Reversal of fortune
Joseph E. Stiglitz
Describing how ideology, special-interest pressure, populist
politics, and sheer incompetence have left the U.S. economy on life
support, the author puts forth a clear, commonsense plan to reverse the
Bush-era follies and regain America’s economic sanity.
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.
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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.
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 macro-economic
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 ailures 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 micro-economic 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
macro-economic failures of the Great Depression.
Deregulation
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.
Downturn
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.
Offensive
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.
Innovation
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.
(Tom Paine.Com) |