Stiglitz on the crisis

by Russ Roberts on September 22, 2008

in Government Intervention

In a recent comment, TopCat asks:

Seems to me, no one here wants to admit the possibility that markets
aren’t rational and self-correcting in the way Friedman/Hayek told us
they were, so they’re looking to put the blame elsewhere.

Maybe they aren’t. Before I want to convert out of the Friedman/Hayek religion, I want to get the facts. In recent posts, I’ve focused on facts that fit my worldview. That’s because I didn’t know much about government’s recent involvement in housing markets. It’s not the whole story. I’m still thinking things through. But one question we should all be asking is whether the mess we’re in is the result of too much government or not enough. I’m in the "too much" camp. Let’s look at the other extreme, the "too little" camp and its most illustrious member, Nobel Laureate Joseph Stiglitz. Here’s his take on the CNN website—to be fair to him, I’m going to go through the whole thing.

NEW YORK (CNN) — Many seem taken aback by the depth and
severity of the current financial turmoil. I was among several
economists who saw it coming and warned about the risks.

I would have liked to see a link to that warning. If anyone out there knows of where and when Joseph Stiglitz raised the alarm, please pass it along.

There is ample blame to be shared; but the purpose of parsing out blame is to figure out how to make a recurrence less likely.

President Bush famously said, a little while ago, that the problem is
simple: Too many houses were built. Yes, but the answer is too
simplistic: Why did that happen?

One can say the Fed failed
twice, both as a regulator and in the conduct of monetary policy. Its
flood of liquidity (money made available to borrow at low interest
rates) and lax regulations led to a housing bubble. When the bubble
broke, the excessively leveraged loans made on the basis of overvalued
assets went sour.

   For all the new-fangled financial instruments, this was just another one of those financial crises based on excess leverage, or borrowing, and a pyramid scheme.

The new "innovations" simply hid the extent of systemic leverage and
made the risks less transparent; it is these innovations that have made
this collapse so much more dramatic than earlier financial crises. But
one needs to push further: Why did the Fed fail?

So in Stiglitz’s view, financial crises are endemic and unavoidable. Every once in a while you get one because of leverage and financial innovation, combined with a bubble. It’s definitely part of the problem. I agree that you do get the occasional mania and some firms and investors go out of business. This one does seem to be a little bit special. Let’s see what else he says.

   First, key regulators like Alan Greenspan
didn’t really believe in regulation; when the excesses of the financial
system were noted, they called for self-regulation — an oxymoron.

This is clever. The key regulator of the banks was evidently Alan Greenspan. The Fed does regulate the banks. Banks have various reserve requirements. No one that I know of has argued that Fed regulation of its regulations was inadequate. Nor do I think the Fed regulates the investment banks. Or do they? But if they do, I don’t that was part of the problem. This wasn’t an Enron problem where off-the-books risks were being hidden or an example of fraudulent balance sheet statements. Actually, there is an example of fraud—that was at Fannie and Freddie to pump up executive bonuses, but they aren’t regulated by the Fed.

Second, the macro-economy was in bad shape with the collapse of the
tech bubble. The tax cut of 2001 was not designed to stimulate the
economy but to give a largesse to the wealthy — the group that had
been doing so well over the last quarter-century.

I have no comment on this last sentence other than to find it to be a remarkable misstatement about who received stimulus checks.

   The coup d’grace was the Iraq War,
which contributed to soaring oil prices. Money that used to be spent on
American goods now got diverted abroad. The Fed took seriously its
responsibility to keep the economy going.

It did this by
replacing the tech bubble with a new bubble, a housing bubble.
Household savings plummeted to zero, to the lowest level since the
Great Depression. It managed to sustain the economy, but the way it did
it was shortsighted: America was living on borrowed money and borrowed

I don’t think the Fed was trying to create a housing bubble. I think that some of the rise in housing prices was due to artificially low interest rates. But Stiglitz neglects to mention the role of the Federal government in subsidizing the demand for housing via Fannie and Freddie’s increased attention to low-income loans as required by HUD, and the Community Reinvestment Act and various other programs that I’ve been chronicling recently. And I’m sure I’ve missed some stuff.

Finally, at the center of blame must be the financial
institutions themselves. They — and even more their executives — had
incentives that were not well aligned with the needs of our economy and
our society.

I agree with that last sentence. The question is what went wrong.

They were amply rewarded, presumably for managing
risk and allocating capital, which was supposed to improve the
efficiency of the economy so much that it justified their generous
compensation. But they misallocated capital; they mismanaged risk –
they created risk.

I think Stiglitz is right. But why did it happen? And why did it create systemic risk rather than simply driving their own firms out of business?

They did what their incentive structures were
designed to do: focusing on short-term profits and encouraging
excessive risk-taking.

