Stiglitz J. Cap Tulo 1. the Making of a Crisis

7/30/2019 Stiglitz J. Cap Tulo 1. the Making of a Crisis

1/26

C H A P T E R O N E

THE MAKING OFA CRISIS

TH E O N L Y S U R P R I S E A B O U T T H E E C O N O M I C C R I S I S O F2008 was that it carne as a surprise to so many. For a few observ-ers, it was a textbook case that was not only predictable but also pre-dicted. A deregulated market awash in liquidity and low interest rates,a global real estte bubble, and skyrocketing subprime lending werea toxic combinat ion. Add in the U.S. fiscal and trade dficit and thecorresponding accumulation in China of huge reserves of dollars-anunbalanced global economyand it was clear that things were horriblyawry.

What was difierent about this crisis from the multitude that hadpreceded it during the past quarter ccntury was that this crisis borea "Made in the USA" label. And while previous crises had been con-tained, this "Made in the USA" crisis spread quickly around the world.We liked to think of our country as onc of the engines of global eco-nomic growth, an exporter of sound economic policiesnot recessions.The last time the United States had exported a major crisis was duringthe Great Depression of the 1930s.'

The basic outlines of the story are wcll known and often told. TheUnited States had a housing bubble. When that bubble broke and hous-ing prices f e l l f r om thcir stratospheric levis, more and more homcown-ers found thernselves "underwater." They owed more on their mortgages


2/26

2 F R E E F A L L

tban wbat their bornes were valued. As they lost their homes, many alsolost their life savings and their dreams for a futurea college educationfor their children, a retirement in comfort. Americans had, in a sense,been living in a dream.The richest country in the world was living beyond its means, andthe strength of the U.S. economy, and the world's, depended on it. Theglobal economy needed ever-increasing consumption to grow; but howcould this continu when the incomes of many Americans had beenstagnating for so long?2 Americans carne up with an ingenious solution:borrow and consume as if their incomes were growing.And borrow theydid. Average savings rates fell to zeroand with many rich Americanssaving substantial amounts, that meant poor Americans had a largenegative savings rate. In other words, they were going deeply into debt.Both they and their lenders could feel good about what was happening:they were able to continu their consumption binge, not having to faceup to the reality of stagnating and declining incomes, and lenders couldenjoy record profits based on ever-mounting fees.

Low interest rates and lax regulations fed the housing bubble. Ashousing prices soared, homeowners could take money out of theirhouses. These mortgage equity withdrawalswhich in one year hit$975 billion, or more than 7 percent of GDP3 (gross domestic prod-uct, the standard measure of the sum of all the goods and services pro-duced in the economy)allowed borrowers to make a down paymenton a new car and still have some equity left over for retirement. But allof this borrowing was predicated on the risky assumption that housingprices would continu to go up, or at least not fall.

The economy was out of kilter: two-thirds to three-quarters of theeconomy (of GDP) was housing related: constructing new houses orbuying contents to fill them, or borrowing against od houses to financeconsumption. It was unsustainableand it wasn't sustained. Thebreaking of the bubble at f i rs t affected the worst mortgages (the sub-prime mortgages, lent to low-income individuis), but soon affected allresidential real estte.

When the bubble popped, the effects were amplified because bankshad created complex producs resting on top of the mortgages. Worse


3/26

T H E M A K i N G O H A C i i s i s 3

s t i J I , they had engaged in multibllion-dollar bets with each other andwith others around the world. This complexity, combined with therapidity with which the situation was deteriorating and the banks' highleverage (they, like households, had financed their investments by heavyborrowing), meant that the banks didn't know whether what they owedto their depositors and bondholders exceeded the valu of their assets.And they realizecl accordingly that thcy couldn't know the position ofany other bank. The trust and conficlence that underlie the bankingsystem evaporated. Banks refused to lend to each otheror deniandedhigh interest rates to compnsate for bearing the risk. Global crcditmarkets began to melt down.

At that point, America and the world were faced with both a finan-cial crisis and an economic crisis. The economic crisis had severalcomponents: There was an unfolding residential real estte crisis, fol-lowcd not long after by problems in commercial real estte. Demandfell, as households saw the valu of their houses (and, if they ownedshares, the valu of those as well) collapse and as their abilityandwillingnessto borrow diminished. There was an nventory cycleascrcdit markets froze ancl demand fe l l , companies reduced their inven-tories as quickly as possible. And there was the collapse o" Americanmanufacturing.

There were also deeper questions: What would replace the unbri-dled consumption of Americans that had sustained the economy inthe years before the bubble broke? How were America and Europcgoing to manage their restructuring, for instance, the transition towarda scrvce-sector economy that had been d i f f i c u l t enough during theboom? Restructuring was inevitableglobali/.ation and the pace oftechnology demanded itbut it would not be easy.

T H E S T O R Y I N S H O R TWhile the challenges going forward are clear, the question remains:1 low did it all happen? This is not the way market economies are sup-posed to work. Something went wrongbaclly wrong.


4/26

4 F R E E F A L L

There is no natural point to cut into the seamless web of history. Forpurposes of brevity, I begin with the bursting of the tech (or dot-com)bubblc in the spring of 2000a bubble that Alan Greenspan, chairmanof the Federal Reserve at that time, had allowed to develop and thathad sustained strong growth in the late 1990s.4 Tech stock prices fell78 percent between March 2000 and October 2002.5 It was hoped thatthese losses would not affect the broader economy, but they did. Muchof investment had been in the high-tech sector, and with the burstingof the tech stock bubble this carne to a halt. In March 2001, Americawent nto a recession.

