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斯蒂格利茨:Freefall (第一章节选)

Freefall: the World Economy and the Great Recession

Freefall: the World Economy and the Great Recession


 America, Free Markets, and the Sinking of the World Economy by Joseph E. Stiglitz
An Excerpt



The only surprise about the economic crisis of 2008 was that it came as a surprise to so many. For a few observers, it was a textbook case that was not only predictable but also predicted. A deregulated market awash in liquidity and low interest rates, a global real estate bubble, and skyrocketing subprime lending were a toxic combination. Add in the U.S. fiscal and trade deficit and the corresponding accumulation in China of huge reserves of dollars--an unbalanced global economy--and it was clear that things were horribly awry. 
What was different about this crisis from the multitude that had preceded it during the past quarter century was that this crisis bore a "Made in the USA" label. And while previous crises had been contained, this "Made in the USA" crisis spread quickly around the world. We liked to think of our country as one of the engines of global economic growth, an exporter of sound economic policies--not recessions. The last time the United States had exported a major crisis was during the Great Depression of the 1930s.

The basic outlines of the story are well known and often told. The United States had a housing bubble. When that bubble broke and housing prices fell from their stratospheric levels, more and more homeowners found themselves "underwater." They owed more on their mortgages than what their homes were valued. As they lost their homes, many also lost their life savings and their dreams for a future--a college education for their children, a retirement in comfort. Americans had, in a sense, been living in a dream.

The richest country in the world was living beyond its means, and the strength of the U.S. economy, and the world's, depended on it. The global economy needed ever-increasing consumption to grow; but how could this continue when the incomes of many Americans had been stagnating for so long? Americans came up with an ingenious solution: borrow and consume as if their incomes were growing. And borrow they did. Average savings rates fell to zero--and with many rich Americans saving substantial amounts, that meant poor Americans had a large negative savings rate. In other words, they were going deeply into debt. Both they and their lenders could feel good about what was happening: they were able to continue their consumption binge, not having to face up to the reality of stagnating and declining incomes, and lenders could enjoy record profits based on ever-mounting fees.

Low interest rates and lax regulations fed the housing bubble. As housing prices soared, homeowners could take money out of their houses. These mortgage equity withdrawals--which in one year hit $975 billion, or more than 7 percent of GDP (gross domestic product, the standard measure of the sum of all the goods and services produced in the economy)--allowed borrowers to make a down payment on a new car and still have some equity left over for retirement. But all of this borrowing was predicated on the risky assumption that housing prices would continue to go up, or at least not fall.

The economy was out of kilter: two-thirds to three-quarters of the economy (of GDP) was housing related: constructing new houses or buying contents to fill them, or borrowing against old houses to finance consumption. It was unsustainable--and it wasn't sustained. The breaking of the bubble at first affected the worst mortgages (the subprime mortgages, lent to low-income individuals), but soon affected all residential real estate.

When the bubble popped, the effects were amplified because banks had created complex products resting on top of the mortgages. Worse still, they had engaged in multibillion-dollar bets with each other and with others around the world. This complexity, combined with the rapidity with which the situation was deteriorating and the banks' high leverage (they, like households, had financed their investments by heavy borrowing), meant that the banks didn't know whether what they owed to their depositors and bondholders exceeded the value of their assets. And they realized accordingly that they couldn't know the position of any other bank. The trust and confidence that underlie the banking system evaporated. Banks refused to lend to each other--or demanded high interest rates to compensate for bearing the risk. Global credit markets began to melt down.

At that point, America and the world were faced with both a financial crisis and an economic crisis. The economic crisis had several components: There was an unfolding residential real estate crisis, followed not long after by problems in commercial real estate. Demand fell, as households saw the value of their houses (and, if they owned shares, the value of those as well) collapse and as their ability--and willingness--to borrow diminished. There was an inventory cycle--as credit markets froze and demand fell, companies reduced their inventories as quickly as possible. And there was the collapse of American manufacturing.

There were also deeper questions: What would replace the unbridled consumption of Americans that had sustained the economy in the years before the bubble broke? How were America and Europe going to manage their restructuring, for instance, the transition toward a service-sector economy that had been difficult enough during the boom? Restructuring was inevitable--globalization and the pace of technology demanded it--but it would not be easy.


While the challenges going forward are clear, the question remains: How did it all happen? This is not the way market economies are supposed to work. Something went wrong--badly wrong.

There is no natural point to cut into the seamless web of history. For purposes of brevity, I begin with the bursting of the tech (or dot-com) bubble in the spring of 2000--a bubble that Alan Greenspan, chairman of the Federal Reserve at that time, had allowed to develop and that had sustained strong growth in the late 1990s. Tech stock prices fell 78 percent between March 2000 and October 2002. It was hoped that these losses would not affect the broader economy, but they did. Much of investment had been in the high-tech sector, and with the bursting of the tech stock bubble this came to a halt. In March 2001, America went into a recession.

