Global Recession : Stiglitz

A Global Recovery for a Global Recession

by JOSEPH E. STIGLITZ

This article appeared in the July 13, 2009 edition of
The Nation.
June 24, 2009
See the entire article at The Nation

This is not only the worst global economic downturn of
the post-World War II era; it is the first serious
global downturn of the modern era of globalization.
America's financial markets failed to do what they
should have done--manage risk and allocate capital
well--and these failures have had a major impact all
over the world. Globalization, too, did not work the
way it was supposed to. It helped spread the
consequences of the failures of US financial markets
around the world. September 11, 2001, taught us that
with globalization not only do good things travel more
easily across borders; bad things do too. September 15,
2008, has reinforced that lesson.

A global downturn requires a global response. But so
far our responses--to stimulate and regulate the global
economy--have largely been framed at the national level
and often take insufficient account of the effect on
others. The result is that there is less coordination
than there should be, as well as a smaller and less
well-designed stimulus than is optimal. A poorly
designed and insufficient stimulus means that the
downturn will last longer, the recovery will be slower
and there will be more innocent victims. Among these
victims are the many developing countries--including
those that have had far better regulatory and
macroeconomic policies than the United States and some
European countries. In the United States a financial
crisis transformed itself into an economic crisis; in
many developing countries the economic downturn is
creating a financial crisis.
The world has two choices: either we move to a better
global regulatory system, or we lose some of the
important benefits that have resulted from
globalization. But continuing the status quo management
of globalization is no longer tenable; too many
countries have had to pay too high a price. The G-20's
response to the global economic crisis, crafted at
meetings in November in Washington and in April in
London, was a beginning--but just a beginning. It did
not do enough to address the short-term problems nor
did it put in place the long-term restructuring
necessary to prevent another crisis.

A United Nations meeting in late June hopes to continue
the global discussion begun at earlier G-20 meetings
and to extend this discussion to what went wrong in the
first place so that we can do a better job of
preventing another crisis. The global politics of this
meeting are complexEighth, unless regulation is comprehensive there can be
a "race to the bottom," with countries with lax
regulation competing to attract financial services.
Ninth, if that race happens, countries will have to
take action to protect their economies--they cannot
allow bad practices elsewhere to harm their citizens.
And tenth, regulation has to be comprehensive across
financial institutions. As we have seen, if we regulate
the banking system but not the shadow banking system,
business will migrate to where it is less well
regulated and less transparent.

Despite this broad consensus, the G-20 said little or
nothing about some key issues: what to do with banks
that have grown not only too big to fail but (according
to the Obama administration) too big to be financially
restructured? The G-20 failed to ask the hard
questions: if these big banks' shareholders and
bondholders are insulated from the risk of default, how
can there be market discipline? What will replace that
discipline? The G-20 has talked about the rapid return
of "private capital," but what does this bode if
private capital returns without market discipline?
There was also talk of continuing to allow over-the-
counter derivatives-trading with no transparency. But
without transparency of each trade--to assess the
nature of the counterparty risk--how can there be
market discipline?


From the perspective of the developing countries,
though, not enough was done about bank secrecy in
offshore as well as onshore centers. Developing nations
are often criticized for corruption, but secret bank
accounts wherever they may be facilitate corruption,
providing safe haven for stolen funds. Developing
countries want this money returned and want access to
information that will allow them to detect secret
accounts.

Financial and capital market liberalization--as well as
banking deregulation--contributed to the crisis and to
the spread of the crisis from the United States to
developing countries. Advanced industrial nations are
reluctant to admit that these policies, which they
pushed so hard on developing countries, are part of the
problem. No wonder, then, that the G-20 did not argue
for a reconsideration of these longstanding policies.

The global economic crisis highlights the deficiencies
of existing international institutions. As developed countries struggle to ensure a quick
recovery, they need to think of the effects of their
actions on developing countries. It is time to begin
the restructuring of our global economic and financial
system in ways that ensure that the fruits of
prosperity are more widely shared and that the system
is more stable. This task will not be accomplished
overnight. But it is a task that must be begun, now.

About Joseph E.Stiglitz
Joseph E. Stiglitz is University Professor at Columbia
University. He received the Nobel Prize in Economics in
2001 for research on the economics of information. Most
recently, he is the co-author, with Linda Bilmes, of
The Three Trillion Dollar War: The True Costs of the
Iraq Conflict.

Stiglitz on the Global Economic Crisis

April 1, 2009
Op-Ed Contributor
Obama’s Ersatz Capitalism

By JOSEPH E. STIGLITZ
THE Obama administration’s $500 billion or more proposal to deal with America’s ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win — and taxpayers lose.

Treasury hopes to get us out of the mess by replicating the flawed system that the private sector used to bring the world crashing down, with a proposal marked by overleveraging in the public sector, excessive complexity, poor incentives and a lack of transparency.

Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging — that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets. In the process, they used overly complex instruments like collateralized debt obligations.

The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently. Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.