This is not the first crisis in our
financial system, not the first time that those who believe in free and
unregulated markets have come running to the government for bail-outs.
There is a pattern here, one that suggests deep systemic problems –
and a variety of solutions:

So in Stiglitz’s view, greedy financial executives who believed in free markets messed up and now they want to get bailed out. No mention of any possible role of Freddie and Fannie or other government regulations in distorting incentives and making the problem worse. On to the solutions.

1. We need first to correct
incentives for executives, reducing the scope for conflicts of interest
and improving shareholder information about dilution in share value as
a result of stock options. We should mitigate the incentives for
excessive risk-taking and the short-term focus that has so long
prevailed, for instance, by requiring bonuses to be paid on the basis
of, say, five-year returns, rather than annual returns.

Secondly, we need to create a financial product safety commission, to
make sure that products bought and sold by banks, pension funds, etc.
are safe for "human consumption." Consenting adults should be given
great freedom to do whatever they want, but that does not mean they
should gamble with other people’s money. Some may worry that this may
stifle innovation. But that may be a good thing considering the kind of
innovation we had — attempting to subvert accounting and regulations.
What we need is more innovation addressing the needs of ordinary
Americans, so they can stay in their homes when economic conditions

Again, Stiglitz’s analysis of the disease is that banks subverted accounting and regulations. We just need the right kind of regulations.

3. We need to create a financial systems stability
commission to take an overview of the entire financial system,
recognizing the interrelations among the various parts, and to prevent
the excessive systemic leveraging that we have just experienced.

I’d love to see that commission in action. The current experts can’t figure out what’s going on. The interrelations are too complex. The only way to avoid this is to have the government run the entire system. That’s the direction we’re heading. Government can only do that well if it’s incredibly simple. In that world, count me as one of those who suggests that we will end up living in a less innovative world.

4. We need to impose other regulations to improve the safety and
soundness of our financial system, such as "speed bumps" to limit
borrowing. Historically, rapid expansion of lending has been
responsible for a large fraction of crises and this crisis is no

5. We need better consumer protection laws, including laws that prevent predatory lending.

6. We need better competition laws. The financial institutions have
been able to prey on consumers through credit cards partly because of
the absence of competition. But even more importantly, we should not be
in situations where a firm is "too big to fail." If it is that big, it
should be broken up.

These reforms will not guarantee that we
will not have another crisis. The ingenuity of those in the financial
markets is impressive. Eventually, they will figure out how to
circumvent whatever regulations are imposed. But these reforms will
make another crisis of this kind less likely, and, should it occur,
make it less severe than it otherwise would be.

I agree with the last sentence. And we’re also going to be a lot poorer with a lower standard of living.

Notice there is no mention of reducing government’s role in the housing market. If anything a reader might suspect there is no role of government in housing markets.

Also missing from this discussion is any theory of why the bubble grew out of control. It is not the first time the financial sector used leverage creatively. And it’s not the first time the Fed lowered interest rates too far. Why did this mess get so large? I suspect it had something to do with the role of politicians and policy makers in artificially encouraging home ownership and loans to people who would not be able to repay them if housing prices fell. Why did financial players get on the band wagon? Some did it because of bad regulation—HUD’s increased requirements on Fannie and Freddie. Some did it because they were making a lot of money for a while, as long as housing prices kept rising.

What do we conclude from this about the right way to run things down the road? Still thinking about it, but I’m still in the "less government" camp for now.

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Randy September 22, 2008 at 2:54 pm

Question for anyone; How is this a "crisis"?

I keep hearing the word, but it seems to me that the appropriate word would be "justice".

People who bought homes with loans they couldn't afford to repay except in the most ideal of circumstances. So now they will have to find apartments. Justice.

Investment banks bought securities that they didn't value correctly and they are now going to lose some money. Justice. So what if its a lot of money – its still justice.

So what am I missing? How is this a "crisis"?

Paul Mansour September 22, 2008 at 3:22 pm

I have a book on my shelf from I think the same Stiglitz, "Wither Socialism". I actually read it. This man does not know why socialism and planning failed. More likely, he can't admit the truth, as like many economists, it would make his entire career look wasted and silly, which it is.

Bret September 22, 2008 at 3:45 pm

Russell Roberts wrote: "I'm still in the "less government" camp for now."

What a surprise!!!!!

Actually, me too (but I'd never admit it).

DKH September 22, 2008 at 4:01 pm

To me, it's interesting that there's no mention of the role of individuals. Did not everyone choose to buy their house? Houses didn't fall into their hands, complete with a predatory lending agreement that already had their signature, correct?

As Randy said above, those who outspent their means are seeing the results of those choices. Unfortunately, the effect of all this on people who made the best choices will be a raising of taxes. Congratulations, for whatever reason, you didn't join the herd. Now pay a tax to the herd.

vidyohs September 22, 2008 at 4:42 pm

Yes chilluns it is true. There can be no foreclosure on a mortgage that was never made nor manipulation of a loan that was never sought.