The administration of President George W. Bush used the short recession following the collapse of the tech bubble as an excuse to push its agenda of tax cuts for the rich, which the president claimed were a cure-all for any economic disease. The tax cuts were, however, not designed to stimulate the economy and did so only to a limited extent. That put the burden of restoring the economy to full employment on monetary policy. Accordingly, Greenspan lowered interest rates, flooding the market with liquidity. With so much excess capacity in the economy, not surprisingly, the lower interest rates did not lead to more investment in plant and equipment. They worked--but only by replacing the tech bubble with a housing bubble, which supported a consumption and real estate boom.

The burden on monetary policy was increased when oil prices started to soar after the invasion of Iraq in 2003. The United States spent hundreds of billions of dollars importing oil--money that otherwise would have gone to support the U.S. economy. Oil prices rose from $32 a barrel in March 2003 when the Iraq war began to $137 per barrel in July 2008. This meant that Americans were spending $1.4 billion per day to import oil (up from $292 million per day before the war started), instead of spending the money at home. Greenspan felt he could keep interest rates low because there was little inflationary pressure, and without the housing bubble that the low interest rates sustained and the consumption boom that the housing bubble supported, the American economy would have been weak.

In all these go-go years of cheap money, Wall Street did not come up with a good mortgage product. A good mortgage product would have low transaction costs and low interest rates and would have helped people manage the risk of homeownership, including protection in the event their house loses value or borrowers lose their job. Homeowners also want monthly payments that are predictable, that don't shoot up without warning, and that don't have hidden costs. The U.S. financial markets didn't look to construct these better products, even though they are in use in other countries. Instead, Wall Street firms, focused on maximizing their returns, came up with mortgages that had high transaction costs and variable interest rates with payments that could suddenly spike, but with no protection against the risk of a loss in home value or the risk of job loss.

Had the designers of these mortgages focused on the ends--what we actually wanted from our mortgage market--rather than on how to maximize their revenues, then they might have devised products that would have permanently increased homeownership. They could have "done well by doing good." Instead their efforts produced a whole range of complicated mortgages that made them a lot of money in the short run and led to a slight temporary increase in homeownership, but at great cost to society as a whole.

The failings in the mortgage market were symptomatic of the broader failings throughout the financial system, including and especially the banks. There are two core functions of the banking system. The first is providing an efficient payments mechanism, in which the bank facilitates transactions, transferring its depositors' money to those from whom they buy goods and services. The second core function is assessing and managing risk and making loans. This is related to the first core function, because if a bank makes poor credit assessments, if it gambles recklessly, or if it puts too much money into risky ventures that default, it can no longer make good on its promises to return depositors' money. If a bank does its job well, it provides money to start new businesses and expand old businesses, the economy grows, jobs are created, and at the same time, it earns a high return--enough to pay back the depositors with interest and to generate competitive returns to those who have invested their money in the bank.

The lure of easy profits from transaction costs distracted many big banks from their core functions. The banking system in the United States and many other countries did not focus on lending to small and medium-sized businesses, which are the basis of job creation in any economy, but instead concentrated on promoting securitization, especially in the mortgage market. 
It was this involvement in mortgage securitization that proved lethal. In the Middle Ages, alchemists attempted to transform base metals into gold. Modern alchemy entailed the transformation of risky subprime mortgages into AAA-rated products safe enough to be held by pension funds. And the rating agencies blessed what the banks had done. Finally, the banks got directly involved in gambling--including not just acting as middlemen for the risky assets that they were creating, but actually holding the assets. They, and their regulators, might have thought that they had passed the unsavory risks they had created on to others, but when the day of reckoning came--when the markets collapsed--it turned out that they too were caught off guard.


As the depth of the crisis became better understood--by April 2009 it was already the longest recession since the Great Depression--it was natural to look for the culprits, and there was plenty of blame to go around. Knowing who, or at least what, is to blame is essential if we are to reduce the likelihood of another recurrence and if we are to correct the obviously dysfunctional aspects of today's financial markets. We have to be wary of too facile explanations: too many begin with the excessive greed of the bankers. That may be true, but it doesn't provide much of a basis for reform. Bankers acted greedily because they had incentives and opportunities to do so, and that is what has to be changed. Besides, the basis of capitalism is the pursuit of profit: should we blame the bankers for doing (perhaps a little bit better) what everyone in the market economy is supposed to be doing?

In the long list of culprits, it is natural to begin at the bottom, with the mortgage originators. Mortgage companies had pushed exotic mortgages on to millions of people, many of whom did not know what they were getting into. But the mortgage companies could not have done their mischief without being aided and abetted by the banks and rating agencies. The banks bought the mortgages and repackaged them, selling them on to unwary investors. U.S. banks and financial institutions had boasted about their clever new investment instruments. They had created new products which, while touted as instruments for managing risk, were so dangerous that they threatened to bring down the U.S. financial system. The rating agencies, which should have checked the growth of these toxic instruments, instead gave them a seal of approval, which encouraged others--including pension funds looking for safe places to put money that workers had set aside for their retirement--in the United States and overseas, to buy them.

In short, America's financial markets had failed to perform their essential societal functions of managing risk, allocating capital, and mobilizing savings while keeping transaction costs low. Instead, they had created risk, misallocated capital, and encouraged excessive indebtedness while imposing high transaction costs. At their peak in 2007, the bloated financial markets absorbed 41 percent of profits in the corporate sector.

