Joseph E. Stiglitz
How to Fail to Recover
Joseph E. Stiglitz
)
NEW YORK – Some people thought that Barack Obama’s election would turn everything around for America. Because it has not, even after the passage of a huge stimulus bill, the presentation of a new program to deal with the underlying housing problem, and several plans to stabilize the financial system, some are even beginning to blame Obama and his team.
Obama, however, inherited an economy in freefall, and could not possibly have turned things around in the short time since his inauguration. President Bush seemed like a deer caught in the headlights –�paralyzed, unable to do almost anything – for months before he left office. It is a relief that the US finally has a president who can act, and what he has been doing will make a big difference.
Unfortunately, what he is doing is not enough. The stimulus package appears big – more than 2% of GDP per year – but one-third of it goes to tax cuts. And, with Americans facing a debt overhang, rapidly increasing unemployment (and the worst unemployment compensation system among major industrial countries), and falling asset prices, they are likely to save much of the tax cut.
Almost half of the stimulus simply offsets the contractionary effect of cutbacks at the state level. America’s 50 states must maintain balanced budgets. The total shortfalls were estimated at $150 billion a few months ago; now the number must be much larger – indeed, California alone faces a shortfall of $40 billion.
Household savings are finally beginning to rise, which is good for the long-run health of household finances, but disastrous for economic growth. Meanwhile, investment and exports are plummeting as well. America’s automatic stabilizers –�the progressivity of our tax systems, the strength of our welfare system – have been greatly weakened, but they will provide some stimulus, as the expected fiscal deficit soars to 10% of GDP.
In short, the stimulus will strengthen America’s economy, but it is probably not enough to restore robust growth. This is bad news for the rest of the world, too, for a strong global recovery requires a strong American economy.
The real failings in the Obama recovery program, however, lie not in the stimulus package but in its efforts to revive financial markets. America’s failures provide important lessons to countries around the world, which are or will be facing increasing problems with their banks:
- Delaying bank restructuring is costly, in terms of both the eventual bailout costs and the damage to the overall economy in the interim.
- Governments do not like to admit the full costs of the problem, so they give the banking system just enough to survive, but not enough to return it to health.
- Confidence is important, but it must rest on sound fundamentals. Policies must not be based on the fiction that good loans were made, and that the business acumen of financial-market leaders and regulators will be validated once confidence is restored.
- Bankers can be expected to act in their self-interest on the basis of incentives. Perverse incentives fueled excessive risk-taking, and banks that are near collapse but are too big to fail will engage in even more of it. Knowing that the government will pick up the pieces if necessary, they will postpone resolving mortgages and pay out billions in bonuses and dividends.
- Socializing losses while privatizing gains is more worrisome than the consequences of nationalizing banks. American taxpayers are getting an increasingly bad deal. In the first round of cash infusions, they got about $0.67 in assets for every dollar they gave (though the assets were almost surely overvalued, and quickly fell in value). But in the recent cash infusions, it is estimated that Americans are getting $0.25, or less, for every dollar. Bad terms mean a large national debt in the future. One reason we may be getting bad terms is that if we got fair value for our money, we would by now be the dominant shareholder in at least one of the major banks.
- Don’t confuse saving bankers and shareholders with saving banks. America could have saved its banks, but let the shareholders go, for far less than it has spent.
- Trickle-down economics almost never works. Throwing money at banks hasn’t helped homeowners: foreclosures continue to increase. Letting AIG fail might have hurt some systemically important institutions, but dealing with that would have been better than to gamble upwards of $150 billion and hope that some of it might stick where it is important.
- Lack of transparency got the US financial system into this trouble. Lack of transparency will not get it out. The Obama administration is promising to pick up losses to persuade hedge funds and other private investors to buy out banks’ bad assets. But this will not establish “market prices,” as the administration claims. With the government bearing losses, these are distorted prices. Bank losses have already occurred, and their gains must now come at taxpayers’ expense. Bringing in hedge funds as third parties will simply increase the cost.