In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest — $12 in “equity” plus $126 in the form of a guaranteed loan.

If, in a year’s time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.

Even in an imperfect market, one shouldn’t confuse the value of an asset with the value of the upside option on that asset.

But Americans are likely to lose even more than these calculations suggest, because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets that they think the market overestimates (and thus is willing to pay too much for).

But the market is likely to recognize this, which will drive down the price that it is willing to pay. Only the government’s picking up enough of the losses overcomes this “adverse selection” effect. With the government absorbing the losses, the market doesn’t care if the banks are “cheating” them by selling their lousiest assets, because the government bears the cost.

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Some Americans are afraid that the government might temporarily “nationalize” the banks, but that option would be preferable to the Geithner plan. After all, the F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later), and Washington Mutual (seized last September, and immediately resold).

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it’s the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high costs of the administration’s plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder.

Joseph E. Stiglitz, a professor of economics at Columbia who was chairman of the Council of Economic Advisers from 1995 to 1997, was awarded the Nobel prize in economics in 2001.

http://www.nytimes.com/2009/04/01/opinion/01stiglitz.html?_r=1&ref=opinion
Stiglitz is the Chair of the Socialist International Committee on the Global Economic Crisis

Economic Hypocrisy: Stiglitz

Dishonesty in the finance sector dragged us here, and
Washington looks ill-equipped to guide us out

By Joseph Stiglitz

The Guardian (UK)
September 16 2008


Houses of cards, chickens coming home to roost - pick
your cliche. The new low in the financial crisis, which
has prompted comparisons with the 1929 Wall Street
crash, is the fruit of a pattern of dishonesty on the
part of financial institutions, and incompetence on the
part of policymakers.

We had become accustomed to the hypocrisy. The banks
reject any suggestion they should face regulation,
rebuff any move towards anti-trust measures - yet when
trouble strikes, all of a sudden they demand state
intervention: they must be bailed out; they are too
big, too important to be allowed to fail.

Eventually, however, we were always going to learn how
big the safety net was. And a sign of the limits of the
US Federal Reserve and treasury's willingness to rescue
comes with the collapse of the investment bank Lehman
Brothers, one of the most famous Wall Street names.

The big question always centres on systemic risk: to
what extent does the collapse of an institution imperil
the financial system as a whole? Wall Street has always
been quick to overstate systemic risk - take, for
example, the 1994 Mexican financial crisis - but loth
to allow examination of their own dealings. Last week
the US treasury secretary, Henry Paulson, judged there
was sufficient systemic risk to warrant a government
rescue of mortgage giants Fannie Mae and Freddie Mac;
but there was not sufficient systemic risk seen in
Lehman.

The present financial crisis springs from a
catastrophic collapse in confidence. The banks were
laying huge bets with each other over loans and assets.
Complex transactions were designed to move risk and
disguise the sliding value of assets. In this game
there are winners and losers. And it's not a zero-sum
game, it's a negative-sum game: as people wake up to
the smoke and mirrors in the financial system, as
people grow averse to risk, losses occur; the market as
a whole plummets and everyone loses.

Financial markets hinge on trust, and that trust has
eroded. Lehman's collapse marks at the very least a
powerful symbol of a new low in confidence, and the
reverberations will continue.

The crisis in trust extends beyond banks. In the global
context, there is dwindling confidence in US
policymakers. At July's G8 meeting in Hokkaido the US
delivered assurances that things were turning around at
last. The weeks since have done nothing but confirm any
global mistrust of government experts.

How seriously, then, should we take comparisons with
the crash of 1929? Most economists believe we have the
monetary and fiscal instruments and understanding to
avoid collapse on that scale. And yet the IMF and the
US treasury, together with central banks and finance
ministers from many other countries, are capable of
supporting the sort of "rescue" policies that led
Indonesia to economic disaster in 1998. Moreover, it is
difficult to have faith in the policy wherewithal of a
government that oversaw the utter mismanagement of the
war in Iraq and the response to Hurricane Katrina. If
any administration can turn this crisis into another
depression, it is the Bush administration.

America's financial system failed in its two crucial
responsibilities: managing risk and allocating capital.
The industry as a whole has not been doing what it
should be doing - for instance creating products that
help Americans manage critical risks, such as staying
in their homes when interest rates rise or house prices
fall - and it must now face change in its regulatory
structures. Regrettably, many of the worst elements of
the US financial system - toxic mortgages and the
practices that led to them - were exported to the rest
of the world.

It was all done in the name of innovation, and any
regulatory initiative was fought away with claims that
it would suppress that innovation. They were
innovating, all right, but not in ways that made the
economy stronger. Some of America's best and brightest
were devoting their talents to getting around standards
and regulations designed to ensure the efficiency of
the economy and the safety of the banking system.
Unfortunately, they were far too successful, and we are
all - homeowners, workers, investors, taxpayers -
paying the price.
_____

Joseph E Stiglitz is university professor at Columbia
University and recipient of the 2001 Nobel prize in
economics josephstiglitz.com

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