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Stiglitz: It’s the stupid economists, stupid

Stiglitz says we’re still Freefall-ing

Last night I saw rock star economist Joseph Stiglitz pimp his new book give a lecture at the London School of Economics.

When I say Stiglitz is a ‘rock star’, I refer not only to his 2001 Nobel Prize, his stint as chief economist at the World Bank, or his string of professorships including his current gig at Columbia University.

I also mean:

  • Last night’s queues of hundreds of young people that stretched around the block
  • The post lecture signing of his new book, Freefall, which was as much a scrum as you’d see at the Brixton Academy
  • The glamorous after-party, which I wasn’t invited to, mainly because it was hosted by the UK Prime Minister

There is also knuckle-dusting rivalry here to rival The Stones Vs The Beatles.

Stiglitz is loving the fall from glory of the ultra-free market economists who held sway in the 1980s and 1990s, and he has only scorn for former Fed Chairman Alan Greenspan.

All good fun, but the bad news, if you believe him, is the Western world is still in a truly terrible state.

Economists are not the only fruitcakes

Stiglitz’s beef with his fellow economists is they provided an intellectual underpinning to the idea that properly free markets were always efficient, rational, and self-correcting (despite evidence that if they were so perfect, our world would look different).

Their theories in turn enabled policymakers in the US and Europe to do away with the regulation that Stiglitz believes protected us between World War 2 and the 1980s.

I broadly agree. Financial crashes and crisis were common in the pre-Depression years, and Stiglitz highlighted how they’ve become common again since the deregulation of the 1980s.

Stiglitz argues that the behaviour of banks and other financial companies that led to the credit crisis gives lie to the idea that the greed of bankers and others inevitably leads – without regulation – to a positive outcome.

“The reason that Adam Smith’s invisible hand seemed to be invisible is because it was not there!” he quipped.

The crisis revealed a catalogue of stupidities, Stiglitz said.

  • For example, he cites the banks’ previous argument that it didn’t matter if sub-prime mortgage holders couldn’t afford their mortgages, because house prices only ever went up – despite the fact incomes were going down, and people could only spend a maximum of 100% of their salaries on housing.
  • Another example – sliced-and-diced mortgage-backed securities (MBS). Bankers made billions from inventing these entirely new kinds of securities, yet the evidence they used to justify them came from data collected before MBS were invented. Either they’d changed the world, or they hadn’t.

It turned out they hadn’t.

“The reason that MBS were innovative was that they were stupid,” Stiglitz said, arguing previous generations had more common sense. (See this video about the credit crisis for more information).

As for Alan Greenspan, Stiglitz was scathing about how Greenspan urged people onto variable mortgages at a time of historically low rates.

  • Firstly, if Greenspan believed in efficient markets like he claimed to, then he should have believed you can’t win picking variable over fixed rate mortgages – except at the cost of more risk.
  • Second, it was a circular argument: The low interest rates Greenspan highlighted were only low because of “the abnormal behaviour of Alan Greenspan!”
  • Finally, if rates were 1%, “which way were they going to go?”

You didn’t need a Phd in economics to guess.

Bank bashing

You also didn’t need to be a genius to have made big money as a banker in the past few years – you just needed to take big risks.

Stiglitz pointed out that incentives for bankers were completely flawed because these supposed financial masters didn’t even distinguish between alpha – the performance added – and beta – the market return – when doling out bonuses.

Since it’s very hard to generate alpha, any self-respecting banker who had nothing to lose but his job went for beta, by greatly increasing the risk he took on behalf of the bank.

Stiglitz joked that for a while he was worried the crucial theory of incentives might need to be re-written, until the crash proved that conventional economics was right all along.

As for today’s bonuses, he used the same argument I have – that you or I could make billions borrowing billions at today’s near-0% emergency rates.

Nobody should be getting rich on this, least of all the financiers who created this mess. (Stiglitz claims the $180 billion bailout bill for AIG alone could have paid for US aid to Africa for 25 years).

