In Davos, the scene is much more sombre than a year ago, and totally different
from two years ago. Then, there were relatively few purveyors of doom — I
was among them.
In a talk in 2007, I had to apologise: my worries of the past two years had
not been realised. Either the theories and evidence on which I based those
forecasts were flawed, or the problems that I foresaw – the bursting of the
housing bubble, with its attendant disruption to markets – would be even
worse. As the bubble had grown larger, so had the consequences of its
bursting. I, of course, thought the latter interpretation more likely.
Events have borne that out.
But even last January there were hopes that the real economy would be spared.
That was unlikely: finance is the lifeblood of any economy. With banks
haemorrhaging, it was going to be hard for them to keep providing the credit
needed.
But there were deeper forces at play. America had been sustained by a
consumption boom; its household savings had fallen to near zero. With the
bursting of the bubble, Americans would have neither the desire nor the
capacity to continue spending at the rate they had. And the likely size of
the cutbacks in consumption spelt serious problems.
For a while, America made up for part of the deficiency by exports. It engaged
in new “beggar-thy-neighbour” policies; a low exchange rate helped the US,
but hurt competitors, but it was only a temporary palliative. America had
exported its toxic mortgages, its deregulatory philosophy and, eventually,
its downturn. As other countries weakened, exports did, too.
Part of what was needed was a strong stimulus. Keynes had explained why, in
such situations, monetary policy is normally ineffective. He likened it to
“pushing on a string”. Companies are not going to invest much when the
economy is plummeting. And the main channel for monetary policy in the
preceding half-decade was feeding a housing bubble and consumption boom.
That game was now over.
A strong stimulus is one that delivers a big bang for the buck – and quickly.
Tax cuts work quickly but, in times like these, are relatively ineffective.
With an overhang of debt and asset values declining, most of last February’s
US tax cuts were not spent. Yet, remarkably, some are arguing that a
substantial fraction of the Obama stimulus should take the form of a tax
cut. The first focus should be on preventing further spending cutbacks; with
states and localities limited to spending what they receive in revenues, and
with tax revenues falling precipitously, making up for this shortfall is the
natural place to begin.
Second, spending should have as positive a long-run impact as possible. To be
sure, the spending will lead to a rise in indebtedness. But if it creates an
asset, whether human capital, infrastructure or new technologies, then the
nation’s balance sheet may even be improved. Tax cuts aimed at promoting
consumption simply increase liabilities, with no asset to match.
Carefully designed business tax cuts, linked to higher investment, can provide
a big bang for the buck and raise productivity. Unfortunately, some of
business tax cuts being discussed in the US are likely to have minimal
effect on investment.
It is remarkable how countries can be so penny-wise and pound-foolish.
Politicians squabble for weeks over how or whether to spend a relatively
small amount. Yet, in almost a blink of the eye, a $700 billion blank cheque
was given to bail out banks. We need to put that in proportion: it is
greater than all of the foreign aid from rich to poor countries for seven
years. It could put US social security on a sound footing for a century.
The hundreds of billions given to the banks have not done what was promised.
Credit is not flowing. Part of the reason is that the bailout was not well
thought through. As we were pouring money into the banks, they were pouring
money out. The fundamental problem is simple: the incentives of the banks do
not coincide with national concerns. Markets work well when private rewards
and social returns are well aligned. They have not been well aligned in the
financial sector: perverse incentives lead to shortsighted behaviour and
excessive risk-taking. Not even bank shareholders have been served well,
although the banks’ managers walked away with billions.
This long-festering problem has reached new proportions. The value of
government-provided capital now dwarfs remaining shareholder equity, yet in
the US the national interest does not even have a seat at the table. In
managing the bailouts, the Federal Reserve and Treasury failed to take into
account the large change in markets in recent years. Some big banks boasted
of transforming themselves from being in the storage business to being in
the moving business. A disproportionate part of the money went into saving
the moving business. Attention should have focused on maximising bang for
the buck in bailouts. That would have meant giving more to regional and
community banks. It would have meant linking the cash to maintenance of
credit.
There was a trickle-down strategy: throwing money at the banks would trickle
down to the rest of the economy. A trickle-up strategy, to prevent
foreclosures, would almost surely have been far more successful. Too much
attention was directed at saving failed and flawed institutions, too little
at creating new alternatives. Think what $700 billion might have done, were
it used to capitalise some new banking institutions. At modest leverage of
12 to 1, it would have financed $8.4 trillion of credit, enough to meet
America’s needs.
There are two other concerns that should guide reforms. First, national debt
has ballooned, especially in the US. So, not only do we have to be sure we
get the most bang for the buck, but we have to get the best return. Congress
intended to provide money in a way that generated as high a taxpayer return
from these risky investments as possible. In practice, America got a raw
deal. This means that US national debt ten years on will be larger, perhaps
much larger.
The second concern is that in solving immediate problems, we do not create
problems for the future. Part of the present problem is that we let banks
grow too big to fail. Yet we have encouraged consolidation. And by making
clear that we will bail out large banks we enhanced “moral hazard”: banks
know that if they gamble and win, they walk off with the proceeds; if they
lose, the taxpayer picks up the tab.
One reason that matters in the US have turned out so badly is that we left
much of the responsibility for getting us out of the mess with those who
created it. At first, they acted as if it was just a matter of confidence:
if government shows it is willing to spend a lot, confidence will be
restored – and then it won’t even have to spend the money. What foolishness!
The banks had made bad loans; there was a bubble, and it had burst. These
were not matters of confidence, but hard realities.
But even now, there are many who seem to believe they did little wrong: it was
a once-in-100-years flood that could not have been anticipated, rather than
something they caused and which has occurred repeatedly. Everybody is
talking of regulatory reform. But for some, it is a matter of moving boxes
around, cosmetic reforms that may weaken regulation.
The deeper question is how far should these events change our views of the
market economy and capitalism? Is there a flaw in the plumbing, and all we
need to do is call in a plumber to fix the leak? Or has this crisis revealed
more fundamental problems, which will require more profound changes in our
economic system?
— Joseph Stiglitz is Professor of Economics at Columbia University. He
received the Nobel Prize for Economics in 2001, served as chairman of the US
Council of Economic Advisers to President Clinton and was chief economist of
the World Bank. His recent books include The Three Trillion Dollar War,
with Linda Bilmes, and The Roaring Nineties.
