Joseph Stiglitz’s recent book, Freefall [Stiglitz, Joseph E. (2010). Freefall: America, Free Markets, and the Sinking of the World Economy. New York: W. W. Norton. ISBN: 9780-0-393-07596-0], describes the factors leading to the current Great Recession. In addition, I read a pair of articles appearing in the fall 2003 and spring 2004 issues of The American Economist (subscription required but probably could be obtained through a local or academic library). These articles describe the work that earned Stiglitz the Nobel Prize in Economics in relatively nontechnical terms. Follow me below the fold to learn about Stiglitz's perspective on the current economic crisis and the theory that earned him the Nobel Prize
Chicago School (Neoclassical, neoliberal, free market) Economics
The story begins with the Chicago school of economics. The essential belief of the Chicago School, "free market," theory is that only a completely "free" market will reach full employment equilibrium and efficient resource allocation. It is the modern version of Adam Smith’s invisible hand. The invisible hand of supply and demand creates a perfect balance and every asset is fairly priced including labor. This means that restraints on the "free" market such as unions and government intervention must be eliminated in order for the "free" markets to work. Hence the "shock therapy" that Naomi Klein so graphically describes in The Shock Doctrine. The purpose of economic shock therapy is to eliminate restraints on free markets so they will reach equilibrium of full employment. In this view, the Great Recession is nothing to worry about because "it was simply the efficient adjustment of the economy to shocks" (p. 258). Government regulation, taxes, unions, social services, Social Security, Medicare, the social "safety net," and regulation of all kinds are considered hindrances to the operation of free markets. When Chicago School economists are in charge of economic interventions, all of these aspects of the economy are attacked. However, the result is not a transition to full employment and a productive society. Instead, a massive transfer of wealth from those who need it the most to those who need it the least occurs.
Stiglitz Schools the Chicago School
In order for the free market theory of the Chicago School to function as predicted, it must be assumed that information in the economic system is perfect. Stiglitz showed that the Chicago School models did not work with even slight deviations from the assumption of perfect information. He argues that information is never perfect in any practical sense and certainly not in the theoretical sense necessary for Chicago style economics to work as predicted. For example, sellers usually know more about what they are selling than buyers. The resulting asymmetries of information give rise to market power so the markets are not efficient and an advantage accrues to those with the most information. In short, the ability of the supposedly "free" market to put a fair price on goods and services goes away when information is imperfect, taking with it the entire Chicago School of neoclassical economic theory. Under these universal conditions, "market failures are pervasive" (Stiglitz, 2003, p. 25) which is exactly what we have just experienced with Chicago school economists in charge of the economy.
Stiglitz’s "Five Failure Facts" that Account for the Freefall
The story of the freefall begins with the "deregulation ideology" that had taken hold by the late 1980’s. Probably the most important aspect of deregulation was the transformation of major commercial banking institutions into investment banks that engaged in excessively risky financial behavior. Stiglitz describes five reasons why the financial system has failed so badly (pp. 114-115). These reasons explain what happened and, for me at least, establish the progressive creds of an economist who should have a major role in Obama’s administration.
- Incentives matter: the rewards were for creating products that led to freefall, and the social good of providing capital (i.e., housing loans) was ignored. "When private rewards are well aligned with social objectives, things work well; when they are not, matters can get ugly" (p. 151).
- Several banking institutions became too big to fail and their rescue was exceedingly costly and ineffective. This had created what is known in economics as a moral hazard. An economic moral hazard occurs in when an economic entity behaves in a riskier manner because they are "insured" or protected from the consequences. Many here on this website have railed against "privatization of the profits and socialization of the losses" which has occurred throughout this economic crisis. Stiglitz points out that this creates the largest "moral hazard" ever seen in the history of economics. The moral hazard is greatest in those corporations dubbed "to big to fail" because they are totally insured (by us, the taxpayers) against any of their own risky behavior. Stiglitz agrees with the equation "too big to fail = too big to exist." We cannot have such large economic entities given free rein to wreck our economy with taxpayers picking up the tab for mistakes.
- Securitization. The invention of more and more complex financial products eventually caused the products to be related to their core loans in such complex ways that their value could not be determined. These complex securities created information asymmetries which were beyond belief. Here’s an outline of the structure:
i. Mortgages were at the base. Many of the mortgages were
unaffordable, un-payable over the long term, given to individuals with inadequate or no income, and underwater from the beginning or soon after (i.e., the house value was below the loan principal).
ii. Mortgages were then bundled into derivative securities and sold, with some being kept off balance sheets by the banks. At various points in the process of creating the derivatives, rating agencies certified the securities as "safe" creating another massive information asymmetry that prevented the derivatives from being fairly and accurately priced by the markets.
iii. Bundles of mortgages were sliced into "tranches," that were ordered according to which tranche received loan payments first. Their structure allowed lower tranches to receive decent ratings. Ratings did not account for the possibility of a market collapse, an inevitable event in the case of a market bubble.
iv. More complexity was piled on as insurance against loan failures was offered (credit default swaps).
v. The result were securities with such complex relationships to the underlying mortgages that it left the banks unable to evaluate their own balance sheets.
vi. When housing prices went down, the system went into freefall because the underlying mortgages quickly went underwater so the best strategy for the original mortgagee was to walk away.
vii. This froze the lending market as the information asymmetries came full circle. After creating an exceedingly complex mishmash of loan portfolios, the banks responsible for lending came to realize that they did not even know the status of their own balance sheets. Not knowing their own balance sheets, banks correctly inferred that no other bank knew its own balance sheet. This choked off the money flow that the system needs to function. Lending was frozen. Housing prices continued to fall and the loans needed to expand businesses and create new jobs also disappeared, exacerbating the freefall.