Stiglitz argues for the usual radical reforms – on transparency, incentives, structural reforms and risk-taking – and supports the Volker plan in the US.

But he is sceptical anything meaningful will come to pass unless individual countries move quickly.

Banks are paying lip service to the idea of global regulation, he says, since they know it will stall more regulation for years, and that they’ll be free to make billions in the meantime.

The economy: Stiglitz’s outlook

Stiglitz is very gloomy about the financial health of the US, although ironically it helps his day job.

“Economists like a sick patient – the sicker the patient, the better,” he admitted, saying it gives more insights into the ‘pathology’ infecting the economy.

He sees symptoms of sickness everywhere:

  • Unemployment – He says one in five Americans who want a job haven’t got one, and that the US faces ‘hysteresis’ – the idea that longer-term unemployment gets stickier.
  • Housing still down – 2.5 to 3.5 million Americans will lose their homes this year, he says, and with it their life savings. A quarter of Americans are in negative equity. The market is dysfunctional, given there are homeless people and vacant houses.
  • Financial system not working – Superficially it’s in repair, but credit is still constrained and small businesses can’t get loans (partly because such loans usually use housing as collateral).
  • Commercial real estate – $0.5 trillion needs to be refinanced every year for the next five years. Bankruptcies are only just beginning.

On a brighter note, Stiglitz doesn’t seem too bothered about government deficits.

He argues, for instance, that Europe should bailout Greece immediately, to see off the ‘attacks’ from the financial markets, which he speaks about as if they consist of one man and his hedge fund, selling the world down the river.

Freefalling: Conclusions

Stiglitz covered a lot of topics – including a jokey diversion into how Asian economies were saving loads of cash because they learned what happened when they didn’t from the crash of 1997-98, as well learning first-hand the flaws of the tough policies their Western doctors proscribed, such as not bailing out their banks (policies we ourselves ignored with our own crisis).

To be honest, it was too much – as if he was reading the chapter summaries of Freefall, rather than going deeper on one theme.

Stiglitz is certainly an engagingly ‘matey’ speaker, and his diagnosis of the credit crisis’s origins is convincing. He made a strong case for financial regulation.

But in terms of the current state of the economy and the recovery, I was less convinced.

I think the economy is booming again (albeit it with long-term headwinds) and that sets me against his doom-mongering.

More importantly, it seems that now the free marketeers have been sidelined, the more Statist economists like Stiglitz think all their arguments are won.

His suggestion that banks should be lending to developing countries and supporting green technologies reminded me of Harvard professor Dani Rodrik’s lecture at the same institution six months ago on ‘Capitalism 3.0’ – another call to change the world on the back of the crash.

Sure, it would be great to save the world, except I see no evidence that banks can do it. Banks would probably just destroy value in a new wave of risk-taking.

Rather than somehow being reinvented as world saviours, I think deposit taking banks should instead be regulated into making few if any trading bets for themselves, and instead be focused on risk mitigation and transactions.

Stiglitz also annoyed me with his claim that the recovery we’ve seen so far is due to stimulus – but that it hasn’t been a big enough recovery in the US yet because Obama’s stimulus was too small.

I agree a little Keynesian counter-cyclical investment in a recession is a tonic, but not at all that crash and recovery is down to the dictate of governments.

Economic cycles go up and down in capitalist societies – ultimately regardless of political meddling.

The US economy is growing at a speedy annualised rate of 5.7%, based on the past quarter. Unemployment is a lagging indicator, and as for housing we saw here in the UK in the mid-1990s that it took years of growth before prices returned to pre-crash levels. Low house prices didn’t stop that GDP growth.

Left-leaning economists have won the case for heavier regulation of the banks and the reduction of their excessive profits (40% of US GDP before the crash, according to Stiglitz – all since gone in the aftermath, which makes you wonder what is GDP really worth as a measure of useful productivity?)

