FREEFALL

America, Free Markets and the Sinking of the World Economy BY JOSEPH STIGLITZ
Joseph Stiglitz is a former Chief Economist for the World Bank, he s a professor at Columbia University, and he s won the Nobel Prize in Economic Sciences and the John Bates Clark Medal, which is awarded by the American Economic Association and is second to the Nobel in terms of prestige. Stiglitz won the Nobel Prize in Economics and attained international acclaim for his work demonstrating the asymmetry of information in markets and rebutting the notion that markets are inherently efficient. The zero-sum nature, in which one person s loss is another s gain, combined with the presence of externalities in and of themselves are evidence of inefficiencies. A common theme throughout Freefall is the belief that it is government s obligation to minimize the impact of negative externalities through a thorough, but not overreaching regulatory system, while maximizing the prevalence of positive externalities with a more forward-looking economic stimulus that generates increased investment and jobs growth. In chapter four Stiglitz tells the story of the housing bubble's emergence and bursting. Stiglitz explains how the availability of cheap money, combined with outright mortgage fraud and deceptive and predatory lending practices put millions of people into homes they couldn t afford and caused real estate prices to skyrocket. That created a bubble that inevitably pop. Many who were sold sub-prime mortgages were ill equipped to understand what they were taking on, and yet they lost their homes, life savings, and dreams of a better future. Many were driven to divorce, some to suicide. The `deregulation frenzy' of the eighties and nineties left these people ill protected. Some of the thrust for deregulation was undoubtedly inspired by political campaign donations by Financial Institutions. Many of the financial products that were bought and sold by the banks were based on flawed models which were often evaluated by `lawyers untrained in the subtle mathematics of the models'. Stiglitz points out now-familiar problems, and in particular runaway securitization in a lack of transparency, an excess of complexity, poor corporate governance, the "too big to fail" syndrome and the rest. He also notes the lax regulation that permitted such things as questionable accounting, information asymmetries, predatory lending and of course, the excesses to which the combination of the conflicts of interest between commercial banking and investment banking with greed run amok lent themselves-in cases a matter of regulation failing to keep up with innovation in the development of financial devices, though in others a matter of the financial community's effective resistance to and reversal of regulations, such as the Gramm-Leach-Bliley Act of 1999 which repealed Glass-Steagall, and the irresponsibility of the Federal Reserve as overseen by Alan Greenspan and Ben Bernanke. In the end of the chapter the author mentions the foreclosure could have been avoided , if only the government , instead of following the course of Bush administration and direct most of its efforts at rescuing the banks, would have followed some of the simple proposals in this chapter. One out of four Americans have a mortgage are underwater: They owe more money on their home than the value of their home. Their home used to be what they used as the reserve for paying their kids college education, for their retirement. Now it's a liability, not an asset. The markets failed in societal functions of managing risk and the mixed motivations of the Rating Agencies meant that the Institutions were not adequately appraised of the risks that they were taking. "In short, there was little or no effective quality control". Securitization did indeed spread risk but this

was more than negated by the asymmetries of information. In other words people had little idea of the detail of what they were buying. The solution to deal with this forclosure situation is seen by Stiglitz in the laws called Chapter 11 , who are ment to give a fresh start to corporations, keeping the jobs and the corporation going as an ongoing enterprise. From Stiglitz point of view , families are as important as corporations. Keeping kids in school, not forcing them out of their home, keeping the community together, is certainly as important as keeping a corporation alive. So Stiglitz calls for a homeowner's Chapter 11. What should be done would be to write down the mortgage, what they owe, to the value of the house. And you convert the debt into, make the bank, in a sense, the new equity owner. And when they, sometime in the future, sell the home, if there is a capital gain they share that with the bank. That's the way the bank is protected. Nobody would do this just to escape; there is accountability here. But it gives homeowners a fresh start and it would deal with a significant part of our foreclosure problem. In the chapter titled "The Great American Robbery" he details the story of how the bail-outs essentially pumped money into the system with too few strings attached, let alone the absence of the kinds of meaningful reform that would resulted in a sounder financial system over the long term, while the Federal Reserve massively expanded the money supply. Stiglitz discusses alternative approaches to the problem, such as a "trickle-up" bail-out approach which would have helped the banks by helping homeowners meet their obligations. He also offers a wide array of ideas for reorganizing the financial system on a more sustainable basis, not least the restoration of Glass-Steagall "in some form," as well as the establishment of an Electronic Funds Transfer System that would enable everyday financial transactions to occur outside the banks, and a Financial Products Safety Commission to facilitate tighter regulation of activities like mortgage lending and the packaging and selling of derivatives. Stiglitz appears to favour some sort of bankruptcy proceeding for banks, as well as legislating for a return to the separation of commercial banks from investment banks, amongst other measures. Stiglitz also examines the stimulus program and finds it to be too slow in arriving, too small, too shortterm and too poorly directed-especially in the parts going into tax cuts, and incompletely filling in the holes in state budgets rather than launching new initiatives-or doing anything meaningful about the mortgage problem. In chapter 5, Stiglitz replays the debate of a year ago over how to rescue the financial system a debate that pitted Stiglitz, Paul Krugman, Nouriel Roubini, and others, who favored government takeovers of sick banks, against Tim Geithner, who convinced the rest of the administration that it was better to support the banks in their existing form. Almost surely, the failures of the Bush and Obama administrations will rank among the most costly mistakes of any modern democratic government at any time . The Bush and Obama administrations had made a simple mistake . . . that the banks pursuit of their own self-interest was necessarily coincident with what was in the national interest. . . . Nor did the deregulators and the politicians who stood behind them want to admit the failure of the economic doctrines that they had advocated. They wanted to return to the world as it was before 2007 . Just as Bush used 9/11 and the fears of terrorism to justify so much of what he did, the Treasury under both Bush and Obama used 9/15 the day that Lehman collapsed and the fears of another meltdown as

a tool to extract as much as possible for the banks and the bankers that had brought the world to the brink of economic ruin .

