WASHINGTON—The economic crisis of 2008 was predictable and economists could have seen it coming, according to economist Joseph Stiglitz.
The “Great Recession” was deeper and more serious than any previous crises since the Great Depression, but not really different in kind. Stiglitz is confident that he knows the source of the “sickness” of our economy and what needs to be done to make it well.
The 2001 Nobel Prize winner in economics gives his understanding of the origins of the crisis in a new book Freefall: America, Free Markets, and the Sinking of the World Economy.
Stiglitz, professor at Columbia University, has been explaining the basics discussed in Freefall recently to large audiences in Washington.
What triggered crisis
For few years during the Clinton administration, Stiglitz was chairman of the Council of Economic Advisers. From 1997-2000, he was chief economist at the World Bank. Even with his impressive resume, people would probably not be flocking in such great numbers to hear this best-selling author, were he not taking on the question that the public is clamoring to know the answer, “How did the largest economy in the world go into a freefall? What policies and what events triggered the great downturn of 2008?”
Without understanding how we got into this situation, we can’t correct what is wrong and ensure that it doesn’t happen again, according to Stiglitz.
The cause lies mostly with our financial markets and institutions that were rationalized by economic theories, which have been proven wrong, according to Stiglitz. Here is where Stiglitz parts company with the prevailing ideology on the role of free markets. Before the severe downturn in 2008, it was widely believed—and still is for Wall Street financiers—that free markets were efficient and if something goes wrong, the market would “self-correct.”
“Markets on their own evidently fail—and fail very frequently,” counters Stiglitz in Freefall.
Stiglitz loves to use Alan Greenspan, former chair of the Federal Reserve, as someone who did not approve of regulating the economy, not even to protect the public interest against fraud. In this view, the role of the central banks is mainly keeping interest rates low. Stiglitz is quick to point out that it is not on personalities, such as Greenspan, that he lays the blame, but on “fundamental flaws in the system.” He says that if Greenspan hadn’t been appointed Federal Reserve chairman by President Ronald Reagan, then “he would have found someone who did not favor regulation.”
Stiglitz puts forth the dictum that when markets are left alone, relying on self-interest of market participants, they don’t bring on optimum efficiency nor guarantee prosperity.
“Economies need a balance between the role of markets and the role of government…In the last 25 years, America lost that balance, and it pushed its unbalanced perspective on countries around the world,” Stiglitz says. He likes to remind us that government has repeatedly saved markets from themselves, and lists an almost endless number of countries where bailouts for questionable lending practices were necessary to restore an economy’s health.
Lesson forgotten
The value of government regulation in keeping the economy running smooth was the lesson from the Great Depression, which “we have forgot,” he claims. For a 50 years after World War II, we had only two or three economic crises, according to Stiglitz, because the regulatory structure created in the 1930s brought “growth and stability.” Since 1980—the beginning of the era of deregulation—we’ve had over 125 crises around the world. The one of 2008 was just the most severe and costly.
Bad incentives lead to market collapse
The conventional wisdom among the financiers and economists that subscribe to the ideology of unfettered markets is that the current downturn was an “earthquake” that it happened to the financial markets, and with some fixes, prosperity will be resumed. Stiglitz rebuts these notions and asserts it was “man-made” and “could have been avoided.”
Freefall describes in detail the particulars of what led to the downturn and deep recession. New financial products of dubious merit, such as subprime mortgages, created a bubble supported by bad lending. The bubble was inflated by new innovations—collateralized debt instruments and credit default swaps—hiding the true value of assets. Stiglitz gives several suggestions for how controls could have been applied, such as increasing the down payments for purchasing a home.
Many people with the wherewithal to deal with such issues couldn’t agree that there was a bubble and thought it may be just economic growth that would continue indefinitely. But then the bubble burst, which led to the market’s collapse.
He said there are four functions that financial markets perform: allocate capital, manage risk, and mobilize savings while keeping transaction costs low. Stiglitz says the American financial institutions failed to perform their societal responsibilities on all four. In particular, they badly misjudged the risk of defaults of subprime mortgages. They misallocated capital and encouraged excessive indebtedness. Proof that something was out of balance, Stiglitz observed that the financial sector contributed 40 percent of corporate profits before the market collapse. What should have been a means to an end had become an end in itself, he says.
Banks gambling
In theory, market discipline would have punished banks for engaging in predatory practices, “lending beyond people’s ability to pay, with mortgages that combined high risks and high transactions costs.” The fall of AIG and the need for $200 billion in taxpayer bailout was based on derivatives—“banks gambling with other banks.” Stiglitz says there were (and still are) bad incentives in the economy that fostered a “culture of risk taking,” which “took over the whole system.” Further, knowing that there are enterprises that are “too big to fail,” provides a huge incentive for excessive risk-taking.
The regulators and regulatory process should have contained these excesses, but they didn’t do their job either, said Stiglitz, although the downfall primarily lies with “the reckless behavior of the banks.”
There are two ways to increase profits, said Stiglitz. One is to take on more risk, and the other is to become more efficient. The first way is generally irresponsible as it puts the institution at risk, while the second builds a solid foundation for wealth. The bankers chose the former, the “easy way” in years 2003-2007.
But they ended up losing more in 2008 than what they gained in prior years of risky behavior. The big banks concentrated on non-transparent, over-the-counter, complex products, where the forces of competition don’t work very well, and profits are made at the margins, Stiglitz says. When banks lost money, those responsible were rewarded with bonuses. Clearly, the system had a “dysfunctional incentive structure.”
Repeatedly, Stiglitz referred to the high “social costs” that these behaviors caused the American people and the world. Nearly one out of five is either unemployed or is part-time, or has given up looking. For blacks, the “official” unemployment is 48 percent, which does not include discouraged jobseekers. One of every four mortgages is under water, meaning what is owed exceeds the value of the home. These mortgages are likely candidates for foreclosures.
And sadly too, because of the mistakes made, our economy is now performing far below its capacity—a gap of trillions, says Stiglitz.
Friends Read Free