The administraron of President George W. Bush used the shortrecession following the collapse of the tech bubble as an excuse topush its agenda of tax cuts for the rich, which the president claimedwere a cure-all for any economic disease. The tax cuts were, however,not designad to stimulate the economy and did so only to a limitedextent. That put the burden of restoring the economy to full employ-ment on monetary policy. Accordingly, Greenspan lowered interestrates, flooding the market with liquidity. With so much excess capacityin the economy, not surprisingly, the lower interest rates did not lead tomore investment in plant and equipment. They workedbut only byreplacing the tech bubble with a housing bubble, which supported aconsumption and real estte boom.

The burden on monetary policy was increased when oil prices startedto soar after the invasin of Iraq in 2003. The United States spent hun-dreds of billions of dollars importing oilmoney that otherwise wouldhave gone to support the U.S. economy. Oil prices rose from $32 abarrel in March 2003 when the Iraq war began to $137 per barrel inJuly 2008. This meant that Americans were spending $1.4 billon perday to import oil (up from $292 million per day before the war started),instead of spending the money at home.6 Greenspan fel t he could keepinterest rates low because there was little inflationary pressure,7 andwithout the housing bubble that the low interest rates sustained andthe consumption boom that the housing bubble supported, the Ameri-can economy would have been weak.In all these go-go years of cheap money, Wall Street did not come


5/26

THE M A K I N G O F A C R I S I S 5

up with a good mortgage product.A good mortgage product would havelow transaction costs and low interest rates and would have helpedpeople manage the risk of homeownership, including protection in theevent their house loses valu or borrowers lose their job. Homeown-ers also want monthly payments that are predictable, that don't shootup without warning, and that don't have hidden costs. The U.S. Finan-cial markets didn't look to construct these better producs, even thoughthey are n use in other countries. Instead, Wall Street firms, focusedon maximizing their returns, carne up with mortgages that had hightransaction costs and variable interest rates with payments that couldsuddnly spike, but with no protection against the risk of a loss in homevalu or the risk of job loss.

Had the designers of these mortgages focused on the endswhatwe actually wanted from our mortgage marketrather than on how tomaxmize their revenues, then they might have devised products thatwould have permanently increased homeownership. They could have"done well by doing good." Instead their efforts produced a whole rangeof complicated mortgages that made them a lot of money in the shortrun and led to a slight temporary increase in homeownership, but atgreat cost to society as a whole.

The failings in the mortgage market were symptomatic of the broaderfailings throughout the financial system, including and especially thebanks. There are two core functions of the banking system. The firstis providing an efficient payments mechanism, in which the bankfacilitates transactions, transferringits depositors' money to those fromwhom they buy goods and services. The second core function is assess-ing and managingrisk and making oans. This is related to the f i r s t corefunction, because if a bank makes poor credit assessrnents, if it gam-bles recklessly, or if it puts too much money into risky ventures thatdefault, it can no longer make good on its promises to return depositors'money. If a bank does its job well, it provides money to start new busi-nesses and expand od businesses, the economy grows, Jobs are created,and at the same time, it earns a high returnenough to pay back thedepositors with interest and to genrate competitive returns to thosewho have invested their money in the bank.


6/26

6 F R E E F A L L

The lure of easy profits from transaction costs distracted many bigbanks from their core functions. The banking system in the UnitedStates and many other countries did not focus on lending to small andmedium-sized businesses, which are the basis of job creation in anyeconomy, but instead concentrated on promoting securitization, espe-cially in the mortgage market.

It was this involvement in mortgage securitization that proved lethal.In the Middle Ages, alchemists attempted to transform base metisinto gold. Modern alchemy entailed the transformation of risky sub-prime mortgages into AAA-rated products safe enough to be held bypensin funds. And the rating agencies blessed what the banks haddone. Finally, the banks got directly involved in gamblingincludingnot just acting as middlemen for the risky assets that they were creat-ing , but actually holding the assets. They, and their regulators, mighthave thought that they had passed the unsavory risks they had createdon to others, but when the day of reckoning carnewhen the marketscollapsedit turned out that they too were caught off guard. 8

P A R S I N G O U T B L A M EAs the depth of the crisis became better understoodby April 2009 itwas already the longest recession since the Great Depressionit wasnatural to look for the culprits, and there was plenty of blame to goaround. Knowing who, or at least what, is to blame is essential if weare to reduce the likelihood of another recurrence and if we are to cor-rect the obviously dysfunctonal aspects of today's financial markets.We have to be wary of too facile explanations: too many begin with theexcessive greed of the bankers. That may be true, but it doesn't pro-vide much of a basis for reform. Bankers acted greedily because theyhad incentives and opportunities to do so, and that is what has to bechanged. Besides, the basis of capitalism is the pursuit of profit: shouldwe blame the bankers for doing (perhaps a little bit better) what every-one in the market economy is supposed to be doing?In the long list of culprits, it is natural to begin at the bottom, with


7/26

T H E M A K I N G O F A C B I S I S 7

the mortgage originators. Mortgage companies had pushed exotic mort-gages on to millions of people, many of whom did not know what theywere getting into. But the mortgage companies could not have donetheir rnischief without being aided and abetted by the banks and ratinaagencies. The banks bought the mortgages and repackaged them, sell-ing them on to unwary investors. U.S. banks and F i n a n c i a l institutionshad boasted about their clever new investment instruments. They hadcreated new producs which, while touted as instruments for managingrisk, were so dangerous that they threatcned to bring down the U.S.

" f i n a n c i a l system. The rating agencies, which should have ehecked thegrowth of these toxic instruments, instead gave them a seal of approval,which encouraged othcrsincluding pensin funds looking for safeplaces to put money that workers had sct aside for their retirementnthe United States and overseas, to buy them.

