ORGANIZER'S DIGEST - Stiglitz - Freefall (2010)

Freefall (2010)
by Joseph Stiglitz
condensed for TUSG.ORG

The only surprise about the economic crisis of 2008 was that it came as a surprise to so many. What was different about this crisis from the multltude that had preceded it during the past quarter century was that this crisis bore a "Made in the USA" label.

The global economy needed ever-increasing consumption to grow; but how could this continue when the incomes of many Americans had been stagnating for so long? Americans came up with an ingenious solution: borrow and consume as if their incomes were growing.

Both borrowers and lenders could feel good about what was happening: borrowers were able to continue their consumption binge, not having to face up to the reality of stagnating and declining incomes, and lenders could enjoy record profits based on ever-increasing fees.

Low interest rates and lax regulations fed the housing bubble.

The economy was out of kilter: two-thirds to three-quarters of the economy (of GDP) was housing related: constructing new houses or buying contents to fill them, or borrowing against old houses to finance consumption.

When the bubble popped, the effects were amplified because banks had created complex products resting on top of the mortgages. Worse still, they had engaged in multibillion-dollar bets with each other around the world.

Global credit markets began to melt down. At that point, America and the world were faced with both a financial crisis and an economic crisis.

The Story in Short: Market Failures

How did it all happen? This is not the way market economies are supposed to work. Something went wrong- badly wrong.

Markets on their own evidently fail- and fail very frequently.

There are many reasons for these failures, but two are particularly germane to the financial sector: "agency" problems and the increased importance of "externalities." When there are important agency problems and externalities, markets typically fail to produce efficient outcomes- contrary to the wide-spread belief in the efficiency of markets.

Agency

The agency problem is a modern one. Modern corporations with their myriad of small shareholders are fundamentally different from family-run enterprises. Scores of people are handling money and making decisions on behalf of (that is, as agents of) others. All along the "agency" chain, concern about performance has been translated into a focus on short-term returns.

In short, there was little or no effective "quality control" on financial dealings. In theory, markets are supposed to provide this discipline. Firms that produce excessively risky products would lose their reputation. Share prices would fall. But this market discipline broke down.

Securitization, the hottest financial products field in the years leading up tot he collapse, provided a textbook example of the risks generated by the new innovations, for it meant that the relationship between lender and borrower was broken. Banks shifted from the "storage business," which had been the traditional business model for banks- originating mortgages and holding on to them- into the "moving business"- where the incentive was to pass on the mortgages as fast as they could to others, usually onto the books of pension funds and others, where the fees were the hightest.

Externalities

In economics, the technical term externality refers to situations where a market exchange imposes costs or benefits on others who aren't party to the exchange. If you are trading on your own account and lose your money, it doesn't really affect anyone else. However, the financial system is now so intertwined and central to the economy that a failure of one large institution can bring down the whole system.

The bankers gave no thought to how dangerous some of the financial instruments were to the rest of us, to the large externalities that were being created. The current failure has affected everyone.

This is one of the rationales for financial market regulation, but after years of concentrated lobbying efforts by the banking industry, the government had not only stripped away existing regulations but also failed to adopt new ones in response to the changing financial landscape.

Today, after the crash, almost everyone says that there is a need for regulation- or at least far more than there was before the crisis. Not having the necessary regulations has cost us plenty: crises would have been less frequent and less costly, and the cost of the regulators and regulations would be a pittance relative to these costs.

In the end, the banks nearly got hoisted by their own petard: The financial instruments that they used to exploit the poor turned against the financial markets and brought them down. When the bubble broke, most of the banks weer left holding enough of the risky securites to threaten their very survival- evidently, they hadn't done as good a job in passing the risk along to others as they had thought.

This is but one of many ironies that have marked the crisis: as a direct result of Greenspan and Bush's attempt to minimize the role of government in the economy, the government has assumed an unprecedented role across a wide swath- becoming the owner of the world's largest automobile company, the largest insurance company, and (had it received in return for what it had given to the banks) some of the largest banks. A country in which socialism is often treated as anathema has socialized risk and intervened in markets in unprecedented ways.

Agency issues and externalities mean that there is a role for government. If it does its job well, there will be fewer accidents, and when the accidents occur, they will be less costly. Every successful economy- every successful society- involves both government and markets. There needs to be a balanced role.

The Big Picture

Underlying all of these symptoms of dysfunction in the United States is a larger truth: the world economy is undergoing seismic shifts. The Great Depression coincided with the decline of U.S. agriculture; indeed, agricultural prices were falling even before the stock market crash of 1929. Increases in agricultural productivity were so great that a small percentage of the population could produce all the food that the country could consume. The transition from an economy based on agriculture to one where manufacturing predominated was not easy.

Today the underlying trend in the United States is the move away from manufacturing and into the service sector. As before, this is partly because of the success in increasing productivity in manufacturing, so that a small fraction of the population can produce all the toys, cars, and TV's that Americans can use.

But in the United States and Europe, there is an additional dimension: globalization, which has meant a shift in the locus of production and comparative advantage to China, India, and other developing countries.

Accompanying this "microeconomic" adjustment are a set of macroeconomic imbalances: U.S. consumption has been financed to a large extent by China and other developing countries that have been producing more than they have been consuming.

While it is natural for some countries to lend to others- some to run trade deficits, others surpluses- the pattern of poor countries lending to the rich is peculiar and the magnitude of the deficits appear unsustainable.