One of the reasons why the financial system did such a poor job at managing risk is that the market mispriced and misjudged risk. The "market" badly misjudged the risk of defaults of subprime mortgages, and made an even worse mistake trusting the rating agencies and the investment banks when they repackaged the subprime mortgages, giving a AAA rating to the new products. The banks (and the banks' investors) also badly misjudged the risk associated with high bank leverage. And risky assets that normally would have required substantially higher returns to induce people to hold them were yielding only a small risk premium. In some cases, the seeming mispricing and misjudging of risk was based on a smart bet: they believed that if troubles arose, the Federal Reserve and the Treasury would bail them out, and they were right.

The Federal Reserve, led first by Chairman Alan Greenspan and later by Ben Bernanke, and the other regulators stood back and let it all happen. They not only claimed that they couldn't tell whether there was a bubble until after it broke, but also said that even if they had been able to, there was nothing they could do about it. They were wrong on both counts. They could have, for instance, pushed for higher down payments on homes or higher margin requirements for stock trading, both of which would have cooled down these overheated markets. But they chose not to do so. Perhaps worse, Greenspan aggravated the situation by allowing banks to engage in ever-riskier lending and encouraging people to take out variable-rate mortgages, with payments that could--and did--easily explode, forcing even middle-income families into foreclosure.

Those who argued for deregulation--and continue to do so in spite of the evident consequences--contend that the costs of regulation exceed the benefits. With the global budgetary and real costs of this crisis mounting into the trillions of dollars, it's hard to see how its advocates can still maintain that position. They argue, however, that the real cost of regulation is the stifling of innovation. The sad truth is that in America's financial markets, innovations were directed at circumventing regulations, accounting standards, and taxation. They created products that were so complex they had the effect of both increasing risk and information asymmetries. No wonder then that it is impossible to trace any sustained increase in economic growth (beyond the bubble to which they contributed) to these financial innovations. At the same time, financial markets did not innovate in ways that would have helped ordinary citizens with the simple task of managing the risk of homeownership. Innovations that would have helped people and countries manage the other important risks they face were actually resisted. Good regulations could have redirected innovations in ways that would have increased the efficiency of our economy and security of our citizens.

Not surprisingly, the financial sector has attempted to shift blame elsewhere--when its claim that it was just an "accident" (a once-in-a-thousand-years storm) fell on deaf ears.

Those in the financial sector often blame the Fed for allowing interest rates to remain too low for too long. But this particular attempt to shift blame is peculiar: what other industry would say that the reason why its profits were so low and it performed so poorly was that the costs of its inputs (steel, wages) were too low? The major "input" into banking is the cost of its funds, and yet bankers seem to be complaining that the Fed made money too cheap! Had the low-cost funds been used well, for example, if the funds had gone to support investment in new technology or expansion of enterprises, we would have had a more competitive and dynamic economy.

Lax regulation without cheap money might not have led to a bubble. But more importantly, cheap money with a well-functioning or well-regulated banking system could have led to a boom, as it has at other times and places. (By the same token, had the rating agencies done their job well, fewer mortgages would have been sold to pension funds and other institutions, and the magnitude of the bubble might have been markedly lower. The same might have been true even if rating agencies had done as poor a job as they did, if investors themselves had analyzed the risks properly.) In short, it is a combination of failures that led the crisis to the magnitude that it reached.

Greenspan and others, in turn, have tried to shift the blame for the low interest rates to Asian countries and the flood of liquidity from their excess savings. Again, being able to import capital on better terms should have been an advantage, a blessing. But it is a remarkable claim: the Fed was saying, in effect, that it can't control interest rates in America anymore. Of course, it can; the Fed chose to keep interest rates low, partly for reasons that I have already explained.

In what might seem an outrageous act of ingratitude to those who rescued them from their deathbed, many bankers blame the government--biting the very hand that was feeding them. They blame the government for not having stopped them--like the kid caught stealing from the candy store who blamed the storeowner or the cop for looking the other way, leading him to believe he could get away with his misdeed. But the argument is even more disingenuous because the financial markets had paid to get the cops off the beat. They successfully beat back attempts to regulate derivatives and restrict predatory lending. Their victory over America was total. Each victory gave them more money with which to influence the political process. They even had an argument: deregulation had led them to make more money, and money was the mark of success. Q.E.D.

