Reversal of fortune
By
Joseph E. Stiglitz Read Spanish Version
From
Vanity Fair
When
the American economy enters a downturn, you often hear the experts
debating whether it is likely to be V-shaped (short and sharp) or
U-shaped (longer but milder). Today, the American economy may be
entering a downturn that is best described as L-shaped. It is in a
very low place indeed, and likely to remain there for some time to
come.
Virtually
all the indicators look grim. Inflation is running at an annual rate
of nearly 6 percent, its highest level in 17 years. Unemployment
stands at 6 percent; there has been no net job growth in the private
sector for almost a year. Housing prices have fallen faster than at
any time in memory — in Florida and California, by 30 percent or
more. Banks are reporting record losses, only months after their
executives walked off with record bonuses as their reward. President
Bush inherited a $128 billion budget surplus from Bill Clinton; this
year the federal government announced the second-largest budget
deficit ever reported. During the eight years of the Bush
administration, the national debt has increased by more than 65
percent, to nearly $10 trillion (to which the debts of Freddie Mac
and Fannie Mae should now be added, according to the Congressional
Budget Office). Meanwhile, we are saddled with the cost of two wars.
The price tag for the one in Iraq alone will, by my estimate,
ultimately exceed $3 trillion.
This
tangled knot of problems will be difficult to unravel. Standard
prescriptions call for raising interest rates when confronted with
inflation, just as standard prescriptions call for lowering interest
rates when confronted with an economic downturn. How do you do both
at the same time? Not in the way that some politicians have proposed.
With gasoline prices at all-time highs, John McCain has called for a
rollback of gas taxes. But that would lead to more gas consumption,
raise the price of gas further, increase our dependence on foreign
oil, and expand our already massive trade deficit. The expanding
deficit would in turn force the U.S. to continue borrowing gargantuan
sums from abroad, making us even more indebted. At the same time, the
higher imports of oil and petroleum-based products would lead to a
weaker dollar, fueling inflationary pressures.
Millions
of Americans are losing their homes. (Already, some 3.6 million have
done so since the subprime-mortgage crisis began.) This social
catastrophe has severe economic effects. The banks and other
financial institutions that own these mortgages face stunning
reverses; a few, such as Bear Stearns, have already gone belly-up. To
prevent America’s $5.2 trillion home financiers, Fannie Mae and
Freddie Mac, from following suit, Congress authorized a blank check
to cover their losses, but even that generosity failed to do the
trick. Now the administration has taken over the two entities
completely, a stunning feat for a supposedly market-oriented regime.
These bailouts contribute to growing deficits in the short run, and
to perverse incentives in the long run. Market economies work only
when there is a system of accountability, but C.E.O.’s, investors,
and creditors are walking away with billions, while American
taxpayers are being asked to pick up the tab. (Freddie Mac’s
chairman, Richard Syron, earned $14.5 million in 2007. Fannie Mae’s
C.E.O., Daniel Mudd, earned $14.2 million that same year.) We’re
looking at a new form of public-private partnership, one in which the
public shoulders all the risk, and the private sector gets all the
profit. While the Bush administration preaches responsibility, the
words are addressed only to the less well-off. The administration
talks about the impact of "moral hazard" on the poor
"speculator" who borrowed money and bought a house beyond
his ability to pay. But moral hazard somehow isn’t an issue when it
comes to the high-stakes speculators in corporate boardrooms.
How
did we get into this mess?
A
unique combination of ideology, special-interest pressure, populist
politics, bad economics, and sheer incompetence has brought us to our
present condition.
Ideology
proclaimed that markets were always good and government always bad.
While George W. Bush has done as much as he can to ensure that
government lives up to that reputation — it is the one area where he
has overperformed — the fact is that key problems facing our society
cannot be addressed without an effective government, whether it’s
maintaining national security or protecting the environment. Our
economy rests on public investments in technology, such as the
Internet. While Bush’s ideology led him to underestimate the
importance of government, it also led him to underestimate the
limitations of markets. We learned from the Depression that markets
are not self-adjusting — at least, not in a time frame that matters
to living people. Today everyone — even the president — accepts the
need for macroeconomic policy, for government to try to maintain the
economy at near-full employment. But in a sleight of hand,
free-market economists promoted the idea that, once the economy was
restored to full employment, markets would always allocate resources
efficiently. The best regulation, in their view, was no regulation at
all, and if that didn’t sell, then "self-regulation" was
almost as good.