- Better to be forward looking than backward looking, focusing on reducing the risk of new loans and ensuring that funds create new lending capacity. Bygone are bygones. As a point of reference, $700 billion provided to a new bank, leveraged 10 to 1, could have financed $7 trillion of new loans.
The era of believing that something can be created out of nothing should be over. Short-sighted responses by politicians – who hope to get by with a deal that is small enough to please taxpayers and large enough to please the banks – will only prolong the problem. An impasse is looming. More money will be needed, but Americans are in no mood to provide it – certainly not on the terms that have been seen so far. The well of money may be running dry, and so, too, may be America’s legendary optimism and hope.
Copyright: Project Syndicate, 2009.
www.project-syndicate.org
tvselvakumaran 08:24 16 Mar 09
Professor Joseph Stiglitz discusses two issues in this article -- (i) the stimulus package, and (ii) the crisis in the financial markets. I have some points to make on these two issues:
(i) Misconception: if the stimulus bill is not large enough, it would not deliver a recovery.
By the end of Summer 2008, political support for a new stimulus bill began to gather in earnest. At that time, it was not known for certain whether the American economy was in a recession. Now, in recent decades, a large number of research papers have been written combining insights from Keynesian theory with business cycle theory towards the aim of smoothening the fluctuations in the business cycle. In fact, the boom in East Asian economies that extended to more than 25 years before 1997, and the 63-year long recession-less growth in the world economy since the end of the second world war, lent credence to the view among academic economists that a recession could be made short and shallow, if not altogether bypassed. As a result, throughout Fall 2008, many economists repeatedly stated that if the stimulus bill is not large enough, it would not lead to a recovery.
Sometime during the winter of 2008, NBER announced that the American economy had actually been in recession since December 2007. It was after this announcement that there was a realization that the current economic recession is a really serious one, and cannot be wished away by a massive one-time stimulus bill. Till then, economists had been pre-occupied with preventing the crisis in the financial system from spreading to the real economy. However, the realization of a serious economic crisis came too late. The political momentum for a massive one-time stimulus bill had already been set in motion. Moreover, since it was now getting very difficult to justify a huge one-time stimulus bill on a theoretical basis, some political compromises had to be made to get bi-partisan support. As a result, a large part of the $800-billion stimulus bill was marked for tax cuts.
However, there were some sensible last-minute adjustments. With the economy already mired in a serious recession, a massive stimulus spending would be like flogging a dead-tired horse. So, the sensible approach was to change the focus of the bill towards structural re-adjustment rather than a stimulus, and backload much of the spending to 2010. Keynesian theory requires continuous monitoring of the markets to enable the central bank or the government to step in and take corrective measures whenever it is obvious that the resource allocations made by the markets would not be optimal in the long run. There is no provision in Keynesian theory to spend several trillion dollars at one time, so that a recession can be postponed by a decade, say. Hence, it would have been better to enact a series of small spending bills to come into effect every three months or so. With the flexibility of tuning the spending according to how the economy reacts to the current recession during each three month interval, it would have provided a much better support for the economy to fight its way out of the recession.
(ii) Financial markets: Recently, Professor Nouriel Roubini has argued that the US financial system is effectively insolvent (Ref: his March 5, 2009 article on Forbes.com). By his calculations, the total losses in the financial system is about $3.6 trillion, of which about half ($1.8 trillion) would have to be absorbed by US financial institutions and the other half by foreign institutions. But the total capital in the US financial institutions is only about $1.4 trillion. Hence the financial system is insolvent, and it needs to be nationalized quickly, in his opinion. Here, I would like to point out that it has always been the case that the estimates for losses in any crisis keep changing dynamically. For example, during the 1989 - 91 S & L crisis, initial estimates for the bank losses ran up as high as 500 billion dollars during 1988 - 90. However when the American economy grew robustly after 1992, the Resolution Trust Council (RTC) was able to sell off the foreclosed assets at reasonably good prices, and reduce the total losses to as low as 100 billion dollars.