Conservatives don't like this blaming of the market; if there is a problem with the economy, in their hearts, they know the true cause must be government. Government wanted to increase household ownership, and the bankers' defense was that they were just doing their part. Fannie Mae and Freddie Mac, the two private companies that had started as government agencies, have been a particular subject of vilification, as has the government program called the Community Reinvestment Act (CRA), which encourages banks to lend to underserved communities. Had it not been for these efforts at lending to the poor, so the argument goes, all would have been well. This litany of defenses is, for the most part, sheer nonsense. AIG's almost $200 billion bailout (that's a big amount by any account) was based on derivatives (credit default swaps)--banks gambling with other banks. The banks didn't need any push for egalitarian housing to engage in excessive risk--taking. Nor did the massive overinvestment in commercial real estate have anything to do with government homeownership policy. Nor did the repeated instances of bad lending around the world from which the banks have had to be repeatedly rescued. Moreover, default rates on the CRA lending were actually comparable to other areas of lending--showing that such lending, if done well, does not pose greater risks. The most telling point though is that Fannie Mae and Freddie Mac's mandate was for "conforming loans," loans to the middle class. The banks jumped into subprime mortgages--an area where, at the time, Freddie Mac and Fannie Mae were not making loans--without any incentives from the government. The president may have given some speeches about the ownership society, but there is little evidence that banks snap to it when the president gives a speech. A policy has to be accompanied by carrots and sticks, and there weren't any. (If a speech would do the trick, Obama's repeated urging of banks to restructure more mortgages and to lend more to small businesses would have had some effect.) More to the point, advocates of homeownership meant permanent, or at least long-term, ownership. There was no point of putting someone in a home for a few months and then tossing him out after having stripped him of his life savings. But that was what the banks were doing. I know of no government official who would have said that lenders should engage in predatory practices, lend beyond people's ability to pay, with mortgages that combined high risks and high transaction costs. Later on, years after the private sector had invented the toxic mortgages, the privatized and under-regulated Fannie Mae and Freddie Mac decided that they too should join in the fun. Their executives thought, Why couldn't they enjoy bonuses akin to others in the industry? Ironically, in doing so, they helped save the private sector from some of its own folly: many of the securitized mortgages wound up on their balance sheet. Had they not bought them, the problems in the private sector arguably would have been far worse, though by buying so many securities, they may also have helped fuel the bubble.

As I mentioned in the preface, figuring out what happened is like "peeling an onion": each explanation raises new questions. In peeling back the onion, we need to ask, Why did the financial sector fail so badly, not only in performing its critical social functions, but even in serving shareholders and bondholders well? Only executives in financial institutions seem to have walked away with their pockets lined--less lined than if there had been no crash, but still better off than, say, the poor Citibank shareholders who saw their investments virtually disappear. The financial institutions complained that the regulators didn't stop them from behaving badly. But aren't firms supposed to behave well on their own? In later chapters I will give a simple explanation: flawed incentives. But then we must push back again: Why were there flawed incentives? Why didn't the market "discipline" firms that employed flawed incentive structures, in the way that standard theory says it should? The answers to these questions are complex but include a flawed system of corporate governance, inadequate enforcement of competition laws, and imperfect information and an inadequate understanding of risk on the part of the investors.

While the financial sector bears the major onus for blame, regulators didn't do the job that they should have done--ensuring that banks don't behave badly, as is their wont. Some in the less regulated part of the financial markets (like hedge funds), observing that the worst problems occurred in the highly regulated part (the banks), glibly conclude that regulation is the problem. "If only they were unregulated like us, the problems would never have occurred," they argue. But this misses the essential point: The reason why banks are regulated is that their failure can cause massive harm to the rest of the economy. The reason why there is less regulation needed for hedge funds, at least for the smaller ones, is that they can do less harm. The regulation did not cause the banks to behave badly; it was deficiencies in regulation and regulatory enforcement that failed to prevent the banks from imposing costs on the rest of society as they have repeatedly done. Indeed, the one period in American history when they have not imposed these costs was the quarter century after World War II when strong regulations were effectively enforced: it can be done.

Again, the failure of regulation of the past quarter century needs to be explained: the story I tell below tries to relate those failures to the political influence of special interests, particularly of those in the financial sector who made money from deregulation (many of their economic investments had turned sour, but they were far more acute in their political investments), and to ideologies--ideas that said that regulation was not necessary.


Today, after the crash, almost everyone says that there is a need for regulation--or at least for more than there was before the crisis. Not having the necessary regulations has cost us plenty: crises would have been less frequent and less costly, and the cost of the regulators and regulations would be a pittance relative to these costs. Markets on their own evidently fail--and fail very frequently. There are many reasons for these failures, but two are particularly germane to the financial sector: "agency"--in today's world scores of people are handling money and making decisions on behalf of (that is, as agents of) others--and the increased importance of "externalities."

The agency problem is a modern one. Modern corporations with their myriad of small shareholders are fundamentally different from family-run enterprises. There is a separation of ownership and control in which management, owning little of the company, may run the corporation largely for its own benefit. There are agency problems too in the process of investment: much was done through pension funds and other institutions. Those who make the investment decisions--and assess corporate performance--do so not on their behalf but on behalf of those who have entrusted their funds to their care. All along the "agency" chain, concern about performance has been translated into a focus on short-term returns.

With its pay dependent not on long-term returns but on stock market prices, management naturally does what it can to drive up stock market prices--even if that entails deceptive (or creative) accounting. Its short-term focus is reinforced by the demand for high quarterly returns from stock market analysts. That drive for short-term returns led banks to focus on how to generate more fees--and, in some cases, how to circumvent accounting and financial regulations. The innovativeness that Wall Street ultimately was so proud of was dreaming up new products that would generate more income in the short term for its firms. The problems that would be posed by high default rates from some of these innovations seemed matters for the distant future. On the other hand, financial firms were not the least bit interested in innovations that might have helped people keep their homes or protect them from sudden rises in interest rates.