The
underlying idea was, on the face of it, absurd: that market failures
come only in macro doses, in the form of the recessions and
depressions that have periodically plagued capitalist economies for
the past several hundred years. Isn’t it more reasonable to assume
that these failures are just the tip of the iceberg? That beneath the
surface lie a myriad of smaller but harder-to-assess inefficiencies?
Let me venture an analogy from biology: A patient arrives at a
hospital in serious condition. Now, it may be that the patient has
simply fallen victim to one of those debilitating ailments that go
around from time to time and can be cured by a massive dose of
antibiotics. In this case we have a macro problem with a macro
solution. But it could instead be that the patient is suffering from
a decade of serious abuse — smoking, drinking, overeating, lack of
exercise, a fondness for crystal meth — and that it has not only
taken a catastrophic toll but also left him open to opportunistic
infections of every kind. In other words, a buildup of micro problems
has led to a macro problem, and no cure is possible without
addressing the underlying issues. The American economy today is a
patient of the second kind.
We
are in the midst of microeconomic failure on a grand scale. Financial
markets receive generous compensation — in the form of more than 30
percent of all corporate profits — presumably for performing two
critical tasks: allocating savings and managing risk. But the
financial markets have failed laughably at both. Hundreds of billions
of dollars were allocated to home loans beyond Americans’ ability to
pay. And rather than managing risk, the financial markets created
more risk. The failure of our financial system to do what it is
supposed to do matches in destructive grandeur the macroeconomic
failures of the Great Depression.
Economic
theory — and historical experience — long ago proved the need for
regulation of financial markets. But ever since the Reagan
presidency, deregulation has been the prevailing religion. Never mind
that the few times "free banking" has been tried — most
recently in Pinochet’s Chile, under the influence of the doctrinaire
free-market theorist Milton Friedman — the experiment has ended in
disaster. Chile is still paying back the debts from its misadventure.
With massive problems in 1987 (remember Black Friday, when stock
markets plunged almost 25 percent), 1989 (the savings-and-loan
debacle), 1997 (the East Asia financial crisis), 1998 (the bailout of
Long Term Capital Management), and 2001–02 (the collapses of Enron
and WorldCom), one might think there would be more skepticism about
the wisdom of leaving markets to themselves.
The
new populist rhetoric of the right — persuading taxpayers that
ordinary people always know how to spend money better than the
government does, and promising a new world without budget
constraints, where every tax cut generates more revenue — hasn’t
helped matters. Special interests took advantage of this seductive
mixture of populism and free-market ideology. They also bent the
rules to suit themselves. Corporations and the wealthy argued that
lowering their tax rates would lead to more savings; they got the tax
breaks, but America’s household savings rate not only didn’t rise, it
dropped to levels not seen in 75 years. The Bush administration
extolled the power of the free market, but it was more than willing
to provide generous subsidies to farmers and erect tariffs to protect
steelmakers. Lately, as we have seen, it seems willing to write blank
checks to bail out its friends on Wall Street. In each of these cases
there are clear winners. And in each there are clear losers —
including the country as a whole.
What
is to be done?
As
America attempts to work its way out of the present crisis, the
danger is that we will listen to the same people on Wall Street and
in the economic establishment who got us into it. For them, our
current predicament is another opportunity: if they can shape the
government response appropriately, they stand to gain, or at least
stand to lose less, and they may be willing to sacrifice the
well-being of the economy for their own benefit — just as they did
in the past.
There
are a number of economic tools at the country’s disposal. As noted,
they can yield contradictory results. The sad truth is that we have
reached the limits of monetary policy. Lowering interest rates will
not stimulate the economy much — banks are not going to be willing
to lend to strapped consumers, and consumers are not going to be
willing to borrow as they see housing prices continue to fall. And
raising interest rates, to combat inflation, won’t have the desired
impact either, because the prices that are the main sources of our
inflation — for food and energy — are determined in international
markets; the chief consequence will be distress for ordinary people.
The quandaries that we face mean that careful balancing is required.
There is no quick and easy fix. But if we take decisive action today,
we can shorten the length of the downturn and reduce its magnitude.
If at the same time we think about what would be good for the economy
in the long run, we can build a durable foundation for economic
health.