Secondly, Professor Roubini's solution to the insolvency of the financial system is that the banks should be nationalized quickly. This solution is fraught with grave danger. Nationalizing banks would lead to the problem of 'socializing losses and privatizing gains', which Professor Joseph Stiglitz points out above. Just today (March 16, 2009), a Wall Street Journal article disclosed that more than two-thirds of the $173 billion of Federal aid given to bailout AIG so far has gone to counter-parties to cover their damages in their CDS and insurance contracts with AIG. These counterparties include (i) municipalities within the US, (ii) foreign institutions, and (iii) well-known US financial institutions like Citigroup, Barclays, UBS, Goldman Sachs, Morgan Stanley, etc. The fundamental truth is that the financial system benefits some people more than others. No matter how quickly Professor Roubini is able to get the government to nationalize insolvent banks, he would find that well-connected financiers have already returned the institutions under their charge to profitability, mostly by using public money, all done through perfectly legal means.
An alternative solution proposed by Professor Kenneth Rogoff is for the Federal Reserve to print a lot of money and invest it to the financial institutions. This would re-capitalize the financial institutions and save them from bankruptcy. Moreover, in a few months, there would be widespread inflation. This would help the home-owners because inflation would reduce the relative severity of their mortgage debts. Since most of the households in America are also immersed in credit card debt, inflation would help them there as well. In addition, the government could spend massively by way of fiscal deficits to ensure that deflationary forces are surely defeated. This solution has the additional feature of fitting in nicely with the Rogoff doctrine, which recommends that Western economies go through a period of sub-optimal growth in order to avoid a global price war for commodities. (The Rogoff doctrine was published in the Financial Times on July 29, 2008).
China was quick to wake up to Professor Rogoff's solution for the financial crisis. Inflation would benefit everybody inside the United States in their current predicament of debt obligations that are disproportionate to their incomes. However, it would severely affect those countries, like China and Japan, which are holding trillions of dollars as foreign currency reserves. To preserve the relative value of its dollar reserves, China has announced its own two-year fiscal spending program of 4 trillion yuan to ensure that its annual GDP grows at a rate of 8%+. The biggest losers in this inflation game would be the poor countries who could not possibly finance their deficits. Even if they did, many of the poor countries do not have a democratic framework in order to hold their rulers to account for the deficit spending.
In October 2008, I proposed a simple low-cost solution for the financial crisis (Ref: Q5 in my "FAQ on the Financial Crisis"). I would like to make one point here that I have not made elsewhere: my solution has the unique feature that it is sustainable. To make this point clear, consider the phenomenon of consumer spending. The global supply chain connects to factories where goods are produced. These factories, in turn, connect to the distribution channels that apply just-in-time technology to stock their retail outlets. The consumer then goes through the shopping experience at the shopping malls or online stores. Consumer shopping trends are cyclical, with each annual cycle having several seasonal cycles as well. In case, there is an over-production of goods during one particular shopping season or a dullness in consumer demand, the stores immediately announce discounts and price cuts.
These price reductions benefit the consumer directly, and they work all the way back through the distribution channels and the supply chain. In this way, a sustainable feedback loop helps to implement an 'informal contract' between the consumer at one end, and all the other participants of the supply network at the other end. And this unwritten contract, in effect, extends over many years. In fact, this mechanism for price adjustments has become an integral part of the consumer culture of the 20th century. My solution for the mortgage crisis aims to provide an analogous feedback loop that connects the security-owners on Wall Street with the home-owners on Main Street.
skydancer 01:35 25 Jul 09
greetings Dr. S....if it's good to have a government offered health insurance program....why not a government offered bank.....create the National Federal Reserve Credit Union.....loan money to citizens at the current Fed rate of 0.25....issue credit cards and make loans at the same rate....have checking and savings accounts.....fully nationalize Freddie and Fannie, lower interest rates and do away with compound interest.....pay the employees a decent living, not less than $50K nor more than $200K/year....well you get the idea, the question is how to make it a reality......?
alexferro 05:02 15 Mar 09
Perhaps we could avoid further messes by adopting financial markets rules inspired on Canadian ones. Their banks dont seem to be suffering from what ails ours.