In short, America's financial markets had failed to perform theiressential societal functions of managing risk, allocating capital, andmobilizing savings while kecping transaction costs low. instead, theyhad created risk, msallocated capital, and encouraged excessiveindebtedness while imposing high transaction costs. At their peak in2007, the bloated financial markets absorbed 41 percent of profits inthe corporate sector.9

One of the reasons why the financial system did such a poor job atmanaging risk is that the market mispricecl and misjudged risk. The"markct" badly misjudged the risk of defaults of subprime mortgages,and made an even worse mistake trusting the rating agencies and theinvestment banks when they repackaged the subprime mortgages,giving a AAA rating to the new producs. The banks (and the banks'investors) also badly misjudged the risk associated with high bank Icver-age. Ancl r i s k y assets that normally would have required substantiallyhigher returns to induce people to hold them were yielding only a smallrisk premium. I n some cases, the seeming mispricing and misjudgingofrisk was basccl on a smart bel: they believcd that if troubles arse, theFederal Reserve ancl the Treasury would bail them out, and they wereright.10The Federal Reserve, led first by Chairman Alan Greenspan a n c l


8/26

8 F R E E F A L L

later hy Ben Bernanke, and the other regulators stood back and let itall happen. They not only claimed that they couldn't tell whether therewas a buhble until after it broke, but also said that even if they had beenable tp, there was nothing they could do about it. They were wrong onboth counts. They could have, for instance, pushed for higher clownpayments on homes or higher margin requirements for stock trading,both of which would have cooled down these overheated markets. Butthey chose not to do so. Perhaps worse, Greenspan aggravatcd the situ-ation by allowing banks to engage in ever-riskier lending and encour-aging people to take out variable-rate mortgages, with payments thatcouldand ddeasily explode, forcing even middle-income famliesinto foreclosure."

Those who argued for deregulationand continu to do so in spiteof the evident consequencescontend that the costs of regulationexceed the benefits. With the global budgetary and real costs of thiscrisis mounting into the triliions of dollars, it's hard to see how its advo-cates can still maintain that position. They arge, however, that thereal cost of regulation is the stifling of innovation. The sad truth is thatin America's financial markets, innovations were directed at circum-venting regulations, accounting standards, and taxation. They createclproducts that were so complex they had the effect of both increasingrisk and information asymmetrics. No wonder then that it is impos-sibe to trace any sustainec increase in economic growth (beyond thebubble to which they contributed) to these financial innovations. Atthe same time, financial markets did not innvate in ways that wouldhave helped ordinary citizens with the simple task of managing the riskof homeowncrship. Innovations that would have helped people andcountres manage the other important risks they face were actuallyresisted. Good regulations could have reclirected innovations in waysthat would have increased the efficiency of our economy and securityof our citi/ens.

Not surprisingly, the financial sector has atternptcd to shift blameelsewherewhen its claim that it was just an "accident" (a once-in-a-thousand-years storm) f e l l on dcaf ears.

Those in the financial sector often blame the Fed for allowins nter-


9/26

T H E M A K I N G O F A C R I S I S 9

cst ratcs to remain too low for too long. But this particular attempt toshift blame is peculiar: what other industry would say that the reasonwhy its p r o f i t s wcre so ow and it performed so poorly was that thecosts of its inputs (sleel, wages) were too low? The major "input" intobanking is the cost of its funds, and yet bankers seem to be complain-ing that the Fed made money too cheap! Had the low-cost funds beenused well, for example, if the funds had gone to support investment innew technology or expansin of enterprises, we would have had a morecompetitive and dynamic economy.

Lax regulation without cheap money might not have led to a bubble.But more importantly, cheap money with a well-functioning or well-reg-ulated banking system could have led to a boom, as it has at other timesand places. (By the same tokcn, had the rating agencies done their jobwell, fewer mortgages would have been sold to pensin funds and otherinstitutions, and the magnitude of the bubble might have been mark-edly lower. The same might have been true even if rating agencies haddone as poor a job as they did, if investors themselves had analyzed therisks properly.) In short, it is a combination of failures that led the crisisto the magnitude that it reachcd.Greenspan and others, in turn, have tried to s h i f t the blame for thelow interest rates to Asian countries and the flood of liquidity fromtheir excess savings.12 Again, being able to import capital on betterterms shoulcl have been an advantage, a blessing. But it is a remarkableclaim: the Fed was saying, in effect, that it can't control interest ratesin America anymore. Of course, it can; the Fed chose to keep interestrates low, partly for reasons that 1 have already explained.]3

n what might sccm an outragcous act of ingratitude to those whorescued thern from their deathbed, many bankers blame the govern-mentbiting the very hand that was feeding them. They blarne thegovernment for not having stopped themlike the kid caught steal-ing from the candy store who blamed the storeowner or the cop forlooking the other way, leading him to beleve he could gct away withhis misdeed. But the argument is even more disingenuous because thefinancia! markets had paid to get the cops off the beat. They success-f u l l y bcat back attcmpts to reglate dcrivativcs and restrict predatory


10/26

O F R E E F A L L

lending. Thcir victory over America was total. Each victory gavc themmore money with which to influence the political process. They evenhad an argumcnt: deregulation had led them to make more money, andmoney was the mark of success. Q.E.D.

