Sunday, May 15, 2011

Joseph E. Stiglitz, Freefall, 2010

A book from the Nobel Prize winner for Economics in 2001 and Chief Economist at the World Bank until 2000 cannot be ignored. This is one of the best books I have ever read preaching on the need of more (and better) government regulation based on the percept of market failures. Yet, the book is more about government failures. The battle between capitalism and communism may be over but the one between the “Hooverites” (right) and the Keynesians (left) in market economies still rages on. Stiglitz sites himself with the left. More left than U.S. president Obama’s policies.
Stiglitz suggests that the prevailing flawed economic perspectives (of the Hooverites) "led to the crisis, made it difficult for key private -sector decision makers and public-sector policy makers to see the problems, and contributed to policy makers' failure to handle the fallout effectively". He hopes that the crisis of the Great Recession that began in 2008, will lead to changes in the realm of policies and in the realm of ideas, not only making another crisis less likely but "perhaps even accelerating the kinds of real innovations that would improve the lives of the people around the world."

Stiglitz questions that the long expansion of the world economy that preceded the crisis during the era of deregulation was due to the policies of globalization and free markets. He attributes the growth on the mountain of debt instead. He proposes that the policies of the IMF and the U.S. Treasury in response to the East Asian crisis in 1997-1998 "showed a luck of understanding of the fundamentals of modern macroeconomics, which call for expansionary monetary and fiscal policies in the face of an economic downturn".

Chapter 1 of the book points out that “America’s financial markets had failed to perform their essential societal functions of managing risk, allocating capital, and mobilizing savings while keeping transactions low”. This failure is attributed to lax government regulation due to the political influence of special interests, “particularly of those who made money from deregulation”.

Stiglitz places a lot of emphasis throughout the book on the distribution of income and the making of the real estate unsustainable bubble. “Without the bubble, aggregate demand – the sum total of goods and services demanded by households, firms, government and foreigners – would have been weak, partly because of the growing inequality in the United States and elsewhere around the world, which shifted money from those who would have spent it to those who didn’t”. The book does not recognize that those who did not spent their money, invested them through the global financial system in loans to ordinary people in America, and elsewhere, who chose to borrow in order to buy bigger and better houses. Stiglitz does not make any suggestions where the non-benevolent creditors of a free world should direct the money they chose not to spend when “the sum total of what people around the world want to buy is less that the world can produce”.  If he did, we could hope to avoid the next crisis that will be caused by the bursting of a future bubble.

Stiglitz points out (chapter 2) that according to the rules of capitalism “when a firm cannot pay its debts, it goes into bankruptcy (or receivership), where typically shareholders loose everything and the bondholders/ creditors become the new shareholders”.  He implies that this should be the rule when government helps failing banks too.  He could be right. I wished he prescribed a cure when shareholders include pension funds and other social agents apart from the rich that could afford to lose some of their wealth without suffering. Stiglitz is very critical on the handout of taxpayer’s money to save the banks, although he recognizes that “The Great Depression was different: The financial system collapsed”.

Stiglitz proposes that the U.S. response to the crisis is flawed. It should be faster, more effective, address long-term problems, focus on investment, be fair, deal with short-run exigencies, targeted at areas of job loss.  The stimulus package should be bigger, investments should be better targeted, tax cuts should stimulate spending. “More progressive taxation (taxing those at the top more heavily, reducing taxes at the bottom) would not only do that {redistribution of income} but also help stabilize the economy”. 

Chapter 5 identifies five reasons why “the financial system has performed so badly”:
1.      "Wrong incentives and a “systemic mismatch between social and private returns”,
2.     “Certain institutions became to big to fail”,
3.     “Big banks moved away from plain-vanilla banking to securitization”
4.     “Commercial banks sought to imitate the high risk high returns of high finance”,
5.     “Too many bankers forgot that they should be responsible citizens”.

Chapter 6 mentions creative accounting “moving potential losses off balance sheet with one hand while recording profitable fees with the other”, as one of the practices bank executives used to get stock prices up. Stiglitz suggests that “a simple reform – basing pay on long-term performance, and making sure that bankers share in the losses and not just gains –might make a big difference”.  He also mentions the need for countercyclical bank regulating policies that would counterbalance the effects of mark-to-market accounting: “The regulators should have allowed less lending against the value of bank’s capital in good times, to dampen the euphoria and the bubble, but more in bad times”.  Stiglitz finishes the chapter by presenting an innovation that came out of Argentina after its financial crisis: A GDP-indexed bond. “That way, creditor interests would be aligned with Argentina’s interests, and they would work to try to help Argentina grow”.

Stiglitz argues that “the financial crisis showed that financial markets do not automatically work well, and that markets are not self correcting”. I am sure that a lot of economists will be counter arguing that the financial crisis have shown that markets are self correcting no matter what any government wants. He advocates a better balance between the role of the government and the role of the market. He is definitely right that the world needs better governments. I am not convinced that the world needs more government, either for saving banks (as the Hooverites did) or for retrofitting the economy in response to global warming (as Stiglitz wants them to do).

In Chapter 8 Stiglitz identifies that “the contrast between the handling of the East Asian crisis and the American crisis has not gone unnoticed. To pull America out of the hole, the country engaged in massive increases in spending and massive deficits, even as interest rates were brought down to zero…Why, people in the Third World ask, is the United States administering different medicine to itself?” The same question is asked by a lot of people in Greece, these days. I guess he should have examined the capacity of these countries to tax their people or borrow more money in order to be able to administer the same cure as the United States did.  Should the US have to run to the IMF for a rescue, I doubt that any medicine administered would be that much different. Stiglitz warns that although the poor suffered under market fundamentalism, they may “suffer again if new regimes again get the balance wrong with excessive intervention in the markets…There has been no successful economy that has not relied heavily on markets…Democracy and market forces are essential to a just and prosperous world”.

Stiglitz proposes that economics is a predictive science. Well, that may be true, but any other science seems to be much better than Stiglitz’s, on that account. He also warns that “one should be suspicious when one hears bankers take up the cause for the poor”. That should be so indeed, but very few people wouldn’t be suspicious! He should also warn that one should be suspicious when government directors, or university professors, take up the same cause. Just because some people are after money, while others are after power or glory, shouldn’t really stop anyone being suspicious of anybody trying to make a living out of helping the poor. People should also be suspicious when they hear professors take up the cause for more research, something that Stiglitz does not fail to do like a good academician.

Chapter 10 proposes that “externalities and other market failures are not the exception but the rule. There is meaning to individual and corporate responsibility. Firms need to do more than maximize their market value.”

In the Afterword of the 2010 paperback edition Stiglitz warns that “The notion that cutting wages is a solution to the problems of Greece, Spain and others within the Eurozone is a fantasy…There is a far easier solution: the exit of Germany from the Eurozone or the division of the Eurozone in two subregions…The imposed austerity will itself not only cause hardship in the afflicted countries but also weaken the European economy and undermine support for European integration. And brinkmanship carries with it a risk: in waiting too long or demanding too onerous conditions, the Eurozone may face a crisis far worse than that which it has experienced so far”.

Stiglitz’s message in this book is summarized on page 340: “The choices that our government made were by no means the worst possible, but they were far from the best.”

This book makes me make a hypothesis: To every market failure there is an associated government failure and vice versa (let’s call this the Economidian hypothesis).

1 comment:

  1. This review is awesome. Helped me a greeat deal for today's exam :)