So who's fault is it, if there is indeed a crisis?

To forestall the martinduck and muirduck types, yes I know that people were tempted, oh the tempatation, yet temptation is just that temptation. No one has to give in to it, and no one can point a finger except back at themselves when they do.

"First let's kill all of the lawyers!"

highmesa September 22, 2008 at 5:24 pm

"But they misallocated capital; they mismanaged risk — they created risk."

I'm going to disagree with that. I believe the firms correctly allocated capital, given the signals that were put in front of them by the Fed. The Fed fed bad information, which caused capital to be allocated differently than it would in a free market.

If there's one thing that free markets do well, it's allocate capital (well, there are a lot of things actually). Given the availability and cost of capital, firms had to extend themselves into these sub-prime markets to stay competitive. Unfortunately for all of us taxpayers, they were given incorrect information (artificially low rates) by the federal reserve.

If your company did not play in this market, you lost market share and profits (and stock price and CEO bonuses). There are likely firms that had the foresight to stay out of this game, but you likely don't know who they are because they are much smaller than they would have been if they did play the game. Plus, their names are not in the headlines from falling apart.

Chris September 22, 2008 at 5:41 pm

Why is this that difficult? Lax lending standards (whether negligently lax or not) combined with low interest rates allowed a bunch of people to hyper-leverage themselves using their homes as collateral. When the market dried up–when it ran out of people to sell homes to–and the cost of borrowing went up, many of those homeowners found themselves under water.

Meanwhile, the banks that lent them the money had repackaged it in various forms and the risk of default was spread among a bunch of big financial players in the industry. Because of the sheer volume of mortgages and the ability of smart MBAs to group and divide it into different assets with different risk/reward profits, mortgages became an investment for many firms out in the market.

When home prices dropped, many of these firms found themselves under-collateralized. Under their agreements with each other, they needed more collateral. With mark-to-market accounting standards, they were forced to write down the value of their mortgage-backed assets. So, they started hoarding cash, unwilling to put it at any further risk. As a result, selling these mortgage-backed assets got harder, their values dropped, and the books looked even worse.

So, that's the situation — a bunch of large financial firms have a bunch of assets with book values approaching $0. Technically, they're bankrupt.

The only real question, and this is the one I don't understand, is so what? Why do I care if AIG, Bear Sterns, Lehman, Countrywide, JP Morgan, Merrill Lynch, Credit Suisse, Bank of America, Wachovia, Wells Fargo, Goldman Sachs etc… all go bankrupt? What's the danger to me?

floccina September 22, 2008 at 6:01 pm

To Stiglitz
1. This is clearly not a too big to fail problem, if the companies were smaller more would have failed, same result.
2. It is not sufficient to show that free people did stupid things you must also show that Government could do better.

Saum September 22, 2008 at 6:04 pm

"If your company did not play in this market, you lost market share and profits (and stock price and CEO bonuses). There are likely firms that had the foresight to stay out of this game, but you likely don't know who they are because they are much smaller than they would have been if they did play the game. Plus, their names are not in the headlines from falling apart."

highmesa: Here's a name of a bank that did not go crazy in the mortgage boom – Wells Fargo. You tell me if it's they are a small player in the mortgage market. :) And, you also tell me if they are falling apart but not showing up in the headlines.

Martin Brock September 22, 2008 at 7:08 pm

Question for anyone; How is this a "crisis"?

I agree with the premise of your question. It's a "crisis" for the same reason that 9/11 was a crisis requiring massive changes in law and trillions of new expenditure, because crises empower statesmen, and statesmen want to be empowered.

Stiglitz' analysis of the problem is remarkably Misean, even if his solution isn't.

Speedmaster September 22, 2008 at 7:14 pm

>> "But one question we should all be asking is whether the mess we're in is the result of too much government or not enough."

This absolutely sums up the public discourse at the moment. Like you, I'm in the 'too much' camp.

Rubbadubdubicus September 22, 2008 at 8:32 pm

Financial institutions exist in such an intricate limbo of regulation and relative freedom that it would be difficult to assign definitive cause without the projection of ideological prejudice. I am content with maintaining that, were it not for government, things would at least be simpler, if not necessarily any less dire. And perhaps they would be more dire, but at least we would be freer.

Fact is, the efficacy of free markets and wastefulness of regulation does not need to be validated by every single economic downturn for laissez-faire to remain justifiable.

Dave September 22, 2008 at 9:26 pm

Don't forgot the role of regulation regarding the ratings agencies in this mess:

Insurance companies, pension funds, mutual funds, and banks all face regulations that limit their ability to hold low-rated debts, and the Basel I and II capital requirements for banks place a great deal of weight on rating agency ratings.