Conservatives don't like this blaming of the market; if there is aproblem with the economy, in their hearts, they know the true causemust be government. Government wanted to increase houschold own-ership, and the bankers' defensc was that they were just doing theirpart. Fannie Mae and Freddie Mac, the two prvate companies that hadstarted as government agencies, have been a particular subject of vili-tication, as has the government program called the Community Rein-vestment Act (CRA), which encourages banks to iend to underscrvedcommunities. Had it not been for these efforts at lending to the poor,so the argument goes, all would have been well. This litany of defensasis, for the rnost part, sheer nonsense. AlG's almost $200 billion bailout(that's a big amount by any account) was bascd on derivatives (creditdefaut swaps)banks gambling with other banks. The banks didn'tneed any push for egalitarian housing to engage in exccssive risk-taking.or did the massive overinvestment in commercial real estte haveanything to do with government homeownership policy. or did therepeated instanccs of bad lending around the world from which thebanks have had to be repeatedly rescued. Moreover, defaut rates orthe CRA lending were actually comparable to other reas of lending

14showing that such lending, if done well, does not pose greater risks.The most telling point though is that Fannie Mae and Freddie Mac'smndate was for "conformng loans," loans to the middle class. Thebanks jumped irito subprimc mortgagesan rea where, at the time,Freddie Mac and Fannie Mae were not making loanswithout anyincentives from the government. The president may have given somespecches about the ownership society, but there is little evidence thatbanks snap to it whcn the president gives a speech. A policy has to beaccompanied by carrots and sticks, and thcrc weren't any. (If a speechwould do the trick, Obama's repeated urging of banks to restructuremore mortgages and to Icnd more to sm a l l businesscs would have hadsome effect.) More to the point, advocates of homeownership meant


11/26


permanent, or at least long-term, ownership. There was no point of put-ting someone in a home for a few months and then tossing him out afterhaving stripped him of his life savings. But that was what the bankswere doing. I know of no government official who would have said thatlenders should engage in predatory practicas, lend beyond people'sability to pay, with mortgages that combined high risks and high trans-action costs. Later on, years after the prvate sector had invented thetoxic mortgages (which I discuss at greater length in chapter 4), theprivatized and under-regulated Fannie Mae and Freddie Mac decidedthat they too should join in the fun. Their executives thought, Whycouldn't they enjoy bonuses akin to others in the industry? Ironically, indoing so, they helped save the prvate sector from some of its own folly:many of the securitized mortgages wound up on their balance sheet.Had they not bought them, the problems in the prvate sector arguablywould have been far worse, though by buying so many securities, theymay also have helped fuel the bubble.15

As I mentioned in the preface, figuring out what happened is like"peeling an onion": each explanation raises new questions. In peelingback the onion, we need to ask, Why did the financial sector fail sobadly, not only in performing its critical social functions, but even inserving shareholders and bondholders well?16 Only executives in finan-cial institutions seem to have walked away with their pockets linedess lined than if there had been no crash, but still better off than,say, the poor Citibank shareholders who saw their investments virtu-ally disappear. The financial institutions complained that the regula-tors didn't stop them from behaving badly. But aren't firms supposed tobehave well on their own? In later chapters I will give a simple explana-tion: flawed incentives. But then we must push back again: Why werethere flawed incentives? Why didn't the market "discipline" firms thatemployed flawed incentive structures, in the way that standard theorysays it should? The answers to these questions are compex but includea flawed system of corporate governance, inadequate enforcement ofcompetition laws, and imperfect nformation and an inadequate under-standing of risk on the part of the investors.While the financial sector bears the major onus for blame, regulators


12/26

12 F R E E F A L L

didn't do the job that they should have doneensuring that banks don'tbchave badly as is their wont. Some in the less regulated part of theinancial markets (like hedge funds), observing that the worst problemsoccurred in the highly regulated part (the banks), gl ibly conclude thatregulation is the problem. "If only they were unregulated like us, theproblems would never have occurred/' they arge. But this misses theessential point: The reason why banks are regulated is that their failurecan cause massive harm to the rest of the economy. The reason whythere is less regulation needed for hedge funds, at least for the smallerores, is that they can do less harm. The regulation did not cause thebanks to behave badly; it was deficiencies in regulation and regulatoryenforcemcnt that failed to prevent the banks from imposing costs onthe rest of society as they have repeatedly done. Indeed, the one periodn American history when they have not imposed thesc costs was thequarter century after World War II when strong regulations were effec-tively enforced: it can be done.

Again, the failure of regulation of the past quarter century needsto be explaincd: the story 1 tell below tries to relate those failures tothe political influence of special interests, particularly of those in thefinancial sector who made rnoney from deregulation (many of theireconomie investrnents had turned sour, but they were far more acutein their political investrnents) , and to ideologicsideas that said thatregulation was not necessary.

M A R K E T F A I L U R E SToday after the crash, almost everyone says that there is a need forregulation-or at least for more than there was beforc the crisis. Nothaving the necessary regulations has cost us plenty: crises would havebeen less frequent and less costly, ancl the cost of the regulators andregulations would be a pittance rclative to these costs. Markets on theirown evidently failand fai l very frcqucntly. There are many rcasons forthese failures, but two are particularly gcrmane to the financial sector:"agency"in today's world scores of pcople are handling money and


13/26

T H E M A K I N G o F A C R I S I S 13

making dccisions on behalf of (that is, as agents of) othersand thencreased importancc of "externalities."

The agency problem is a modern one. Modern corporations withtheir myriad of small shareholders are fundamentally difierent fromfamily-run enterprises. There is a separation of ownership and controlin which management, owning little of the company, may run the cor-poration largely for its own benefit.17 Thcre are agency problems tooin the process of investment: much was done through pensin fundsand other iristitutions. Those who make the investment decisionsandasscss corporate performancedo so not on their behalf but on behalfof those who have entrustecl their funds to their care. All along the"agency" chain, concern about performance has been translated into afocus on short-term relurns.

With its pay dependent not on long-term returns but on stock marketprices, management naturally does what it can to drive up stock marketpricesevcn if that entails deceptive (or creative) accounting. Itsshort-terrn focus is reinforced by the demand for high quarterly returnsfrom stock market analysts. That drive for short-term returns led banksto focus on how to genrate more lees-and, in some cases, how tocircumvent accounting and financia! regulations. The innovativenessthat Wall Street ultimately was so proud of was dreaming up new prod-ucs that .would genrate more income in the short term for its firms.The probems that would be posed by high default rates from some ofthese innovations secmed matters for the distant future. On the otherhand, financial firms were not the least bit interested in innovationsthat might have helpcd pcople keep their homes or protect them fromsuelden rises in interest rates.