In short, there was little or no effective "quality control." Again, in theory, markets are supposed to provide this discipline. Firms that produce excessively risky products would lose their reputation. Share prices would fall. But in today's dynamic world, this market discipline broke down. The financial wizards invented highly risky products that gave about normal returns for a while--with the downside not apparent for years. Thousands of money managers boasted that they could "beat the market," and there was a ready population of shortsighted investors who believed them. But the financial wizards got carried away in the euphoria--they deceived themselves as well as those who bought their products. This helps explain why, when the market crashed, they were left holding billions of dollars' worth of toxic products.

Securitization, the hottest financial-products field in the years leading up to the collapse, provided a textbook example of the risks generated by the new innovations, for it meant that the relationship between lender and borrower was broken. Securitization had one big advantage, allowing risk to be spread; but it had a big disadvantage, creating new problems of imperfect information, and these swamped the benefits from increased diversification. Those buying a mortgage-backed security are, in effect, lending to the homeowner, about whom they know nothing. They trust the bank that sells them the product to have checked it out, and the bank trusts the mortgage originator. The mortgage originators' incentives were focused on the quantity of mortgages originated, not the quality. They produced massive amounts of truly lousy mortgages. The banks like to blame the mortgage originators, but just a glance at the mortgages should have revealed the inherent risks. The fact is that the bankers didn't want to know. Their incentives were to pass on the mortgages, and the securities they created backed by the mortgages, as fast as they could to others. In the Frankenstein laboratories of Wall Street, banks created new risk products (collateralized debt instruments, collateralized debt instruments squared, and credit default swaps, some of which I will discuss in later chapters) without mechanisms to manage the monster they had created. They had gone into the moving business--taking mortgages from the mortgage originators, repackaging them, and moving them onto the books of pension funds and others--because that was where the fees were the highest, as opposed to the "storage business," which had been the traditional business model for banks (originating mortgages and then holding on to them). Or so they thought, until the crash occurred and they discovered billions of dollars of the bad assets on their books. 


The bankers gave no thought to how dangerous some of the financial instruments were to the rest of us, to the large externalities that were being created. In economics, the technical term externality refers to situations where a market exchange imposes costs or benefits on others who aren't party to the exchange. If you are trading on your own account and lose your money, it doesn't really affect anyone else. However, the financial system is now so intertwined and central to the economy that a failure of one large institution can bring down the whole system. The current failure has affected everyone: millions of homeowners have lost their homes, and millions more have seen the equity in their homes disappear; whole communities have been devastated; taxpayers have had to pick up the tab for the losses of the banks; and workers have lost their jobs. The costs have been borne not only in the United States but also around the world, by billions who reaped no gains from the reckless behavior of the banks.

When there are important agency problems and externalities, markets typically fail to produce efficient outcomes--contrary to the widespread belief in the efficiency of markets. This is one of the rationales for financial market regulation. The regulatory agencies were the last line of defense against both excessively risky and unscrupulous behavior by the banks, but after years of concentrated lobbying efforts by the banking industry, the government had not only stripped away existing regulations but also failed to adopt new ones in response to the changing financial landscape. People who didn't understand why regulation was necessary--and accordingly believed that it was unnecessary--became regulators. The repeal in 1999 of the Glass-Steagall Act, which had separated investment and commercial banks, created ever larger banks that were too big to be allowed to fail. Knowing that they were too big to fail provided incentives for excessive risk-taking.

In the end, the banks got hoisted by their own petard: The financial instruments that they used to exploit the poor turned against the financial markets and brought them down. When the bubble broke, most of the banks were left holding enough of the risky securities to threaten their very survival--evidently, they hadn't done as good a job in passing the risk along to others as they had thought. This is but one of many ironies that have marked the crisis: in Greenspan and Bush's attempt to minimize the role of government in the economy, the government has assumed an unprecedented role across a wide swath--becoming the owner of the world's largest automobile company, the largest insurance company, and (had it received in return for what it had given to the banks) some of the largest banks. A country in which socialism is often treated as an anathema has socialized risk and intervened in markets in unprecedented ways.

These ironies are matched by the seeming inconsistencies in the arguments of the International Monetary Fund (IMF) and the U.S. Treasury before, during, and after the East Asian crisis--and the inconsistencies between the policies then and now. The IMF might claim that it believes in market fundamentalism--that markets are efficient, self-correcting, and accordingly, are best left to their own devices if one is to maximize growth and efficiency--but the moment a crisis occurs, it calls for massive government assistance, worried about "contagion," the spread of the disease from one country to another. But contagion is a quintessential externality, and if there are externalities, one can't (logically) believe in market fundamentalism. Even after the multibillion-dollar bailouts, the IMF and U.S. Treasury resisted imposing measures (regulations) that might have made the "accidents" less likely and less costly--because they believed that markets fundamentally worked well on their own, even when they had just experienced repeated instances when they didn't.