Unbelievably, Congress and the Securities and Exchange Commission (SEC) were sending strong signals to the rating agencies in 2005 and 2006 to encourage greater ratings inflation in subprime-related collateralised debt obligations!

The regulation of compensation practices in asset management likely played an important role in the willingness of institutional investors to invest their clients’ money so imprudently in subprime mortgage-related securities.

Mace September 23, 2008 at 12:49 am

Doesn't the Federal government determine which firms get to be officially-sanctioned "rating agencies", i.e. government intervention in the credit markets created a cartel that, without much hindsight, desperately needs some competition?

Vic September 23, 2008 at 4:27 am

Has Stiglitz read any Austrian econ? The business cycle was explained almost a century ago by Mises. Fractional reserve banking is the cause.

It's amazing that so few free market economists recognize this.

Hammer September 23, 2008 at 9:36 am

"4. We need to impose other regulations to improve the safety and soundness of our financial system, such as "speed bumps" to limit borrowing. Historically, rapid expansion of lending has been responsible for a large fraction of crises and this crisis is no exception."

It is odd to me that Stiggy doesn't recognize that exceedingly low interest rates coupled with government pressure to issue loans to those who would normally be considered "high risk" loan applicants is exactly what caused the "rapid expansion of lending" in question. It seems to me that if there had not been so much focus on getting people into houses regardless of their ability to pay for them, we would have had a lot less lending to people who shouldn't be borrowing.

Ironist September 23, 2008 at 10:03 am

Speaking of incentives, Russ, if the CRA forced banks to give mortgages to people they knew would never pay them back, the originating banks had a huge incentive to get rid of those mortgages. Fannie came up with the MBS, which neatly solved that problem. The banks could make government-directed shaky loans and still dodge the default risk. What worked at the level of the individual bank, however, did not work so well at the macro level; too much bad paper was inextricably mixed in with the good, and the system seized up when housing prices started to fall from unrealistic levels.

Sam Grove September 23, 2008 at 1:06 pm

I received an email from recently about an upward revaluation of our property.

At the linked page, there was a list of foreclosed homes near us that were almost all of the "affordable housing" variety.

pauld September 23, 2008 at 3:10 pm

"It is not sufficient to show that free people did stupid things you must also show that Government could do better."

I think this comment hits the nail on the head. Markets fall short of perfection. The relevant comparison is how they compare to an alternative system that relies more on government regulation.

Sam Grove September 23, 2008 at 8:49 pm

Markets fall short of perfection.

It is not appropriate to speak of "perfection" or "imperfection" when referring to "the market". The market is a venue of human behavior regarding production and trade in support of their requirements and desires for living.

Some people might say the market is imperfect because some women become prostitutes, but that's because their aesthetics hold prostitution in a negative light. Prostitution is a fact of life.

The responses of the market are a fact of life. This financial mess is a big signal, and an accurate interpretation of the signal is key to making appropriate choices.

There appears to be little reason for optimism. The political process is at work and we can only speak our minds and hope others will listen. Certainly some are incapable of listening, they've already made up their minds.

So the question is: why do they keep coming around here. They know what they believe.

The market is more akin to a natural force which cannot be managed as much as accepted and plan accordingly.

Humans may be imperfect, but what does that mean? It's a useless judgment.

Greg Ransom September 24, 2008 at 1:41 am

I'm guessing "TopCat" is talking through his hat when he references the ideas of Hayek and Friedman.

Friedman and Hayek had significantly different views of how economic explanations work, how markets work, and how the macro economy works.

Most importantly, Hayek never made the argument that markets or agents were "rational" — Hayek is very far from being a 1970's Chicago economist.

And the central insight at the center of Hayek's principle project in economic science, is the insight that markets can be _systematically_ distorted via the "loose joint" of money and credit. Systematic false price signals in the market for money and credit and time can _block_ the process of coordination — of "self correction" — in the economy.

So "TomCat" needs to do more work — and attain genuine understanding of at least Hayek's work — before he's going to be capable of casting a meaningful and intelligible question referencing Hayek and "the market" as understood by Hayek.

"TomCat" hasn't given us a critique or a forceful rhetorical challenge, he's simply give us a jumble of confused words — and exposed his own ignorance.

William Bethard October 1, 2008 at 4:49 pm

Here is one paper where Stiglitz opined that, " . . . the probability
of a severe interest rate shift, sustained over ten years, combined with high credit loss rates, is effectively zero."

Implications of the New
Fannie Mae and Freddie Mac
Risk-based Capital Standard
Joseph E. Stiglitz, Jonathan M. Orszag and Peter R. Orszag

This was a paper prepared at the request of Fannie and Freddie.

Prof. Stiglitz now blames "greedy executives" but weren't those executives just as greedy when he wrote the paper back in 2002

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