In short, there was little or no effective "quality control." Again,in thcory, markets are supposed to provide this discipline. Firms thatproduce excessively risky produets would lose their reputation. Shareprices would f a l l . But in today's dynamic world, this market disciplinebrokc down. The financia! wizards nvented highly risky produets thatgave about normal returns for a whilewith the downside not apparenlfor years. Thousands of money managcrs boasted that they could "beatthe market," and there was a ready population of shortsighted investors


14/26

F R E E F A L L

who believed them. But the Bnancial wizarcls got earried away in theeuphoriathey deceved themselves as well as those who bought theirproducts. This hclps explain why, when the market erashed, they wereleft holding billions of dollars' worth o: toxic products.

Securitization, the hottest fnancial-produets field in the years lead-ing up to the collapse, provided a textbook example of the risks gener-ated by the new innovations, for it meant that the relationship betweenlender and borrower was broken. Securitization had one big advan-tage, allowing risk to be spread; but it had a big disadvantage, creatingnew problems of imperfect information, and these swamped the ben-efits from increascd diversifieation. Those buying a mortgage-backcdsecurity are, in effect, lending to the homcowner, about whom theyknow nothing. They trust the hank that sells them the product to havechecked it out, and the bank trus ts the mortgage originator. The mort-gage originators' incentives were focused on the quantity of mortgagesoriginated, not the quality. They produced massive amounts of trulylousy mortgages. The banks like to blame the mortgage originators, butjust a glance at the mortgages should have revealcd the inherent risks.The fact is that the bankers didn't -want to hnow. Their incentives wcreto pass on the mortgages, and the secundes they created backed by themortgages, as fast as they could to others. In the Frankenstein labora-tories or- Wall Street, banks created new risk products (collateralizeddebt in strumcnts, collateralized debt instrurnents squared, and creditdefault swaps, some of which Twill discuss in later chapters) withoutmechanisms to manage the monster they had created. They had goneinto the movingbusiness-takingmortgages from the mortgage origina-tors, repaekaging theiri, and moving them onto the books of pensinfunds and others-becausc that was where the tees were the highcst,as opposed to the "storage business," which had bcen the traditionalbusiness model for banks (originating mortgages and then holding onto them). Or so they thought, until the crash occurred and they discov-erecl billions o dollars of the bad assets on their books.


15/26

THE M A K I N G O F A C R I S I S 15

Externalities

The bankers gave no thought to how dangerous some of the financialinstruments were to the rest of us, to the large externalities that werebeng created. In economics, the tcchnical term extemality refers tosituations where a market exchange imposes costs or benefits on otherswho aren't party to the exchange. If you are trading on your own accountand lose your money, it doesn't really affect anyone else. However, thefinancial system is now so intertwined and central to the economy thata falure of one large institution can bring down the whole system. Thecurrent failure has affected everyone: millions of homeowners have losttheir homes, and millions more have seen the equity in their homes dis-appear; whole communities have been devastated; taxpayers have hadto pick up the tab for the losses of the banks; and workers have losttheir Jobs. The costs have been borne not only in the United States butalso around the world, by billions who reaped no gains from the reck-less behavior of the banks.

When there are important agency problems and externalities, mar-kets typically fa i l to produce efficient outcomescontrary to the wide-spread belief in the efficiency of markets. This is one of the rationalesfor financial market regulation. The regulatory agencies were the lastline of defense against both excessively risky and unscrupulous behav-ior by the banks, but after years of concentrated lobbying efforts by thebanking industry, the government had not only stripped away existingregulations but also failed to adopt new ones in response to the cbang-ing financial landscape. People who didn't understand why regulationwas necessaryand accordingly believed that it was unnecessarybecame regulators. The repeal in 1999 of the Glass-Steagall Act, whichhad separated investment and commercial banks, created ever largerbanks that were too big to be allowed to fa i l . Knowing that they weretoo big to fail provided incentives for excessive risk-taking.

In the end, the banks got hoistcd by their own petard: The financialinstruments that they used to exploit the poor turned against the finan-cial markets and brought them down. When the bubble broke, most ofthe banks were left holding enough of the risky securities to threaten


16/26

16 F R E E F A L L

their very survivalevidently, they hadn't done as good a Job in passingthe risk along to others as they had thought. This is but one of manyironies that have marked the crisis: in Greenspan and Bush's attempt tominimize the role of government in the economy, the government hasassumed an unprecedented role across a wide swathbecoming theowner of the world's largest automobile company, the largest insurancecompany, and (had it received in return for what it had given to thebanks) some of the largest banks. A country in which socialsm is oftentreated as an anathema has socialized risk and intervened in markets inunprecedented ways.

These ironies are matched by the seeming inconsistencies in thearguments of the International Monetary Fund (IMF) and the U.S.Treasury before, during, and after the East Asian crisisand the incon-sistencies between the policies then and now. The IMF might claimthat it believes in market fundamentalismthat markets are efficient,self-correcting, and accordingly, are best J e f t to thcir own devices if oneis to maximize growth and efficiencybut the moment a crisis occurs,it calis for massive government assistance, worried about "contagin,"the spread of the disease from one country to another. But contagin isa quintessential externality, and if there are externalities, one can't (log-ically) believe in market fundamentalism. Even after the multibiliion-dollar bilouts, the IMF and U.S. Treasury resisted imposing measures(regulations) that might have made the "accidents" less likely and lesscostiybecause they believed that markets fundamentally worked wellon their own, even when they hacl just experienced repeated instanceswhen they didn't.

