The global economic
crisis and Alternatives to
Rebuild the Economy
Joseph E. Stiglitz
Rio
May, 2009
The future is bleak

The most serious economic disturbance
since Great Depression
• Most downturns since have been inventory
cycles

Economy recovers as soon as excess inventories are
decumulated
• Or a result of Central Bank stepping on brakes
too hard

Economy recovers as soon as Central Bank discovers
its mistake, removes its foot from brake
• This economic downturn is a result of major
financial mistakes

Akin in many ways to frequent financial crises in
developing countries

America’s economy has been sustained by
consumption boom, fueled by a housing bubble
• Savings fell to zero
• That game is over
• Posing a global problem: America’s consumption boom
sustained the global economy

The storm is just beginning
• Rising unemployment
• More foreclosures, as house prices continue to fall


3.6 million so far, 2 million expected in next year
12 million mortgages underwater and numbers rising
• Credit constraints likely to persist—poorly designed bailout
• Shouldn’t confuse end of free fall, or even slight
recovery from bottom, with the beginnings of a robust
recovery
Each of components of aggregate
demand weakening


States and localities cutting back
Households likely to increase savings
substantially
• May be good in short run, but “paradox of thrift” means
that national income will be reduced
• Restraints on ability and willingness to borrow



Loss in wealth
Had been borrowing on assumption of rising house prices
Investment likely to slow
• Real estate has been main source of investment—
declining at record levels (overbuilding)
• Other firms face credit constraints, uncertainty, declining
sales

Exports have been major source of demand
• But dollar is strengthening
• And downturn is spreading
A Vicious Cycle



Weak economy, higher
unemployment
More foreclosures, more bad loans,
weaker banking system, more
restricted lending
Lower prices for housing, reduced
consumption, weaker economy
Becoming a global slowdown


Myth of decoupling
Effects spreading to Europe
• Partly because of major financial losses in Europe
• Including in Eastern Europe
• Partly because of exchange rate adjustments, impact on
exports
• Both part of globalization

Now spread to China, India, Brazil
• Even countries that did not make any of the mistakes
that the U.S. did, had good regulatory and monetary
policies

Will affect most countries
• Through effects on global financial
markets



Highly indebted countries, with large trade
deficits, likely to be most affected
Also through investment
Financial market protectionism
• Through prices of commodities
• Through trade
• Through remittances
“Periphery” likely to be greatly
affected

Heavy dependence on exports
•
•
•
•






Declines in exports
Partly explained by
Partly explained by
Partly explained by
investment
greater than anticipated
lack of trade credit
inventory adjustment
large fall of demand for durables,
Heavy dependence on foreign direct investment
Heavy dependence on foreign borrowing
Some with heavy dependence on remittances
Less resources to combat downturn and its effects
Even countries with “good” economic policies are being
affected
Irony: money is flowing back to US
• Even though it was source of problem
• Because of relative confidence in US government guarantee
Brazil is in a Good Position

Monetary policy has given it room to
maneuver—
• Unlike the U.S.
• Which has been forced to engage in risky
strategies, with uncertain long term
consequences
• And little short run impacts—other than
preventing the crisis from going into freefall


But will be important to use all available
instruments
As large economy, more room for effective
stimulus spending
BROAD GENERAL LESSONS

Need to rethink what are “good” policies
and institutions
• Most would have thought that the U.S. had
good policies and institutions



Evidently not
Problems are pervasive and deep-seated
So question is: What are good policies and
institutions?
• Deregulatory policies of U.S. were similar to
those advocated under Washington Consensus
by IMF and U.S. Treasury
September 15: A Watershed


The fall of the Berlin Wall marked the end
of Communism and the belief in that
economic system
The massive bail-outs in the US marked
the end of market fundamentalism, belief
in unfettered markets
• Markets are not self-adjusting, self-correcting
• At least in the relevant time frame
• America’s response is being called “Socialism
with American Characteristics”
America’s financial markets have
failed and failed massively






Supposed to mobilize savings, allocate capital,
manage risk
Didn’t mobilize savings: encouraged living on
credit card
Misallocated capital
Created risk
But failed to create products that would help
ordinary American households and firms manage
the risks which they faced
High transactions costs—and resisted creating an
efficient Electronic Payments Mechanism
Underlying market failures

Underlying problem: Lack of congruence between
social returns and private rewards


Net return 2004 to date negative
Incentive systems
• Encouraged excessive risk taking, myopic behavior
• Encouraged lack of transparency, greater complexity