- Commercial banks, the banks that provide mundane loans, became like investment banks, engaging in high-risk money making ventures. They gambled on the assumption that housing prices would always increase. This led to a variety of mortgage types that were doomed from the start if housing prices ever fell and of course they did.
- Finally, bankers forgot that they need to be responsible contributors to the social good. Instead, they became greedy exploiters of the public treasury.
According to Stiglitz, the public rescue of the banks violated a fundamental rule of capitalism. When a business fails, it should go bankrupt and then reorganize under our Chapter 11 laws. Of course, banks saw no contradiction in being rescued from their own immoral behavior. In fact, banks are lobbying heavily to continue operating under the assumption that rescue will be available for any of their mistakes. This creates an intolerable moral hazard in which the banks are rewarded for high-risk gambling with tremendous profit potential and no chance of a loss because they are insured by taxpayers.
Fixing a Complex System
September 15, 2008, the date that Lehman Brothers collapsed, may be to market fundamentalism (the notion that unfettered markets, all by themselves, can ensure economic prosperity and growth) what the fall of the Berlin Wall was to communism. ...Today only the deluded (which include many American conservatives, but far fewer in the developing world) would argue that markets are self-correcting and that society can rely on the self-interested behavior of market participants to ensure that everything works honestly and properly—let alone works in a way that benefits all. (p. 219)
A couple of pages later, Stiglitz makes the same point more succinctly "Free market ideology turned out to be an excuse for new forms of exploitation" (p. 221).
An economy is a complex system and it needs free markets to function efficiently. Russia’s super-managed economy had no chance of long-term success because no group of bureaucrats can ever figure out exactly what needs to be produced. We need free markets operating under the law of supply and demand, with opportunities for competition and innovation, to produce approximately the right amounts of what we need at fair prices. When monopolies and information asymmetries enter the market systems, powerful elites will exert their market power and wealth transfer from the masses to the elites will occur. We have just lived through the most massive market failure in history and its effects are still being played out. All the paper that was traded and speculated upon could not be fairly valued because of massive information asymmetries and a stupid assumption that the housing market would rise perpetually. When it became evident that the paper was worthless, or nearly so, the economy ground to a halt because bank balance sheets went negative and they could no longer make loans needed to grow the economy, especially the job market.
What Do We Want?
Stiglitz opens his concluding chapter by characterizing the recent economic freefall as a "near death" experience for the world economy that should force us to reexamine priorities and values. I have seen absolutely no signs that any of the underlying economic problems are being addressed. Not a single regulation has been passed and no one has gone to jail. The people who caused this mess remain in power. Performance and retention bonuses beyond my wildest dreams of financial success are going to those who caused this mess. Conservatives rail and vote against efforts to stimulate the economy while they turn around and accept the stimulus money for their own districts. We regularly fight to save Social Security and Medicare instead of increasing taxes on the super-rich. We pay too much attention to GDP which does not reflect the well-being of individuals in society. We spend more on healthcare than most nations while having poorer outcomes (We’re Number 37). All of this evidence suggests our economy is functioning to benefit a few elites and not the average person. We need to change this quickly.
A Book I Did Not Need to Read, but One I Really Wanted to Read
Although there were times when I thought the prose could have been more tightly edited and I wished time had been taken to include an index, I fully understand the purpose of this book which was to join the debate while it was still active rather than providing a frustrating postmortem on a dead economy. I recommend this book to any DK reader who wants to understand the current economic crisis. I did not need to read this book because I was already familiar with most of the details of the economic freefall through regular reading on DK. What I really wanted to understand was the work that earned Stiglitz the Nobel Prize in Economics and how it related to the Chicago school, so effectively described by Naomi Klein. In this goal I was a bit disappointed in Freefall. I needed to find a couple of additional Stiglitz papers in order to understand the big picture. However, I now feel I have a grasp of the big picture and it is not pretty. Stiglitz’ work basically destroys the Chicago free-market school. No one who is a member of the Chicago school should be in charge of any aspect of the economy beyond the cash in their own wallets. The Chicago school makes assumptions about the workings of an economy that do not apply to the real world. Instead, Chicago style economics is an excuse to transfer wealth from us to them.
I saw Freefall as a position paper addressed to the POTUS and I sincerely hope that Obama has it on his reading list. Going further, Stiglitz needs to play a central role in our economy as either an advisor to the POTUS or as Fed Chairman. My own academic background is in psychology and leadership studies and one of the things I have learned is that information asymmetries apply to leadership as much as they do to the economy. In order for leadership processes to function effectively a diverse flow of information is needed. Impediments on the flow of information mean that decisions are likely to have poor outcomes. Thus, the information available in the Obama administration must be diversified, and including the voice of Joseph Stiglitz is a solid way to get an important progressive voice in the administration.