The bilouts provide an example of a set of inconsistent policies withpotentially long-run consequences. Economists worry about incentivesone might say it is their number-one preoccupation. One of the argu-ments put forward by many in the financial markets for not helpingmortgage owners who can't meet their repayments is that it gives rise to"moral hazard"that is, incentives to repay are wcakened if mortgageowners know that therc is some chance they will be helped out if theydon't repay. Worries about moral hazard led the IMF and the U.S. Trea-sury to arge vehemently against bilouts in Indonesia and Thailand


17/26


setting of a massive collapsc of the banldng system and exacerbatingthe downturns in those countries. Worries about moral hazard playedinto the decisin not to bail out Lehman Brothers. But this decisin, inturn, led to the most massive set of bailouts in history. When it carneto America's big banks in the aftermath of Lehman Brothers, concernsabout moral ha/.ard were shunted aside, so much so that the banks' off i -cers were allowed to enjoy huge bonuses for record losses, dividendscontinued unabated, and shareholders and bondholders were protected.The repeated rescues (not just bailouts, but ready provisin of liquidityby the Federal Reserve in times of trouble) provide part of the expa-nation of the current crisis: they encouraged banks to become increas-ingly reckless, knowing that there was a good chance that if a problemarse, they would be rescued. (Financial markets referred to this as the"Greenspan/Bernanke put.") Regulators made the mistaken judgmentthat, because the economy had "survived" so wel!, markets worked wellon their own and regulation was not needednot noting that they hadsurvived because of massive government intervention. Today, the prob-lem of moral hazard is greater, by far, than it has ever been.

Agency issues and externalities mean that there is a role for govern-ment. If it does its job well, there wiJl be fewer accidents, and when theaccidents occur, they will be less costly. When there are accidents, gov-ernment-will have to help in picking up the pieces. But how the govern-ment picks up the pieces affects the likelihood of future crisesanda society's scnse of fairness and justice. Every successful economyevery successul societyinvolves both government and markets.There needs to be a balanced role. It is a matter not just of "how much"but also of "whal." During the Reagan and both Bush administrations,the United States lost that balancedoing too little then has meantdoing too much now. Doing the wrong things now may mean doingmore in the future.

RecessionsOne of the striking aspects of the "free market" revolutions initiatedby Presiclent Ronald Reagan and Prime Minister Margaret Thatcher of


18/26

1 8 F R E E F A L L

England was that perhaps the most important set of instances whenmarkets fa i l to yeld efficient outcomes was forgotten: the repeated epi-sodes when resources are not fu l ly utilized. The economy often operatesbelow capacity, with millions of people who would like to find work notbeing able to do so, with episodic fluctuations in which more than oneout of twelve can't find Jobsand numbers that are far worse for minor-ities and youth. The official unemployment rate doesn't provide a fullpicture: Many who would like to work full-time are working part-timebecause that's the only job they could get? and they are not includedn the unemployment rate. or does the rate include those who jointhe rolls of the disabled but who would be working if they could onlyget a job. or does it include those who have been so discouraged bytheir failure to find a job that they give up looking. This crisis though isworse than usual. With the broader measure of unemployment, by Sep-tember, 2009, more than one in six Americans who would have likedto have had a full-time job couldn't find one, and by October, matterswere worse.18 While the market is self-correctingthe bubble eventu-ally burstthis crisis shows once again that the correction may be slowand the cos enormous. The cumulative gap between the economysactual output and potential output is in the trillions.

W H O C O U L D H A V EF O R E S E E N T H E C R A S H ?

In the aftermath of the crash, both those in the financial market andtheir rcgulators claimcd, "Who could have foreseen these problems?"In fact, many critics hadbut their dir forecasts were an inconvenienttruth: too much money was being made by too many people for theirwarnings to be hcard.

I was certainly not the only person who was expecting the U.S.economy to crash, with global consequences. New York Universityeconomist Nouriel Roubini, financier George Soros, Morgan Stan-ley's Stephen Roach, Yale University housing expert Robert Shiller,and former Clinton Counci! of Economic Advisers/National Economic


19/26

T H E M A K i N G O F A C R I S I S 19

Council staffer Robert Wescott all issued repeated warnings. They wereall Keynesian economists, sharing the view that markets were not self-correcting. Most of us were worried about the housing bubble; some(such as Roubini) focused on the risk posed by global imbalances to asudden adjustment of exchange rates.

But those who had engineercd the bubble (Henry Paulson had ledGoldman Sachs to new heights of leverage, and Ben Bernanke hadallowed. the issuance of subprime mortgages to continu) maintainedtheir faith in the ability of markets to self-correctuntil they had toconfront the reality of a massive collapse. One doesn't have to have aPh.D. in psychology to understand why they wanted to pretend that theeconomy was going through jus t a minor dis turbance, one that couldeasily be brushed aside. As late as March 2007, Federal Reserve Chair-man Bernanke claimed that "the impact on the broader economy andfinancial markets of the problems in the subprime market seems likelyto be contained."19 A year later, even after the collapse of Bear Stearns,with rumors swirling about the imminent demise of Lehman Brothers ,the off ic ia l line (told not only publicly but also behind closed doorswith other central bankers) was that the economy was already on itsway to a robust recovery after a few blips.

The real estte bubble that had to burst was the most obvious symp-tom of'^economic illness." But behind this symptom were more funda-mental problems. Many had warned of the risks of deregulation. As farback as 1992, I worried that the securiti/ation of mortgages would endin disaster, as buyers and sellers a l k e underestmated the lkelihood ofa price decline and the extent of correlation.20

Indeed, anyone looking closely at the American economy could easilyhave seen that there were major "macro" problems as well as "micro"problems. As I noted earlier, our economy had been sustained by anunsustainable bubble. Without the bubble, aggregate demandthesum total of the goods and services demanded by households, firms,government, and foreignerswould have been weak, partly because ofthe growing inequality in the United States and esewhere around theworld, which shifted money f rom those would have spent it to thosewho didn't.21


20/26

20 F R E E F A L L

For years, my Columbia colleague Bruce Greenwald and I had drawnattention to the further problem of aglobal lack of aggregate demandthe total of all the goods and services that people throughout the worldwant to buy. In the world of globalization, global aggregate demand iswhat matters. If the sum total of what people around the world wantto buy is less than what the world can produce, there is a problema weak global economy. One of the reasons for weak global aggregatedemand is the growing level of reservesmoney that countries setaside for a "rainy day."