Lack of transparency, excessive complexity
• Underlying cause of credit crunch


Too big to fail—encouraged excessive risk taking
Underlying problems in corporate governance
Rating Agencies





Believed in financial alchemy—could convert F
rated subprime mortgages into A rated securities
safe enough for pension funds; played an
essential role in securitization process
Played key role: facilitated flow of funds into bad
lending
Conflicts of interest—paid by those they rated
Competition made it worse: race to the bottom
Failed to assess risks accurately—flawed models
• Underestimated correlations, likelihood of small
probability events, risk of price declines
• Reinforced mistakes of the banks
• Failures were predictable and predicted

Not for the first time (also failed in East Asia
crisis)
Securitization




Allowed greater diversification of risk and
risk spreading
But created new asymmetries of
information
Incentives for lower quality of lending
Banks and rating agencies failed to take
into account the effects of new
asymmetries of information and new risky
products on foreclosure rates
Derivatives, CDS, and other
risky products







Double-edged sword
Could help manage risk
But also could be used as new high power
gambling instrument
Contributed to lack of transparency
Which in turn contributed to credit crisis
Risk recognized
Fight over regulation in the 90s
• Financial markets won short-run battle
• They, the American economy, and the world
lost in the long run
Underlying public failures

Macro - excessive liquidity, low interest rate
• Partially in response to breaking of tech bubble, soaring oil
prices

Followed example of Latin America in the 70s
• Should have designed better fiscal policies
• But cheap credit should be a “good thing”—basis of rapid
growth, if well used—real problem with financial markets and
regulation

Deregulation, failure to enforce existing regulation, to adopt
new regulations to respond to changing financial landscape
• Deregulation philosophy
• Regulators who didn’t believe in regulation


Loose money and lax regulations were an explosive mixture
Failure to enforce competition laws contributed to “too big
to fail”
Flawed bail-out



Non-transparent, unaccountable
Cash for trash could not be done quickly
Is it enough?
• We don’t know—banks too non-transparent
• But what would have been enough one month ago is not
enough today
• Bail-outs getting larger and larger—to little effect
• But exposing taxpayers to increasing risk
• Massive blood transfusion to a patient suffering from
internal hemorrhaging


Finally beginning to do something
But not enough—need write down of principle
• Need to address real economy


Stimulus not enough
Badly designed
Flawed bail-out

Will it ensure resumption of lending?
• Probably not
• Didn’t stop banks from distributing
money to shareholders, even as
government was pumping money in
(contrast with U.K.)
• Didn’t provide adequate oversight
(contrast with U.K.)
Flawed bail-out

Will it restore confidence?
• Probably only to a limited extent
• No change in those in charge (contrast
to U.K.), no sense of accountability
• So far, no change in regulations and
regulatory structures

Worry about “cosmetic reform”
• Increase in guarantees helpful, but still
insufficient
Flawed bail-out

Did the taxpayer get a good deal?
• One question for which there is a clear
answer—taxpayers got a raw deal






Prices of shares after announcement
Pricing of preferred shares, terms
Contrast with Buffett, U.K.
Congressional Oversight Panel—taxpayers badly
cheated
More recent bail-outs worse
CBO estimates massive losses
• Important: growing national debt will make
taking appropriate actions more and more
difficult
The result…



Economic downturn will be longer
and deeper than it otherwise would
have been
And America’s national debt will be
much larger than it otherwise would
have been
Both will have global consequences
Incipient controversies

Second round of a stimulus?
• Size of national debt may impose
constraints
• Before economy is on robust recovery
• Irony: worries about size of deficit
likely to come from financial sector, but
only after they have had their bail-out
Incipient Controversies

How extensive should bail-outs be? And under
what terms?
• Government could have resuscitated economy much
more effectively with less money by creating new
institutions, rather than saving old institutions

Debate reminiscent of debates in the economies in
transition
• What is best way to save old institutions?




