Bouncing back from economic freefall

ECONOMICS: Freefall: America, Free Markets and the Sinking of the World EconomyBy Joseph Stiglitz, WW Norton, 361pp, £17.99

NOBEL PRIZE-WINNING economist Joseph Stiglitz created waves on a recent visit to Dublin. He forced the spin machine into overdrive with his characterisation of the Nama proposals as “criminal”. It was claimed he would not have had much knowledge of the details. Nobel laureates tend to be able to process information fairly rapidly though. It is clear from his latest offering – an account of the current global crisis, its origins and implications – that he has no time for vast corporate social welfare payments.

The stellar academic work that earned him his prize focused on “market failures”. When private incentives and social returns are out of sync, unfettered markets, or the “invisible hand” of Adam Smith, deliver inefficient outcomes. Opposing schools of thought point to “government failures” in response. And they have a point. Wouldn’t John O’Donoghue have been much less flathúlach if it was his own money he was spending on hotels and limousines, or Martin Cullen on his voting machines? This view is epitomised in Ronald Reagan’s “nine scariest words in the English language: I’m from the government and I’m here to help”. And it is the best argument against nationalised banks. But Stiglitz points out that it is those who are generally most hostile to government intervention who come looking for the largest bail-outs when capitalism turns its claws on them.

His preferred solution to the US banking crisis is standard US capitalism. The institution survives, with bondholders becoming the new shareholders. The funds that the US government came up with for its own Nama-equivalent “cash for trash” scheme should go only to new or well-managed banks. With modest leverage, this could service the economy’s credit needs. No bailouts without radical restructuring.

A former chairman of Clinton's council of economic advisers, and later chief economist of the World Bank, Stiglitz's first assault on the best-seller lists came in 2002 with Globalisation and its Discontents. The book attacked the IMF and the US Treasury for the policy prescriptions they tried to force on developing countries in crisis: slashing budget deficits, raising interest rates and opening banking systems to foreign ownership. "Would the US follow such policies in bad times?" he asked. Even more prescient was the title of his next book, The Roaring Nineties, which followed a year later. With its echoes of Gatsby, flapper girls and the Charleston, the suggestion was that another Wall Street Crash might be at hand.

Freefalltakes up where The Roaring Ninetiesleft off. We have had the crash. Shareholders must wish they had been more alert to his consistent warnings of the mismatch between corporate executives' incentives and shareholder interests. In the case of banks "too big to fail", another market failure arises. Knowing that you are likely to be bailed out encourages riskier behaviour. Roosevelt had agonised over the introduction of Federal Deposit Insurance for just such reasons. Insurance, implicit or explicit, requires regulation.

These lessons and others had been learnt during the Great Depression. But memories fade. One of the most important legal legacies of that era, the Glass-Steagall Act, was revoked in 1999 after a $200 million lobbying effort. Commercial banks had been tightly regulated. Investment banks were not, as they were supposed to be allowed go belly up. Glass-Steagall had insisted on the separation of such activities. In the decade or so after repeal, the market share of the five largest banks quadrupled, worsening the problem of “too big to fail”.

The demand for new financial engineering to produce higher yields on apparently low-risk assets grew as China’s voracious appetite for US government bonds drove yields down. “Securitisation”, which saw US mortgages with different risk profiles pooled, packaged and sold on through the financial system, appeared to fit the bill. Not only did the complicated mathematics of the new risk assessment models prove to be based on faulty assumptions, however, they provided false assurances that commonsense indicators such as rapid credit growth and the emergence of 100 percent mortgages could be safely ignored. And everyone from the ratings agencies to the regulators used the same models.

As many risky sub-prime mortgages had been shovelled into even the least risky tranches of the new securities as the coveted triple A rating would allow. When US house prices fell, the fragility of the system became apparent and everything seized up.

Probably the biggest question that Stiglitz raises is over the value to society of these new financial innovations. An underlying assumption has been that innovations are beneficial to society and regulation must not stifle this process. Stiglitz argues though that the financial sector makes its profits from transactions costs, whereas society’s interests are in the minimisation of these costs. Activities internal to the banking system grew far more rapidly than end services to the real economy. Complexity facilitates higher fees, securitisation allows for greater churn and the banks have no incentive to develop and implement an efficient electronic payments system.

“An outsized financial sector’s profits may come at the expense of the prosperity and efficiency of the rest of the economy”. Similar concerns were raised by the Turner review, commissioned by the UK chancellor of the exchequer in October 2008.

Stiglitz’s own personal banking inquiry unearths lots of culprits. The remarkable openness of the American system, which privileges free speech over the right to one’s good name, allows for plenty of naming and shaming. Not least on the question of who has been chosen to advise various administrations and what sectional interests they represent.

Recent US policies designed to spur lending were instead funding speculative investments and fuelling profits. The Obama administration’s announcement of a new “get tough” policy in recent weeks signals a shift in the balance of power to those on the same wavelength as Stiglitz.

Frank Barry is professor of international business and economic development at Trinity College Dublin