Developing countries put aside hundreds of billions of dollars inreserves to protect themselves from the high level of global volatilitythat has marked the era of deregulation, and from the discomfort theyfeel at turning to the IMF for help.22 The prime minister of one of thecountries that had been ravished by the global financial crisis of 1997said to me, "We were in the class of '97. We learned what happens ifyou don't have enough reserves."

The oil-rich countries too were accumulating reserves^they knewthat the high price of crudc was not sustainable. For some countries,there was another reason for reserve accumulation. Export-led growthhad been lauded as the best way for developing countries to grow; afternew trade rules under the World Trade Organization took away manyof the tradtional instruments developing countries used to help cratenew industries, many turned to a polcy of keeping their exchange ratescompetitive. And this meant buying dollars, selling their own curren-cies, and accumulating reserves.These were all good reasons for accumulating reserves, but they had

a bad consequencc: there was insufficient global demand. A half tril-lion doltars, or more, was being set aside in these reserves every yearin the years prior to the crisis. For a while, the United States had cometo the rescue with debt-based proflgate consumption, spending wellbeyond its means. It became the world's consumer of last resort. Butthat was not sustainable.


21/26


The Global CrisisThis crisis quickly became globaland not surprisingly, as nearlya quarter of U.S. mortgages had gone abroad.23 Unintentionally, thishelped the United States: had foreign institutions not bought as muchof its toxic instruments and debt, the situation here might have beenfar worse.24 But first the United States had exported its deregulatoryphilosophywithout that, foreigners might not have bought so manyof its toxic mortgages.25 In the end, the United States also exported itsrecession. This was, of course, only one of several channels throughwhich the American crisis became global: the U.S. economy is still thelargest, and it is hard for a downturn of this magnitude not to have aglobal impact. Moreover, global financial markets have become closelyinterlinkedevidenced by the fact that two of the top three beneficia-rles of the U.S. government bailout of AIG were foreign banks.

In the beginning, many in Europe talked of decoupling, that theywould be able to maintain growth in their economies even as Amer-ica went into a downturn: the growth in Asia would save them from arecession. It should have been apparent that this too was just wishfulthinking. Asia's economies are still too small (the entire consumption ofAsia is just 40 percent of that of the United States),26 and their growthrelies heavily on exports to the United States. Even after a massivestimulus, China's growth in 2009 was some 3 to 4 percent below whatit had been before the crisis. The world is too interlinked; a downturnin the United States could not but lead to a global slowdown. (Thereis an asymmetry: because of the immense interna! and not fully tappedmarket in Asia, it might be able to return to robust growth even thoughthe United States and Europe remain weak-a point to which I returnin chapter 8.)

While Europe's financial institutions suffered from buying toxicmortgages and the risky gambles they had made with American banks,a number of European countries grappled with problems of their owndesign. Spain too had allowed a massive housing bubble to develop andis now sufferng from the near-total collapse of its real estte market. Incontrast to the United States, however, Spain's strong banking regula-


22/26

2 2 F R E E F A L L

tions have allowed its banks to withstand a much bigger trauma withbetter results-though, not surprisingly, its overall economy has beenhit far worse.

The United Kingdom too succumbed to a real estte bubble. Butworse, under the influence of the city of London, a major Financial hub,it fell into the trap of the "race to the bottom," trying to do whateverit could to attract Financial business. "Light" regulation did no betterthere trian in the United States. Because the British had allowed theFinancial sector to take on a greater role in their economy, the cost ofthe bailouts was (proportionately) even greater. As in the United States,a culture oFhigh salaries and bonuses developed. But at least the Brit-ish understood that iFyou give taxpayer money to the banks, you have todo what you can to make sure they use it For the purposes intendedfor more Joans, not for bonuses and dividends.And at least in the U.K.,there was some understanding that there had to be accountabilitythe heads of the bailed-out banks were replacedand the British gov-ernment demanded that the taxpayers get Fair valu in return For thebailouts, not the giveaways that marked both the Obama and Bushadministrations' rescues.27

Iceland is a wonderFul example oFwhat can go wrong when a smalland open economy adopts the deregulation mantra blindly. Its well-edu-cated-people worked hard and were at the ForeFront oF modern technol-ogy. They had overeme the disadvantages oF a remote location, harshweather, and depletion oFFish stocksone oFtheir traditional sourcesoF incometo genrate a per capita income oF $40,000. Today, thereckless behavior of their banks has put the country's Future in jeopardy.

I had visited Iceland several times earlicr in this decade and warnedoF the risks oF its liberalizationpolicies.28 Ths country oF300,000 hadthree banks that took on deposits and bought assets totaling some $176billion, eleven times the country's GDP.29 Wth a dramatic collapseoF Iceland's banking system in the Fall oF 2008, Iceland became theFirst developed country in more than thirty years to turn to the IMFfor help.50 Iceland's banks had, like banks elscwhcre, taken on highleverage and high risks. When Financial markets realized the risk andstarted pulling money out, these banks (and especially Landsbanki)