Bankruptcy (especially chapter 11) simply changes
management and financial claims; real assets don’t
disappear
Are we bailing out auto industry, or Wall Street
bondholders?
Confusing saving banks with saving bankers, bondholders,
and shareholders
Debt to equity swaps would enhance financial stability,
confidence
Incipient controversies

How extensive should the regulations be?
• Some worry that the pendulum will swing too
far, innovation will be stifled
• But most of innovation was involved in
regulatory, accounting, and tax arbitrage, had
little social value

Little innovation to help ordinary Americans manage
the important risks they face (stay in their own
homes)
• Good regulation may actually enhance “good”
innovation and contribute to a more productive
economy
Incipient Controversies

Who should pay for the bail-outs of the
financial sector?
• Originally, they claimed the bail-outs would
pay for themselves
• As size has increased, likelihood has decreased
• Current estimates are very large losses
• Some suggest making them pay would
discourage attracting private capital
• Others argue matter of efficiency and equity

Similar to polluter pays principle in environmental
economics
Big Questions Today


Where is economy going? Will proposed
stimulus and bank bail-out work? And
what will things be like at the other end?
Growing consensus
• Even large stimulus not likely to make up for
shortfall in aggregate demand
• Unless something dramatic is done, when we
emerge from recession, likely to emerge into
“malaise” rather than into strong growth
What is to be done?

Problem is global, not just American
•

America has been the source of global aggregate
demand
Alternative sources of increased aggregate
demand
1. Redistribution—offsetting marked increased inequality
in recent years
2. Responding to the needs of global warming—huge
investments required
3. Reforming the global financial system—new global
reserve system, annual creation of SDR’s
4. Assistance to developing countries

Don’t have resources for stimulus, protect banks, provide
safety net
Lessons for other countries

Washington Consensus model didn’t
even work in Washington
• We are all Keynesians now


But not all Keynesians are the same
Keynesian economics can be abused and
used for special interests, just as any other
economic doctrine
• We will be redesigning our corporate
governance and regulatory systems

There will be resistance from those who
benefited from old system
Lessons for other countries

Design regulatory structures
assuming that others are not doing
their job
• Ring-fence core financial system
• Regulation has to be comprehensive

Little point in having transparency in just a
part of the system
• Host country has to play central role in
regulation

Need strong consumer protection,
anti-trust, safety and soundness, and
access regulations
• Speed limits
• Consumer protection
• Worse lending combined risky and
predatory lending
• Key function of finance is to provide
credit, especially to small and medium
sized firms

CRA requirements to encourage finance to
underserved groups, imposed on all
Rethinking Monetary Policy

Stability is necessary for growth
• But price stability is not the only aspect
of stability
• Excessive focus on price stability part of
key mistake of Central Banks around
the world
• Need to focus more on financial stability
New global landscape

Problem was “made in America,” and so far,
America’s political system’s response to crisis has
been disappointing
• Even in contrast to “old Europe”

America is still largest economy
• But America is no longer largest source of savings
• America has lost dominance in manufacturing
• America may now lose pre-eminence in financial
markets


Role in financial intermediation based on presumption of
“better institutions,” comparative advantage in managing
risk and allocating capital
Latin America, Africa increasingly turning to
China as a source of finance
New Global Landscape

Old international governance structure failed
• IMF, Financial Stability Forum didn’t do much to prevent
crisis




Imposed large number of conditions
Including counterproductive pro-cyclical macro-policies
Encouraged financial sector deregulation which played such
a big role in creating the crisis—and even in its propagation
Encouraged capital market liberalization, which too played
key role in the spread of the crisis
• Led to greater risk
• Without any greater growth


Promoted monetary policies that didn’t pay sufficient
attention to financial stability
Underlying problems political and ideological
• Proposed governance reforms not likely to make much
difference, though steps in the right direction.
• Yet they are the only institutions we have
UN Commission

UN Commission emphasizing need for
additional funds and recommending:
•
•
•
•
new
new
new
new


credit facilities
global regulatory authority,
global economic coordinating council
global reserve system
Key to restoring global aggregate demand
Institutions created in first half of 20th
century not up to tasks of 21st century
• And many have a legacy of pushing failed
ideology that may impair effectiveness
BIG QUESTIONS AHEAD

What kind of financial system do we
want when the economy emerges
from crisis?
• Can’t, shouldn’t go back to pre-crisis
structure
• Recovery strategy should be based on
long term vision

Bail-outs have reinforced old problems,
money disproportionately going to too big to
fail institutions
BIG QUESTIONS AHEAD

Crisis is forcing rethinking about what kind
of society, economy works best
• Need to get the balance between the market
and the government (and other non-state
actors) right
• Markets were unstable, inefficient, exploitive


They discovered there was money at the bottom of
the pyramid and did everything they could to make
sure it didn’t remain there
Silver lining on this cloud: Societies all
over the world are beginning to rethink