Based on a Joseph Stiglitz lecture delivered 26th of July 2010 at the University of Queensland in Australia. Extensively modified. Free Fall: Free Markets and the sinking of the global economy What I'm going to talk about tonight is the sinking of the global economy, the mistakes in economic policy that contributed to it, and the lessons that ought to be drawn from it. There are 3 questions I'm going to be dealing with this evening: where are we in the global economic crisis, how did we get here, and what are the lessons - how do we get to a more stable and prosperous economy. We have clearly pulled back from the brink of this disaster that we were at in September 2008, but the world is not yet on a course of robust economic recovery. In fact, the most likely prospect is that growth will slow towards the end of this year (this was July 2010) or early next year (that would be 2011 - and boy was he right with that prediction!) The only source of near-term strength is in Asia. Europe and the United States are facing the prospect of slow economic growth for at least the next several years, and in fact some countries are likely to enter a second recession, something you will hear in the press referred to as a "double-dip" recession - basically two recessions back to back with a brief period - maybe 6 to 18 months - of slow growth in between. How did we get here? Before this crisis, global growth was supported by a series of bubbles. First we had the tech bubble, and we replaced the tech bubble with a housing bubble. There were real estate bubbles in many countries around the world, but the largest was in the United States. Many economic leaders - people like Alan Greenspan - talked about a new economy. They believed that financial innovation and deregulation had brought us TO this new economy, in which economic downturns would be a thing of the past. But in fact, this financial innovation and deregulation actually allowed the bubble to grow bigger and bigger. And in fact, if we look at the history of capitalism, there has only been a short period - the three decades after the Great Depression - when the world did not face economic crisis after economic crisis. And the reason this three decade period was different from all other periods in economic history is that, in response to the Great Depression, the United States and most other developed nations put in place a set of very sensible regulations designed to prevent widespread risk-taking in the financial world at the expense of the general population. In other words to prevent people from taking risks in order to make a profit, but then passing on the risk to another party while
pocketing the profit. These regulations ensured that in order to make a profit, you had to take a risk. You couldn't pass on the risk to someone else. And these regulations worked. They prevented crises. Unfortunately, a mistaken view arose in the minds of Mr. Greenspan (and many other conservative economists - by which I mean essentially economists on the Republican side of the house.) And this mistaken view was that markets on their own were efficient, were self-correcting, and that the government regulations that were put in place after the Great Depression could now be relaxed. That we had entered a new era in which markets were so efficient that we no longer needed these regulations. As a result of this belief, a new era of financial deregulation began in the 1980s under President Reagan in the United States, Margaret Thatcher in the United Kingdom, and similar leaders in other countries. And we don't have to wait to 2008 to see the effect of relaxing these regulations. The savings and loan crisis of the 1980s and 1990s has many things in common with the subprime mortgage crisis of 2008. In both cases, financial regulation was relaxed in such a way as to allow one group of people to reap the benefits of greater risk-taking - in this case it was the CEOs of the savings and loan institutions which were in search of higher profits for their institutions - while a different group of people bears the downside of that risk - in this case it was the risk that if the savings and loan institutions fail the Federal Deposit Insurance Corporation - the government - will have to bail them out. So the CEOs of these corporations could take a chance of being rewarded by the market and by their shareholders for bravely raising the profits of the savings and loans, while someone else - the American taxpayer - bears the risk. And so this crisis can be directly traced to the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980. This Act gave the S&Ls many of the capabilities of banks, without the same regulations as banks. In order to combat inflation in the 1970s, the Federal Reserve Bank had raised interest rates to their highest levels since the Federal Reserve Bank began. Interest rates on home mortgages rose to as high as 19%. Thus, fewer people took out home loans, which were the primary type of loans S&Ls had always made. At the same time, the high interest rates in the economy meant that people were no longer willing to keep their money in an S&L savings account, which only paid about 4 to 5% interest. They could earn higher rates of return by investing their money in stocks and bonds. Thus, S&Ls were getting squeezed at both ends. They were losing depositors and they were also losing their loan customers. Their profitability was so low that many S&Ls went out of business, and others were soon to follow. In order to avoid going out of