To
go back to that patient in the emergency room: we need to address the
underlying causes. Most of the treatment options entail painful
choices, but there are a few easy ones. On energy: conservation and
research into new technologies will make us less dependent on foreign
oil, reduce our trade imbalance, and help the environment. Expanding
drilling into environmentally fragile areas, as some propose, would
have a negligible effect on the price we pay for oil. Moreover, a
policy of "drain America first" will make us more dependent
on foreigners in the future. It is shortsighted in every dimension.
Our
ethanol policy is also bad for the taxpayer, bad for the environment,
bad for the world and our relations with other countries, and bad in
terms of inflation. It is good only for the ethanol producers and
American corn farmers. It should be scrapped. We currently subsidize
corn-based ethanol by almost $1 a gallon, while imposing a
54-cent-a-gallon tariff on Brazilian sugar-based ethanol. It would be
hard to invent a worse policy. The ethanol industry tries to sell
itself as an infant, needing help to get on its feet, but it has been
an infant for more than two decades, refusing to grow up. Our
misguided biofuel policy is taking land used for food production and
diverting it to energy production for cars; it is the single most
important factor contributing to higher grain prices.
Our
tax policies need to be changed. There is something deeply peculiar
about having rich individuals who make their money speculating on
real estate or stocks paying lower taxes than middle-class Americans,
whose income is derived from wages and salaries; something peculiar
and indeed offensive about having those whose income is derived from
inherited stocks paying lower taxes than those who put in a 50-hour
workweek. Skewing the tax rates in the other direction would provide
better incentives where they count and would more effectively
stimulate the economy, with more revenues and lower deficits.
We
can have a financial system that is more stable — and even more
dynamic — with stronger regulation. Self-regulation is an oxymoron.
Financial markets produced loans and other products that were so
complex and insidious that even their creators did not fully
understand them; these products were so irresponsible that analysts
called them "toxic." Yet financial markets failed to create
products that would enable ordinary households to face the risks they
confront and stay in their homes. We need a financial-products safety
commission and a financial-systems stability commission. And they
can’t be run by Wall Street. The Federal Reserve Board shares too
much of the mind — set of those it is supposed to regulate. It could
and should have known that something was wrong. It had instruments at
its disposal to let the air out of the bubble — or at least ensure
that the bubble didn’t over-expand. But it chose to do nothing.
Throwing
the poor out of their homes because they can’t pay their mortgages is
not only tragic — it is pointless. All that happens is that the
property deteriorates and the evicted people move somewhere else. The
most coldhearted banker ought to understand the basic economics:
banks lose money when they foreclose — the vacant homes typically
sell for far less than they would if they were lived in and cared
for. If banks won’t renegotiate, we should have an expedited special
bankruptcy procedure, akin to what we do for corporations in Chapter
11, allowing people to keep their homes and re-structure their
finances.
If
this sounds too much like coddling the irresponsible, remember that
there are two sides to every mortgage — the lender and the borrower.
Both enter freely into the deal. One might say that both are,
accordingly, equally responsible. But one side — the lender — is
supposed to be financially sophisticated. In contrast, the borrowers
in the subprime market consist mainly of people who are financially
unsophisticated. For many, their home is their only asset, and when
they lose it, they lose their life savings. Remember, too, that we
already give big homeowner subsidies, through the tax system, to
affluent families. With tax deductions, the government is paying in
some states almost half of all mortgage interest and real-estate
taxes. But many lower-income people, whose deductions are meaningless
because their tax bill is too small, get no help. It makes much more
sense to convert these tax deductions into cashable tax credits, so
that the fraction of housing costs borne by the government for the
poor and the rich is the same.
About
these matters there should be no debate — but there will be.
Already, those on Wall Street are arguing that we have to be careful
not to "over-react." Over-reaction, we are told, might
stifle "innovation." Well, some innovations ought to be
stifled. Those toxic mortgages were certainly innovative. Other
innovations were simply devices to circumvent regulations —
regulations intended to prevent the kinds of problems from which our
economy now suffers. Some of the innovations were designed to tart up
the bottom line, moving liabilities off the balance sheet — charades
designed to blur the information available to investors and
regulators. They succeeded: the full extent of the exposure was not
clear, and still isn’t. But there is a reason we need reliable
accounting. Without good information it is hard to make good economic
decisions. In short, some innovations come with very high price tags.
Some can actually cause instability.