The problem, Stiglitz argues, is that even if the financial system was stabilized, the way it was stabilized has made the recovery slower and more difficult than need be , and has also helped undermine public confidence in government, exacerbating the dysfunctions of our political system. The core of this book lies in Stiglitz's account of the US policy response, which he believes has been a string of disasters. Disaster number one, he says, was Barack Obama's instinctive conservatism. He chose a "muddle-through" strategy, which, though it may have seemed low-risk politically, has turned out to be highly risky for the 16 million Americans who have no job, and the two million families whose homes have been repossessed. And, crucially, Obama refused to formulate a vision because, Stiglitz says, his whole electoral appeal was based on feel-good vagueness: "While the risks of formulating a vision were clear, so were those of not having one. Without a vision the whole 'reform' process might be seized by those in the financial sector, leaving the country with a financial system that was even more fragile than the one that had failed." And so it came to pass. Disaster number two, he believes, was the decision to maintain most of the personnel of the very Bush administration that had fuelled the cycle of boom and bust, supplementing them with a team of right-wingers from the Clinton years. Disaster number three was the way Obama maintained the revolving door between Wall Street and Washington, which put former bankers in charge of regulating for the future and overseeing quid pro quo from America's bailed-out billionaires. Disaster number four was the meagre scale of the fiscal stimulus, which, the author argues, is failing to make an impact and will require a second stimulus. He predicts a Japanese-style recovery in the United States, with the economy facing a prolonged period of below-potential output and problems such as excess borrowing, high consumption and low wages still not sorted out. At the centre of the policy response Stiglitz advocates is the state. The state should have forced the banks to restructure financially at the height of the crisis, wiping out their shareholders, and handing ownership and control to those who held their debts, a large portion of which would in any case have been state-owned. Stiglitz does not argue for outright nationalisation: his is a market-based solution that involves properly applying the rules of the market to the banks. He correctly identifies what stopped Obama doing this, over and above the influence of leading Wall Street personnel: the belief that the banks were too big to fail, or to restructure - or, to put it another way, that the state was too small. With the chance for that now gone, Stiglitz advocates a forcible break-up of the top banks, a comprehensive set of regulations, and statutory protection for the consumers of financial products. This, he argues, has to be done within the framework of a much bigger restructuring of the US economy, and a rethinking of America's role in the world. In the chapter titled Avarice Triumphs over Prudence , Stiglitz is highly critical when it comes to financial regulation although here he aims his guns more at the financial sector than at the administration. Because of the threat of regulatory capture, he favors simple rules: the regulations have to be simple and transparent, and the regulatory structure has to be designed to prevent excessive influence from the financial markets . The author's line is clear. The banks need to be brought to heel and forced, through strict regulation, to confine their attention to what they were designed to do in the first place: act as a safe haven for

people's money and as a source of (properly assessed) loans for homes and businesses. Nothing more. Banking should be "simple and dull". Money should be a means of exchange and not a commodity in its own right. Simple principles; massive changes. Among the largest is that the developed West, needs to admit that their way is neither the only way nor remotely the best way. On the regulatory front, the author concludes that banks should hold more capital. There should be greater regulation of financial innovation and further standardisation of derivatives. And Stiglitz is supportive of the arguments put by Volcker and Mervyn King to the effect that if banks are too big to fail they are too big to survive, and should be broken up. The chapter offers a reluctant but persuasive elaboration of how the Obama administration decided to embrace the financial sector and the Fed, continuing and enlarging both the bailout and the too-big-tofail philosophy that it inherited from George W. Bush. The answer given by Stiglitz in Freefall, to "what went wrong" is, in sum, that the meltdown wascaused by a combination of greedy bankers, deregulation of the financial markets, and cheap money. Between them they created a bubble, in which vastly over-valued real estate funded unsustainable levels of consumption in the U.S. When (and the procession of outsize adjectives has to continue) huge financial institutions with huge bad debts found themselves slipping over the edge into de facto bankruptcy in 2008 as a result, the rest of the world went with them. The examination Stiglitz subjects the crisis to is frank and unsparing, and he is not shy about naming names where he feels it is appropriate: Tim Geithner and Larry Summers, Obama's top economics men, come in for as much criticism as Alan Greenspan for the role he played during the Bush years. But the book is not all explanation and attribution of culpability. It also strongly argues a case for what should be done next. Foremost among the proposals is a fully global and transparent system of financial regulation that tackles such big problems as the incentive schemes which lead to undue risk-taking, gambling and short-termism, as well as the question of whether the world can continue to afford too-big-to-fail financial institutions. Stiglitz's prescriptions for the future are convincing, and everything he says is leavened by an admirable concern for the ordinary men and women who are the true victims of the bankers' greed and unaccountability, and the lack of protection afforded them by regulation. The fact that Stiglitz has for years been warning that the free-for-all financial system was heading for trouble adds weight and value to all he says.