The bailouts provide an example of a set of inconsistent policies with potentially long-run consequences. Economists worry about incentives--one might say it is their number-one preoccupation. One of the arguments put forward by many in the financial markets for not helping mortgage owners who can't meet their repayments is that it gives rise to "moral hazard"--that is, incentives to repay are weakened if mortgage owners know that there is some chance they will be helped out if they don't repay. Worries about moral hazard led the IMF and the U.S. Treasury to argue vehemently against bailouts in Indonesia and Thailand--setting off a massive collapse of the banking system and exacerbating the downturns in those countries. Worries about moral hazard played into the decision not to bail out Lehman Brothers. But this decision, in turn, led to the most massive set of bailouts in history. When it came to America's big banks in the aftermath of Lehman Brothers, concerns about moral hazard were shunted aside, so much so that the banks' officers were allowed to enjoy huge bonuses for record losses, dividends continued unabated, and shareholders and bondholders were protected. The repeated rescues (not just bailouts, but ready provision of liquidity by the Federal Reserve in times of trouble) provide part of the explanation of the current crisis: they encouraged banks to become increasingly reckless, knowing that there was a good chance that if a problem arose, they would be rescued. (Financial markets referred to this as the "Greenspan/Bernanke put.") Regulators made the mistaken judgment that, because the economy had "survived" so well, markets worked well on their own and regulation was not needed--not noting that they had survived because of massive government intervention. Today, the problem of moral hazard is greater, by far, than it has ever been.

Agency issues and externalities mean that there is a role for government. If it does its job well, there will be fewer accidents, and when the accidents occur, they will be less costly. When there are accidents, government will have to help in picking up the pieces. But how the government picks up the pieces affects the likelihood of future crises--and a society's sense of fairness and justice. Every successful economy--every successful society--involves both government and markets. There needs to be a balanced role. It is a matter not just of "how much" but also of "what." During the Reagan and both Bush administrations, the United States lost that balance--doing too little then has meant doing too much now. Doing the wrong things now may mean doing more in the future.


One of the striking aspects of the "free market" revolutions initiated by President Ronald Reagan and Prime Minister Margaret Thatcher of England was that perhaps the most important set of instances when markets fail to yield efficient outcomes was forgotten: the repeated episodes when resources are not fully utilized. The economy often operates below capacity, with millions of people who would like to find work not being able to do so, with episodic fluctuations in which more than one out of twelve can't find jobs--and numbers that are far worse for minorities and youth. The official unemployment rate doesn't provide a full picture: Many who would like to work full-time are working part-time because that's the only job they could get, and they are not included in the unemployment rate. Nor does the rate include those who join the rolls of the disabled but who would be working if they could only get a job. Nor does it include those who have been so discouraged by their failure to find a job that they give up looking. This crisis though is worse than usual. With the broader measure of unemployment, by September, 2009, more than one in six Americans who would have liked to have had a full-time job couldn't find one, and by October, matters were worse. While the market is self-correcting--the bubble eventually burst--this crisis shows once again that the correction may be slow and the cost enormous. The cumulative gap between the economy's actual output and potential output is in the trillions.


In the aftermath of the crash, both those in the financial market and their regulators claimed, "Who could have foreseen these problems?" In fact, many critics had--but their dire forecasts were an inconvenient truth: too much money was being made by too many people for their warnings to be heard.

I was certainly not the only person who was expecting the U.S. economy to crash, with global consequences. New York University economist Nouriel Roubini, financier George Soros, Morgan Stanley's Stephen Roach, Yale University housing expert Robert Shiller, and former Clinton Council of Economic Advisers/National Economic Council staffer Robert Wescott all issued repeated warnings. They were all Keynesian economists, sharing the view that markets were not self-correcting. Most of us were worried about the housing bubble; some (such as Roubini) focused on the risk posed by global imbalances to a sudden adjustment of exchange rates.

But those who had engineered the bubble (Henry Paulson had led Goldman Sachs to new heights of leverage, and Ben Bernanke had allowed the issuance of subprime mortgages to continue) maintained their faith in the ability of markets to self-correct--until they had to confront the reality of a massive collapse. One doesn't have to have a Ph.D. in psychology to understand why they wanted to pretend that the economy was going through just a minor disturbance, one that could easily be brushed aside. As late as March 2007, Federal Reserve Chairman Bernanke claimed that "the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." A year later, even after the collapse of Bear Stearns, with rumors swirling about the imminent demise of Lehman Brothers, the official line (told not only publicly but also behind closed doors with other central bankers) was that the economy was already on its way to a robust recovery after a few blips.

The real estate bubble that had to burst was the most obvious symptom of "economic illness." But behind this symptom were more fundamental problems. Many had warned of the risks of deregulation. As far back as 1992, I worried that the securitization of mortgages would end in disaster, as buyers and sellers alike underestimated the likelihood of a price decline and the extent of correlation.

Indeed, anyone looking closely at the American economy could easily have seen that there were major "macro" problems as well as "micro" problems. As I noted earlier, our economy had been sustained by an unsustainable bubble. Without the bubble, aggregate demand--the sum total of the goods and services demanded by households, firms, government, and foreigners--would have been weak, partly because of the growing inequality in the United States and elsewhere around the world, which shifted money from those would have spent it to those who didn't.