I do not think though that leftist economists have proved we should go down some socialist state-directed path for the whole economy. That is one argument that had been rightly demolished by the 1980s – and with a lot more pain along the way for citizens labouring under such regimes than we’ve suffered from the credit crisis.

We’re not freefalling now, Joe, we’re bouncing back. Let’s not lose perspective.

For more Joseph Stiglitz, read his book Freefall, which is available from Amazon in the US and in the UK.

Filed under: Commentary

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{ 8 comments… add one and remember nothing here is personal advice }
  • 1 The Investor February 9, 2010, 1:35 pm

    Update: Business Week has covered something Stiglitz said that I didn’t mention – that the UK and US deserve to keep their triple-A credit ratings.

  • 2 Financial Samurai February 9, 2010, 9:44 pm

    Good stuff! I heard The Stig speak live a couple times before. It’s always good to hear very bitter, and relatively underpaid intellects bash everybody! They have an underlying inferiority complex (despite the nobel prize) b/c they think they are smarter than everyone else, and yet don’t get paid more than everyone else. These folks are curious beings.

    Remember the phrase “those who can’t, teach”? Tell Joe to put his neck on the line and take risks. It’s fun to bounce talking heads, esp Stiglitz who tells us what went wrong, but doesn’t do anything to make things right. For that, he’s a genius!
    .-= Financial Samurai on: How To Get Your Super Motivated Boyfriend to Marry You =-.

  • 3 The Investor February 10, 2010, 2:17 am

    @Sam – Hey, good to hear your thoughts, which I sort of agree with. I think an economist is like a weatherman – good at describing what’s going on in the short-term, but useless at the long-term, and also powerless to really change events.

    “The Stig” (!) was great on diagnosing the problems that led to the credit crisis, but I certainly wasn’t convinced of all his prescriptions for going forward… I find that a lot of left-leaning economists are better at the past than the future, starting with Marx! 🙂

  • 4 Len Penzo February 10, 2010, 5:34 am

    I am jealous, Investor. I would have loved to hear Stiglitz!

    “I find that a lot of left-leaning economists are better at the past than the future.”

    Ya think? (Hyperbole on) These were essentially the same type of guys who were so good at developing the Soviet Union’s 5-year plans that resulted in the iconic long lines for everything from Vodka to toilet paper. (Hyperbole off)

    They’re still responsible for long queues now – albeit now it’s a result of them shilling their books!

    Enjoyed the review!

    Best,

    Len
    Len Penzo dot Com
    .-= Len Penzo on: The Best of the Best in Money and Personal Finance #11 =-.

  • 5 The Investor February 10, 2010, 9:40 am

    @Len – Yep: It’s worrying how the valid criticisms of the ultra-free market in the wake of the financial crisis is empowering these guys to think they’ve won battles still firmly *lost*.

    I saw a lecture a couple of weeks ago by a food expert in this country – the head of the Soil Association, a sort of organic certifying board and campaign group – and – based partly on the credit crisis, believe it or not – he was talking about how the agricultural system would be better and more secure if government and citizens twinned local towns with distant farms and guaranteed to buy all their food, and so forth.

    To hell with the free market! Layers of expensive bureaucrats to plan it all and a big Excel document can work out who wants to eat what next January – and the farmers won’t exploit this at all of course. Yeah right. Crackers! We’d be starving in three months.

  • 6 Financial Samurai February 14, 2010, 6:53 pm

    Mate, The Stig and this post is highlighted in the latest Katana wrap. Nice!
    .-= Financial Samurai on: The Katana: Happy Chinese New Year! =-.

  • 7 The Investor February 15, 2010, 12:13 am

    @Sam – Cheers. I appear to have been linked to by the Huffington Post, too, but I’m still looking. Perhaps it was in an unindex-ed comment or page. Still, the Huff. Feel the polito-wonk love.

  • 8 The Investor February 16, 2010, 11:30 am

    Update: Video podcast of Stiglitz’s lecture now available on the LSE past events podcast page.

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