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Stiglitz on the crisis

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.