For years, my Columbia colleague Bruce Greenwald and I had drawn attention to the further problem of a global lack of aggregate demand--the total of all the goods and services that people throughout the world want to buy. In the world of globalization, global aggregate demand is what matters. If the sum total of what people around the world want to buy is less than what the world can produce, there is a problem--a weak global economy. One of the reasons for weak global aggregate demand is the growing level of reserves--money that countries set aside for a "rainy day."

Developing countries put aside hundreds of billions of dollars in reserves to protect themselves from the high level of global volatility that has marked the era of deregulation, and from the discomfort they feel at turning to the IMF for help. The prime minister of one of the countries that had been ravished by the global financial crisis of 1997 said to me, "We were in the class of '97. We learned what happens if you don't have enough reserves."

The oil-rich countries too were accumulating reserves--they knew that the high price of crude was not sustainable. For some countries, there was another reason for reserve accumulation. Export-led growth had been lauded as the best way for developing countries to grow; after new trade rules under the World Trade Organization took away many of the traditional instruments developing countries used to help create new industries, many turned to a policy of keeping their exchange rates competitive. And this meant buying dollars, selling their own currencies, and accumulating reserves.

These were all good reasons for accumulating reserves, but they had a bad consequence: there was insufficient global demand. A half trillion dollars, or more, was being set aside in these reserves every year in the years prior to the crisis. For a while, the United States had come to the rescue with debt-based profligate consumption, spending well beyond its means. It became the world's consumer of last resort. But that was not sustainable.


This crisis quickly became global--and not surprisingly, as nearly a quarter of U.S. mortgages had gone abroad. Unintentionally, this helped the United States: had foreign institutions not bought as much of its toxic instruments and debt, the situation here might have been far worse. But first the United States had exported its deregulatory philosophy--without that, foreigners might not have bought so many of its toxic mortgages. In the end, the United States also exported its recession. This was, of course, only one of several channels through which the American crisis became global: the U.S. economy is still the largest, and it is hard for a downturn of this magnitude not to have a global impact. Moreover, global financial markets have become closely interlinked--evidenced by the fact that two of the top three beneficiaries of the U.S. government bailout of AIG were foreign banks.

In the beginning, many in Europe talked of decoupling, that they would be able to maintain growth in their economies even as America went into a downturn: the growth in Asia would save them from a recession. It should have been apparent that this too was just wishful thinking. Asia's economies are still too small (the entire consumption of Asia is just 40 percent of that of the United States), and their growth relies heavily on exports to the United States. Even after a massive stimulus, China's growth in 2009 was some 3 to 4 percent below what it had been before the crisis. The world is too interlinked; a downturn in the United States could not but lead to a global slowdown. (There is an asymmetry: because of the immense internal and not fully tapped market in Asia, it might be able to return to robust growth even though the United States and Europe remain weak.

While Europe's financial institutions suffered from buying toxic mortgages and the risky gambles they had made with American banks, a number of European countries grappled with problems of their own design. Spain too had allowed a massive housing bubble to develop and is now suffering from the near-total collapse of its real estate market. In contrast to the United States, however, Spain's strong banking regulations have allowed its banks to withstand a much bigger trauma with better results--though, not surprisingly, its overall economy has been hit far worse.

The United Kingdom too succumbed to a real estate bubble. But worse, under the influence of the city of London, a major financial hub, it fell into the trap of the "race to the bottom," trying to do whatever it could to attract financial business. "Light" regulation did no better there than in the United States. Because the British had allowed the financial sector to take on a greater role in their economy, the cost of the bailouts was (proportionately) even greater. As in the United States, a culture of high salaries and bonuses developed. But at least the British understood that if you give taxpayer money to the banks, you have to do what you can to make sure they use it for the purposes intended--for more loans, not for bonuses and dividends. And at least in the U.K., there was some understanding that there had to be accountability--the heads of the bailed-out banks were replaced--and the British government demanded that the taxpayers get fair value in return for the bailouts, not the giveaways that marked both the Obama and Bush administrations' rescues.

Iceland is a wonderful example of what can go wrong when a small and open economy adopts the deregulation mantra blindly. Its well-educated people worked hard and were at the forefront of modern technology. They had overcome the disadvantages of a remote location, harsh weather, and depletion of fish stocks--one of their traditional sources of income--to generate a per capita income of $40,000. Today, the reckless behavior of their banks has put the country's future in jeopardy.

