By Lars Lofgren
As an early critic of the Washington Consensus (an opinion that got him fired from his position as the Chief Economist at the World Bank) and a 2001 Nobel Prize winner, Joseph Stiglitz has repeated challenged the conventional norms regarded economic and financial policy. Frequently, he has been proven completely correct. Within the below video, Stiglitz offers his insights into the underlying trends that led to the financial crisis, as well as critiques of the government’s response. Our notes follow.
In 2005 and 2006, Stiglitz became increasingly alarmed with real estate fueling such a large portion of the economy. Between two thirds and 80% of the economy was attributed to real estate markets, and economies simply cannot be so dependent upon a single variable. The housing bubble had kept the economy going to such an extent that average household savings rates had actually fallen to zero.
Banks kept much of their bad lending off their balance sheet. They managed to cover it well enough to hide it from themselves as well as regulators. Banks also knew that other banks were hiding their bad loans which led to a complete breakdown in trust that ultimately led to the financial crisis. This credit paralysis could have shut down the economy if governments had not stepped in.
In short, the conditions that led to the financial crisis were the result of incentives that encouraged bad lending by bankers and excessive risk-taking.
The Federal Reserve largely ignored the problem, believing there was no bubble even as it began to collapse.
The thirty year period after the Great Depression employed sufficient regulation to avoid bubbles of this magnitude. The stripping of those regulations in addition to avoiding regulation of new financial tools like credit-default swaps has allowed modern bankers to pursue greater risk. There are two reason for the deregulation, (1) lobbying by the financial industry and (2) the promotion of free market ideals by economists. The “invisible hand” of markets and the pursuit of self-interest does not automatically lead to increased prosperity for the whole. Stiglitz’s Nobel Prize work on asymmetric information between actors addresses this issue.
During the Great Depression, similar debates arose over deficits. In 1937, the stimulus of the New Deal was cut back which halted the recovery and put it into another decline.
Obama has done comparably well with handling the economy in response to the crisis. His policies included all of the necessary components: enacting a stimulus, addressing mortgages, restructuring banks, and pursuing financial regulation. Bush had only focused on funding the banks without imposing restrictions, an extreme form of trickle-down economics which never works.
Obama’s support of the stimulus was the right policy decision. However, the stimulus was not nearly big enough and there were seriously flaws with the design of the stimulus. For example, there should have been more aid to the states, which has become increasingly evident. The stimulus should not have included tax cuts either; it only leads to increased saving which completely defeats the objective of a stimulus. Nevertheless, unemployment would have been around 12% without the stimulus.
While Obama has attempted to address the mortgage problem, he has neglected underwater mortgages entirely (where the debt is worth more than the house). this will lead to higher defaults on mortgages in 2010 than 2008 and 2009, further impeding economic growth.
There was no vision for the kind of financial system we wanted and needed. The purpose of a financial system is to allocate capital and manage risk. Our financial system mis-allocated capital and created risk. The bank bailout perpetuated this system, making problems like “too big to fail” even worse.
New regulation has largely been completely absent (Note: this has changed with the recent passing of the financial reform bill).
The vast majority of the financial sector believes that if the government had not saved many of the banks and provided a stimulus, the American economy would be in a deep depression. The government should not only be responsible for saving the financial sector in a crisis, but it should also be responsible for regulation to avoid reaching a crisis in the first place.
There is a large degree of confusion between the bank bailout and the stimulus, two completely separate programs. Stiglitz remains incredibly critical of the bank bailout because it did not increase lending. The money was used for bonuses and dividends but not recapitalization. This occurred because we did not attach conditions. Furthermore, the preferred shares that the government received in return were worth only two thirds or less of what the government gave to the banks.
There needs to be a new regulatory framework and incentive structures. The “too big to fail” banks must be addressed as well; there is little incentive to keep them from gambling in the future if the government is forced to save them. Transparency is another serious problem. There has been a move towards less transparency which only leads to less trust in the future.
Conflicts of interest have arisen by allowing commercial banks to also be investment banks. The Glass-Steagull act prevented this but was appealed under the Clinton Administration. This tends to enlarge banks as well as provides incentives for not being conservative.
Many in the financial sector are also critical of current policies. The government is essentially subsidizing the major banks, distorting the market and creating an uneven playing field for competitors.
While we have been dealing with the short term problems of the crisis, long term problems like the environment have continued to get worse. In fact, we are now less prepared to solve these other problems because of the massive debt we have undertaken in the attempt to resolve the crisis.
GDP is not a reliable indicator of economic progress. Before the crisis, 40% of the GDP was in the financial sector, much of which was speculation. In other words, GDP can be significantly distorted, especially by bubbles. GDP does not measure the sustainability of economic growth. Similarly, prices frequently do not account for the use of scarce resources like air which further distorts economic metrics of progress. If we correct some of our measurements, we could avoid such adverse effects on the environment.
Since Stiglitz’s interview, a financial reform bill has passed. As many commentators have highlighted, it spans over 100,000 pages. Here’s an excerpt from a Washington Post article:
The legislation will roll out various measures over time, ensuring that Washington and Wall Street will see the dramatic changes unfold over several years.
Almost immediately, a new Federal Insurance Office will be set up, and the government will have the authority to seize big, failing companies as soon as the bill is enacted.
Other changes include a new regulator of consumer financial products, regulations on derivatives, and restrictions on banks that are federally insured from trading for their own benefit. The New York Times has an excellent summary of the bill and the intended results. As the articles point out, there are many critics of the bill on both sides, claiming it is either not expansive enough or that its policies will simply be ineffective. Considering the complexity and size of the bill, it will be some time before a thorough analysis of its policies and effects is accomplished.
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