s newly deregulated financial sector got back in touch with its dark side, starting a thirty-year phase of consolidation, financial instability, large-scale criminality, and political corruption. In the late 1980s, America experienced its first financial crises since the Great Depression, although by current standards they seem quaint. One crisis was caused by deregulation and rampant criminality; the other, by a complex financial innovation that supposedly reduced risk, but that actually increased it. Sound familiar?

  Even though hundreds of financial executives went to prison, dozens of financial firms were bankrupted by their executives’ corruption, and we endured our first serious postwar financial crises, by the end of the 1980s the financial sector was wealthier and more politically powerful than ever. It was a genie that America hasn’t yet been able to return to the bottle.

  America Embattled

  THE DECADE BETWEEN 1972 and 1982 was a very rough period for the US. Between 1973 and 1975 alone, the country went through the Watergate hearings, Richard Nixon resigning in disgrace to avoid impeachment, the Yom Kippur war, the first OPEC oil embargo, the fall of South Vietnam, and a sudden recession caused by the first OPEC oil shock. Just as the effects of the first oil shock had receded, an Islamic revolution deposed the Shah of Iran and OPEC tripled oil prices again in 1979, yielding an unprecedented combination of recession, inflation, and high interest rates. Then, for the icing on the cake, the Soviet Union invaded Afghanistan.

  But it was also in the 1970s that America first encountered its more fundamental economic challenges: the long-term costs of its military when it was misused in distant, poorly managed wars; the complacency and internal decay of America’s largest companies and industries; Asian competition based on the “just in time” or “lean” production model; the growth of outsourcing permitted (even driven) by information technology; the declining market value of unskilled labour; and the need to raise the educational level of the population.

  By 1980 it was increasingly clear that the long, lazy, global dominance of American industry was over. American productivity growth declined, from 3 percent per year in the 1950s and 1960s to less than 1 percent in the 1970s and 1980s. Cars imported from Japan were not only less expensive and more fuel efficient than those from Michigan but also better—fewer assembly defects, longer lifetimes, less expensive to maintain. Similar effects were seen in consumer electronics, machine tools, steel, even semiconductor memories and IBM-compatible mainframe computers, high-technology markets that Japanese firms entered aggressively in the late 1970s. American specialists noticed that Japanese firms often adopted new technologies faster than their American rivals, even technologies that had been invented in America. Similarly, although Japan was far more dependent on imported oil than the US, its economy recovered much faster from the 1970s oil shocks.

  This unfamiliar combination of low growth, two oil shocks, recessions, and rising foreign challenges led to sudden anxiety and rising anger. In 1980 MIT professor Lester Thurow published an imperfect but very prescient book, The Zero-Sum Society, arguing that we had entered a painful phase of low growth and distributional conflict. In policy circles, an intense debate started. Some argued in favour of protectionism, others for aggressive government investments and industrial policy.

  Many economists dismissed both Thurow’s book and the entire issue. Others argued that increased savings and investment, together with a gradual depreciation of the dollar, would take care of America’s trade deficits and “competitiveness” problem. All mainstream economists (including some who now say otherwise) denied that the entrenchment of incompetent management, globalization, low-wage Asian competition, or Asian national strategic industrial policies could cause a decline in living standards. To be sure, it was a confusing time; America had never experienced anything like it before. (As a young academic I participated in some of those debates, and I didn’t get everything right, either.)

  America’s political leadership seemed adrift. And unfortunately, Americans were not, at that moment, ready to be told that America’s easy domination of the world economy was over, and that America needed to refocus on saving, improved education, information technology, tougher antitrust policy, energy conservation, and greater understanding of other nations.

  Or perhaps, actually, Americans would have listened, if their political leaders had told them the truth. But they didn’t. They lied, and with occasional exceptions they have continued to lie ever since. By 1980 America was ripe for a simplistic, reassuring story about how everything would be better if only taxes were lower, government regulation scaled back, and the American military strengthened.

  With those crude ideas Ronald Reagan sailed into office, on little more than his grin and his optimism, in part because President Jimmy Carter did not offer a coherent alternative. Carter was sincere, but he seemed ineffectual and timid. In contrast, and to the surprise of many, Reagan proved a strong president who accomplished much of his agenda—sometimes for good, often for ill. Tax cuts and deregulation became the order of the day. Even from the start, though, there was a big element of dishonesty in Reagan’s strategy. He cut taxes, but not government spending, so America’s economic recovery came in part from unsustainable deficits. Government officials claimed that tax cuts would pay for themselves, which they knew was a lie. And what they called “deregulation” was often simply political corruption. Lobbyists and industry executives were appointed to run government agencies, and several industries sharply increased their spending on political donations, lobbying, and revolving-door hiring.

  Nowhere was this clearer than in finance. It was in financial services that the Reagan administration initiated America’s descent into criminality, financial crisis, political corruption, inequality, and decline.

  Banking in 1980

  WHEN REAGAN TOO
K office, the American financial sector was still organized according to laws enacted in response to the Great Depression—the so-called “New Deal”.

  Banks and bankers had compiled a terrible record in the 1920s—creating financial bubbles, misdirecting deposits for their own personal benefit, and off-loading bad loans onto their customers in the form of fraudulent investment funds.1 Excessive leverage, fraud, and Ponzi-like behaviour were widely regarded as having contributed to the 1920s bubble and the Great Depression.

  The New Deal laws were intended to remove such temptations, or at least limit their damage. The 1933 Glass-Steagall Act forbade any bank accepting customer deposits to also underwrite or sell any kind of financial securities.2 The Securities Act of 1933 and the Securities Exchange Act of 1934 required extensive financial disclosure by publicly-held companies and investment banks, and created the US Securities and Exchange Commission to police them. Also in response to the Depression, in 1938 the US government created Fannie Mae to purchase and insure mortgages issued by banks and savings and loan institutions (S&Ls), once again under strict regulation. The Investment Company Act of 1940 regulated asset managers such as mutual funds.

  As late as 1980, this structure remained in place. Commercial banking, investment banking, residential mortgage lending, and insurance were distinct industries, tightly regulated at both the national and local levels, and also very fragmented, with no single firm or even group of firms dominating any sector. Commercial banking was a stable, dull industry. Most bank branches closed at 3 p.m.; “banker’s hours” allowed for lots of time on the golf course. There were strict limits on branches outside a bank’s home state; interest rates were tightly regulated. The industry was divided roughly between a few big “money centre” banks, headquartered primarily in New York City and Chicago, and thousands of small local and regional banks scattered across the country.