I had visited Iceland several times earlier in this decade and warned of the risks of its liberalization policies. This country of 300,000 had three banks that took on deposits and bought assets totaling some $176 billion, eleven times the country's GDP. With a dramatic collapse of Iceland's banking system in the fall of 2008, Iceland became the first developed country in more than thirty years to turn to the IMF for help. Iceland's banks had, like banks elsewhere, taken on high leverage and high risks. When financial markets realized the risk and started pulling money out, these banks (and especially Landsbanki) lured money from depositors in the U.K. and Netherlands by offering them "Icesaver" accounts with high returns. The depositors foolishly thought that there was a "free lunch": they could get higher returns without risk. Perhaps they also foolishly thought their own governments were doing their regulatory job. But, as everywhere, regulators had largely assumed that markets would take care of themselves. Borrowing from depositors only postponed the day of reckoning. Iceland could not afford to pour hundreds of billions of dollars into the weakened banks. As this reality gradually dawned on those who had provided funds to the bank, it became only a matter of time before there would be a run on the banking system; the global turmoil following the Lehman Brothers collapse precipitated what would in any case have been inevitable. Unlike the United States, the government of Iceland knew that it could not bail out the bondholders or shareholders. The only questions were whether the government would bail out the Icelandic corporation that insured the depositors, and how generous it would be to the foreign depositors. The U.K. used strong-arm tactics--going so far as to seize Icelandic assets using anti-terrorism laws--and when Iceland turned to the IMF and the Nordic countries for assistance, they insisted that Icelandic taxpayers bail out U.K. and Dutch depositors even beyond the amounts the accounts had been insured for. On a return visit to Iceland in September 2009, almost a year later, the anger was palpable. Why should Iceland's taxpayers be made to pay for the failure of a private bank, especially when foreign regulators had failed to do their job of protecting their own citizens? One widely held view for the strong response from European governments was that Iceland had exposed a fundamental flaw in European integration: "the single market" meant that any European bank could operate in any country. Responsibility for regulation was put on the "home" country. But if the home country failed to do its job, citizens in other countries could lose billions. Europe didn't want to think about this and its profound implications; better to simply make little Iceland pick up the tab, an amount some put at as much as 100 percent of the country's GDP.

As the crisis worsened in the United States and Europe, other countries around the world suffered from the collapse in global demand. Developing countries suffered especially, as remittances (transfers of money from family members in developed countries) fell and capital that had flowed into them was greatly diminished--and in some cases reversed. While America's crisis began with the financial sector and then spread to the rest of the economy, in many of the developing countries--including those where financial regulation is far better than in the United States--the problems in the "real economy" were so large that they eventually affected the financial sector. The crisis spread so rapidly partly because of the policies, especially of capital and financial market liberalization, the IMF and the U.S. Treasury had foisted on these countries--based on the same free market ideology that had gotten the United States into trouble. But while even the United States finds it difficult to afford the trillions in bailouts and stimulus, corresponding actions by poorer countries are well beyond their reach.


Underlying all of these symptoms of dysfunction is a larger truth: the world economy is undergoing seismic shifts. The Great Depression coincided with the decline of U.S. agriculture; indeed, agricultural prices were falling even before the stock market crash in 1929. Increases in agricultural productivity were so great that a small percentage of the population could produce all the food that the country could consume. The transition from an economy based on agriculture to one where manufacturing predominated was not easy. In fact, the economy only resumed growing when the New Deal kicked in and World War II got people working in factories.

Today the underlying trend in the United States is the move away from manufacturing and into the service sector. As before, this is partly because of the success in increasing productivity in manufacturing, so that a small fraction of the population can produce all the toys, cars, and TVs that even the most materialistic and profligate society might buy. But in the United States and Europe, there is an additional dimension: globalization, which has meant a shift in the locus of production and comparative advantage to China, India, and other developing countries.

Accompanying this "microeconomic" adjustment are a set of macroeconomic imbalances: while the United States should be saving for the retirement of its aging baby-boomers, it has been living beyond its means, financed to a large extent by China and other developing countries that have been producing more than they have been consuming. While it is natural for some countries to lend to others--some to run trade deficits, others surpluses--the pattern, with poor countries lending to the rich, is peculiar and the magnitude of the deficits appear unsustainable. As countries get more indebted, lenders may lose confidence that the borrower can repay--and this can be true even for a rich country like the United States. Returning the American and global economy to health will require the restructuring of economies to reflect the new economics and correcting these global imbalances.

We can't go back to where we were before the bubble broke in 2007. Nor should we want to. There were plenty of problems with that economy--as we have just seen. Of course, there is a chance that some new bubble will replace the housing bubble, just as the housing bubble replaced the tech bubble. But such a "solution" would only postpone the day of reckoning. Any new bubble could pose dangers: the oil bubble helped pushed the economy over the brink. The longer we delay in dealing with the underlying problems, the longer it will be before the world returns to robust growth.

There is a simple test of whether the United States has made sufficient strides in ensuring that there will not be another crisis: If the proposed reforms had been in place, could the current crisis have been avoided? Would it have occurred anyway? For instance, giving more power to the Federal Reserve is key to the proposed Obama regulatory reform. But as the crisis began, the Federal Reserve had more powers than it used. In virtually every interpretation of the crisis, the Fed was at the center of the creation of this and the previous bubble. Perhaps the Fed's chairman has learned his lesson. But we live in a country of laws, not of men: should we have a system requiring that the Fed first be burned by fire to ensure that another won't be set? Can we have confidence in a system that can depend so precariously on the economic philosophy or understanding of one person--or even of the seven members of the Board of Governors of the Fed? As this book goes to press, it is clear that the reforms have not gone far enough.

We cannot wait until after the crisis. Indeed, the way we have been dealing with the crisis may be making it all the more difficult to address these deeper problems. The next chapter outlines what we should have done to address the crisis--and why what we did fell far short.

Reprinted from Freefall: America, Free Markets, and the Sinking of the World Economy by Joseph E. Stiglitz Copyright (c) 2010 by Joseph E. Stiglitz. Used with permission of the publisher, W.W. Norton & Company, Inc.


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