23/26

T H E M A K I N G O F A C R I S I S 2 3

lured money from depositors in the U.K. and Netherlands by offeringthem "Icesaver" accounts wth high returns. The depositors foolishlythought that there was a "free lunch": they could get higher returnswithout risk. Perhaps they also foolishly thought their own governmentswere doing their regulatory Job. But, as everywhere, regulators hadlargely assumed that markets would take care of themselves. Borrowingfrom depositors only postponed the day of reckoning. Iceland could notafford to pour hundreds of billions of dollars into the weakened banks.As this reality gradually dawned on thosc who had provided funds tothe bank, it became only a matter of time before there would be a runon the banking system; the global turmoil following the Lehman Broth-ers collapse precipitated what would in any case have been inevitable.Unlike the United States, the government of Iceland knew that it couldnot bail out the bondholders or shareholders. The only questions werewhether the government would bail out the Icelandic corporation thatinsured the depositors, and how generous it would be to the foreigndepositors. The U.K. used strong-arm tacticsgoing so far as to seizeIcelandic assets using anti-terrorism lawsand when Iceland turnedto the IMF and the Nordic countrics for assistance, they nsisted thatIcelandic taxpayers bail out U.K. and Dutch depositors even beyondthe amounts the accounts had been insured for. On a return visit toIceland in September 2009, almost a year later, the anger was palpable.Why should Iceland's taxpayers be made to pay for the failure of a pri-vate bank, especially when foreign regulators had failed to do their Jobof protecting their own citizens? One widely hele! view for the strongresponse from European governments was that Iceland had exposed afundamental flaw in European integration: "the single market" meantthat any European bank could oprate in any country. Responsibilityfor regulation was put on the "home" country. But if the home coun-try failed to do its Job, citizens in other countries could lose billions.Europe didn't want to think about this and its profound mplications;better to simply make little Iceland pick up the tab, an amount someput at as much as 100 perccnt of the country's GDR31

As the crisis worsened in the United States and Europe, other coun-tries around the world suffered from the collapse in global demancl.

2 4 H R E E F A L L


24/26

Developing countries suffered especially, as remittances (transfers ofmoney from family members in developed countries) fell and capitalthat had flowed into them was greatly dirninishedand in somc casesreversed. While America's crisis began with the Financial sector andthen spread to the rest of the economy, in many of the developing coun-triesincluding those where financial regulation is far better than inthe United Statesthe problems in the "real economy" were so largethal they eventually affected the financial sector. The crisis spread sorapidly partly because of the polcies, especially of capital and finan-cial market liberalizaron, the IMF and the U.S. Treasury had foistedon these countriesbased on the same free market ideology that hadgotten the United States into trouble.32 But while even the UnitedStates finds it d i f f i cu l t to afford the trillions in bailouts and stimulus,corresponding actions by poorer countries are well beyond their reach.

The Big PictureUnderlying all of these symptoms of dysfunction is a larger truth:the world economy is undergoing seismc shifts. The Great Depres-sion coincided wilh the decline of U.S. agriculture; indeecl, agricul-tural priccs wcrc f a l l i n g even before the stock market crash in 1929.Increases in agricultural productivity were so great that a small percent-age of the population could produce a l l the food that the country couldconsume. The transition from an economy based on agriculture to onewhere manufacturing prcdominatcd was not easy. In fact, the economyonly resumed growing when the New Deal kicked in and World War IIgot people working in factorics.Today the undcr lying trend in the United States is the move awayfrom manufacturing and into the service sector. As before, this is partlybecause of the success in increasing productivity in manufacturing, sothat a small fraction of the population can produce all the toys, cars,and TVs that even the mosL materialistic and proflgate society mightbuy. But in the United States and Europc, there is an additional dimen-sin: globalization, which has meant a shift in the locus of produc-

T H E M A K I N G O F A C R I S I S 2 5


25/26

tion and comparative advantage to China, India, and other developingcountries.

Accompanying ths "microeconomic" adjustment are a set of mac-roeconomic imbalances: while the United States should be saving forthe retirement of its aging baby-boomers, it has been living beyond itsmeans, financed to a large extent by China and other developing coun-tries that have been producing more than they have been consuming.While it is natural for some countries to lend to otherssome to runtrade dficits, others surplusesthe pattern, with poor countries lend-ing to the rich, is peculiar and the magnitude of the dficits appearunsustainable. As countries get more indebted, lenders may lose con-fidence that the borrower can repayand this can be truc even for arich country like the United States. Returning the American and globaleconomy to health will require the restructuring of economies to reflectthe new economies and correcting these global imbalances.

We can't go back to where we were before the bubble broke in2007. or should we want to. There were plenty of problems withthat economyas we have just seen. Of course, there s a chance thatsome new bubble will replace the housing bubble, just as the housingbubble replaced the tech bubble. But such a "solution" would onlypostpone the day of reckoning. Any new bubble could pose dangers:the oil bubble helped pushed the economy over the brink. The longerwe delay in dealing with the underlying problems, the longer it will bebefore the world returns to robust growth.

There is a simple test of whether the United States has made suf-ficent strides in ensuring that there will not be another crisis: If theproposed reforms had been in place, could the current crisis have beenavoided? Would it have occurred anyway? For instance, giving morepower to the Federal Reserve is key to the proposed Obama regulatoryreform. But as the crisis bcgan, the Federal Reserve had more powersthan it used. In virtually every interpretation of the crisis, the Fed wasat the center of the creation of this and the previous bubble. Perhapsthe Fed's chairman has learned his lesson. But we live in a country oflaws, not of men: should we have a system requiring that the Fed first

26 F R E E F A L L


26/26

be burned by fire to ensure that another won't be set? Can we have con-fidence in a system that can depend so precariously on the economicphilosophy or understanding of one personor even of the seven mem-bers of the Board of Covernors of the Fed? As this book goes to press, itis clear that the reforms have not gone far enough.

We cannot wat until after the crisis. Indeed, the way we have beendealing -with the crisis may be making it all the more difficult to addressthese deeper problems. The next chapter outlines what we should havedone to address the crisisand why what we did fe l l far short.

:*

Stiglitz J. Cap Tulo 1. the Making of a Crisis

Documents

Transcript of Stiglitz J. Cap Tulo 1. the Making of a Crisis