business, the S&Ls, as soon as they were allowed to, took on more risk, primarily by investing their excess deposits in U.S. real estate. When real estate values fell, these investments fell sharply in value. Many S&Ls went out of business simultaneously, because they had all followed pretty much the same strategy. That's when the Federal Deposit Insurance Corporation's guarantees on peoples deposits kicked in and the federal bailout of the S&Ls became necessary. Because the S&Ls were bailed out at the end of the S&L crisis, financial CEOs in all the financial companies - commercial banks, investment banks, insurance companies, et cetera - came to believe they would be bailed out again if they ever got into trouble. Economists call this problem "moral hazard." If you bail someone out when they take too much risk and get in trouble, it will encourage them to take too much risk again. During the 1980s and 1990s, similar events took place in Korea, Indonesia, Thailand, Argentina, Brazil, Russia, and many others. In each case, banks took on too much risk, went to the brink of bankruptcy, and the government bailed them out. In 1998, the failure of a single hedge fund in the United States - Long Term Capital Management - threatened to bring down the entire global economy. And what made this possible was the invention of and subsequent extensive use of financial derivatives by certain hedge funds - Long Term Capital Management being simply the most egregious example; not the only one, just the worst one. Derivatives use leverage to increase risk and potential return even more - to magnify both. Guess what? The use of derivatives by investment banks during the housing bubble of 2000-2006 is the primary reason this current crisis that we're in is so big and so extensive. But the focus on derivatives can cause us to take our eyes off the more fundamental problem. Sure, derivatives magnified the risk, but the underlying problem is that one group of people got the BENEFIT of risk-taking while another group of people had to bear the associated risk. This is sometimes referred to as a de-coupling of risk and return. Back in 1987, President Reagan appointed Alan Greenspan as chairman of the Federal Reserve Bank - a regulator who didn't believe in the necessity of regulation. Eleven years later, at the urging of Mr. Greenspan, the U.S. Congress passed a law saying that derivatives could not be regulated. The passage of this law is a tribute to Mr. Greenspan's persuasiveness as an economist, because just prior to this law being passed, the hedge fund Long Term Capital Management had failed and had had to be bailed out. Long Term Capital Management, using derivatives, had been enjoying annual profits as high as 40% per year. But then
they placed a one and a half trillion dollar bet on the rapid growth of the Russian economy, and the Russian financial crisis of 1997 took them down. One of the most influential ideas in economics is Adam Smith's invisible hand - the idea that the pursuit of self-interest leads, as if by an invisible hand, to the well-being of society in general. But some of the most interesting, to me, work in economics in the past three decades has been in the area of asymmetric information, and how it can prevent Adam Smith's invisible hand from working. Asymmetric information means that one of the two parties to an economic transaction knows more about the transaction than the other party does. Asymmetric information can be seen most clearly in the case of a patent medicine salesman. From about 1630 until the passage of the Food and Drug Act of 1906 patent medicine salesmen went around the country and they sold people worthless elixirs that they claimed could cure cancer, polio - actually whatever the people in the audience had, they claimed it could cure it. They would have a confederate in the audience come up looking very sickly and they would take a tablespoonful of this medicine and then they would claim to be miraculously cured. To make the patent medicines seem powerful they would put things in them to give them a "kick" - opium, alcohol, cocaine, rattlesnake venom, red pepper and turpentine were just a few of the ingredients used to achieve this purpose. Because rattlesnake venom was used in some of these concoctions, "snake oil" became a popular word for this whole class of medicines. The patent medicine salesman knew his elixirs were worthless, but his customers did not. Asymmetric information. So an economic transaction took place in which one party was enriched but the other party was not. Guess why we don't have patent medicine salesmen today? Because of the passage of the Food and Drug Act of 1906 and the establishment of the Food and Drug Administration. Now if you want to market a medicine in the United States you need to prove to the Food and Drug Administration that your medicine works - that it actually improves the condition you claim it improves - and that it is safe for human consumption. Government regulation to eliminate the problem of asymmetric information. Guess what caused the financial crisis in 2008? Asymmetric information. Icelandic pension funds and retired people who were looking for a safe investment that paid more than a 3% interest rate invested in the CDOs and CMOs that the investment banking community invented and sold during the U.S. real estate bubble of 2000-2008. Standard and Poor's and Moody's investment rating services, which were supposed to be independent, gave these investment
products a AAA safety rating. And they were paying returns of 7 or 8%. So people bought them. In fact, they couldn't get enough of them, so the investment banks manufactured more. The investment banks knew or suspected that these derivatives were not a good deal for the people that bought them - that they were too risky to make a paltry 7 or 8% return a good deal. But the buyers didn't know that. The mortgage BROKERS who generated the subprime mortgages that were packed INTO these CDOs and CMOs by the investment banks definitely knew that those mortgages were bad. That they were very, very risky investments and therefore not worth very much. So two groups of sellers in the chain knew the investments were worth a lot less than they were selling for but they quickly packaged them and sold them to unsuspecting buyers so they wouldn't be left holding any of that risk: asymmetric information and decoupling of risk and return. So you can ascribe the problem to the dishonesty of the snake oil salesmen - or the investment bankers and subprime mortgage lenders in this case - or to the lack of regulation to make it impossible for those people to take advantage of their superior knowledge of the poor quality of what they are selling; either way the solution is the same. You have to have effective government regulation to prevent people from selling something for a lot more than it is worth, and for lying to the people who are buying it about how much it is worth. Otherwise, the social benefits of a free market economy are lost. The benefits of harnessing the best efforts of people in markets to create wealth and value out of thin air in order to be able to put a little PIECE of that value in their own pockets are lost.