The
free-market fundamentalists — who believe in the miracles of markets
— have not been averse to accepting government bailouts. Indeed,
they have demanded them, warning that unless they get what they want
the whole system may crash. What politician wants to be blamed for
the next Great Depression, simply because he stood on principle? I
have been critical of weak anti-trust policies that allowed certain
institutions to become so dominant that they are "too big to
fail." The harsh reality is that, given how far we’ve come, we
will see more bailouts in the days ahead. Now that Fannie Mae and
Freddie Mac are in federal receivership, we must insist: not a dime
of taxpayer money should be put at risk while shareholders and
creditors, who failed to oversee management, are permitted to walk
away with anything they please. To do otherwise would invite a
recurrence. Moreover, while these institutions may be too big to
fail, they’re not too big to be reorganized. And we need to remember
why we’re bailing them out: in order to maintain a flow of money into
mortgage markets. It’s outrageous that these institutions are
responding to their near-monopoly position by raising fees and
increasing the costs of mortgages, which will only worsen the housing
crisis. They, and the financial markets, have shown little interest
in measures that could help millions of existing and potential
homeowners out of the bind they’re in.
The
hardest puzzles will be in monetary policy (balancing the risks of
inflation and the risk of a deeper downturn) and fiscal policy
(balancing the risk of a deeper downturn and the risk of an exploding
deficit). The standard analysis coming from financial markets these
days is that inflation is the greatest threat, and therefore we need
to raise interest rates and cut deficits, which will restore
confidence and thereby restore the economy. This is the same bad
economics that didn’t work in East Asia in 1997 and didn’t work in
Russia and Brazil in 1998. Indeed, it is the same recipe prescribed
by Herbert Hoover in 1929.
It
is a recipe, moreover, that would be particularly hard on working
people and the poor. Higher interest rates dampen inflation by
cutting back so sharply on aggregate demand that the unemployment
rate grows and wages fall. Eventually, prices fall, too. As noted,
the cause of our inflation today is largely imported — it comes from
global food and energy prices, which are hard to control. To curb
inflation therefore means that the price of everything else needs to
fall drastically to compensate, which means that unemployment would
also have to rise drastically.
In
addition, this is not the time to turn to the old-time fiscal
religion. Confidence in the economy won’t be restored as long as
growth is low, and growth will be low if investment is anemic,
consumption weak, and public spending on the wane. Under these
circumstances, to mindlessly cut taxes or reduce government
expenditures would be folly.
But
there are ways of thoughtfully shaping policy that can walk a fine
line and help us get out of our current predicament. Spending money
on needed investments — infrastructure, education, technology —
will yield double dividends. It will increase incomes today while
laying the foundations for future employment and economic growth.
Investments in energy efficiency will pay triple dividends —
yielding environmental benefits in addition to the short- and
long-run economic benefits.
The
federal government needs to give a hand to states and localities —
their tax revenues are plummeting, and without help they will face
costly cutbacks in investment and in basic human services. The poor
will suffer today, and growth will suffer tomorrow. The big advantage
of a program to make up for the shortfall in the revenues of states
and localities is that it would provide money in the amounts needed:
if the economy recovers quickly, the shortfall will be small; if the
downturn is long, as I fear will be the case, the shortfall will be
large.
These
measures are the opposite of what the administration — along with
the Republican presidential nominee, John McCain — has been urging.
It has always believed that tax cuts, especially for the rich, are
the solution to the economy’s ills. In fact, the tax cuts in 2001 and
2003 set the stage for the current crisis. They did virtually nothing
to stimulate the economy, and they left the burden of keeping the
economy on life support to monetary policy alone. America’s problem
today is not that households consume too little; on the contrary,
with a savings rate barely above zero, it is clear we consume too
much. But the administration hopes to encourage our spendthrift ways.
What
has happened to the American economy was avoidable. It was not just
that those who were entrusted to maintain the economy’s safety and
soundness failed to do their job. There were also many who benefited
handsomely by ensuring that what needed to be done did not get done.
Now we face a choice: whether to let our response to the nation’s
woes be shaped by those who got us here, or to seize the opportunity
for fundamental reforms, striking a new balance between the market
and government.
Joseph
E. Stiglitz, a Nobel Prize–winning economist, is a professor at
Columbia University.
http://www.vanityfair.com/politics/features/2008/11/stiglitz200811?currentPage=1
