The Fall: A Chronicle of the
Financial Crisis
Joseph E. Stiglitz
The Crisis in Brief
 Excess credit fed a housing bubble
– Problems exacerbated by poorly designed mortgages (low
doc “liar loans,” zero or negative amortization loans,
variable rate mortgages, teaser rates)
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The Crisis in Brief
 Excess credit fed a housing bubble
– Securitization meant that originator did not bear costs of
flawed mortgage products
 Based on the principle that a “fool is born every moment”
 Globalization had opened up a global marketplace for fools
 Rating agencies’ flawed incentives and flawed models made
it all possible
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The crisis was predictable, and predicted
 The bubble was not sustainable
– Savings rate had dropped to zero
– House prices were soaring, while most people’s incomes
were declining
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The crisis was predictable, and predicted
 When the bubble broke, it was inevitable that
there would be long term consequences
– Excessive leverage on the part of households and banks
– Deleveraging is a slow process
– Bankruptcies destroy organizational capital
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This crisis is like many other crises
around the world
 Crises have marked capitalism since the beginning
– The only period in which there were not crises is the short
period after the Great Depression when there was good
regulation
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This crisis is like many other crises
around the world
 Since the deregulation movement began 30 years
ago, there have been more than 100 crises, mostly
in developing countries
– Governments and the IMF came to the rescue
– The wrong inference was made: markets worked, but
only because they were rescued
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Crisis is like a slow train wreck
 First, the rate of increases in housing prices slowed
down
– Some mortgage products were designed to run into
problems even then
 Then housing prices crashed—with predictable
consequences
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Crisis is like a slow train wreck
 Banks had created complex, non-transparent
products—which they and investors did not fully
understand—and engaged in off balance sheet
activities
– While some of the products were justified as helping to
manage risk, they actually increased risk
– Meant that banks didn’t know their own balance sheet
– Couldn’t know that of others
– Credit markets froze
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Government to the rescue
 Saved the banks, the bankers, their shareholders
and bondholders
– Ersatz Capitalism—new level of moral hazard (socializing
losses, privatizing gains)
– Repealing the ordinary rules of capitalism (entailing
bankruptcy when debt obligations cannot be paid, putting
banks into conservatorship)
– Increased concentration in the banking system—
increasing the problems of too-big-to-fail
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Mortgages
 Finally did something—but too little
 Almost nothing about the underwater mortgages
 Pace of foreclosures continues almost unabated
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The Stimulus
 Worked—but for the stimulus, the unemployment
rate would probably have peaked at close to 12%
 But it was too small, and not well designed
 Based on the hypothesis that the economy had hit
a small bump, repair the financial system, and
everything would return to normal
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Hypothesis was wrong
 There were fundamental problems before the
crisis—growth in America and around the world
was largely supported by unsustainable American
consumption
 Even if America’s financial institutions were
functioning perfectly, households unlikely to return
profligate ways
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What will fill the gap?
 Government has been doing this temporarily
– But ability and willingness to do this is limited
– Growing fiscal pressures are leading to more
contractionary policies around the world, especially in
Europe after the Greek crisis
– In US, states and localities are facing massive shortfalls of
revenues—with balanced budget framework, negative
stimulus to the economy
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What will fill the gap?
 Monetary policy has little power to stimulate the
economy
– Though it may succeed in creating bubbles in emerging
markets
– It has not succeeded in encouraging lending by banks in
the US and Europe
– Understandable, given their weak balance sheets
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The Crisis Continues
 As government came to the rescue, its fiscal
positions worsened
– In effect, debts were transferred to the government
– Assumed that government could manage them better
– Rescue policies did work—were it not for policies, there
likely would have been a depression
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Again, following historical pattern
 Sovereign debt crises often follow financial crises
 Hope that this time things would be different
– Most crises are in developing countries, with limited ability
to raise taxes and high debt to GDP ratios
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Again, following historical pattern
 Hope that this time things would be different
– But European crisis shows that that is not the case
– Greece had high debt and deficit
– But many of the countries in Europe face similar problems
– Explanation for the Trillion Dollar Bailout Program
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Not Just a Matter of Profligacy
 Spain had a budget surplus before the crisis
 Spain had only a 60% debt/GDP ratio
 Spain had better bank regulation (at least in some
dimensions) than the US and most other countries
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Not Just a Matter of Profligacy
 Yet today, Spain stands at the precipice
– Huge deficit
– 20% unemployment
– More than 40% youth unemployment
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The world faces a dilemma
 Response demanded of Spain and other countries
with large deficits is to cut back spending (or raise
taxes)
 The effect could be massively contractionary
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The world faces a dilemma
 The improvement in the deficit will be minimal
– Reminiscent of Argentinean death spiral
– Disappointment with size of improvement in deficit/GDP
will cause higher interest rates, worsening the problem,
leading to further cutbacks
– Even the rescue packages may not due the trick
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Global Perspectives
 One bright spot is growth in Asia
– Partial decoupling—based on vast untapped domestic
markets
– But too small to lead to recovery of US and Europe
– And there is limited spillover from their expansion
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Global Perspectives
 Problems of reserve accumulation (which weakens
global aggregate demand) worsened
– Those countries with large reserves fared better
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But Europe’s problems will impact US
 Irony: America exported its toxic mortgages and
its recession to Europe
 Now, Europe is likely to return favor
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But Europe’s problems will impact US
 One hope for American recovery was strong
exports
– Based on a weak dollar
– US had been winning “negative beauty contest”
– But it looks like Europe will take over, at least for a time
– Prospects of strong exports with a weak euro (strong
dollar) and a weak Europe are bleak
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Prospects of a quick global recovery
remain bleak
 In U.S., problem is not that of a jobless recovery,
but rather of an anemic recovery—too slow to
create jobs for new entrants to the labor force, let
alone to eliminate the job deficit
– One out of six Americans who would like a full time job
still can’t get one
– Housing problems may impede recovery of labor market
– Middle of decade (at earliest) before return to “normal”
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Prospects of a quick global recovery
remain bleak
 In Europe, matters are even worse
 Questions are raised: Will the euro survive? Will
some European governments default?
– Will countries be willing to take cutbacks required by
“markets”?
– Especially with prolonged high unemployment rates
(including among the youth)
– Uncertainties will play on investors, force higher interest
rates, and exacerbate the problems
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“Can it Happen Again?”
 If history is our guide, not only can it happen
again, it will happen again
– Though it may take slightly different form
– With slightly different instruments
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“Can it Happen Again?”
 Question is: have we “learned the lessons,” so
that the likelihood is reduced, the consequences
mitigated?
 The answer is almost surely no:
– We know that markets are not self-regulating
– We know that perverse incentives give rise to perverse
behavior
– We know that regulations are required
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“Can it happen again?”
 But so far the responses to the crisis have been
mixed—little has been done about underlying
problems
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“Can it happen again?”
 And in some dimensions, matters are worse
– A more concentrated banking system—giving rise to
greater problems of “too big to fail”
– The bailouts and the manner in which they were
conducted exacerbated moral hazard problem
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“Can it happen again?”
 And in some dimensions, matters are worse
– Prevalent incentive structures provide incentives for short
sighted behavior and excessive risk taking.
– Open question still about derivatives regulations
– Some success in preventing worse mortgage abuses
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Regulation and Creativity
 In some quarters, there are worries about whether
new regulations will stifle creativity
 But much of the sectors’ creative energy was
directed at regulatory, tax, and accounting
arbitrage
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Regulation and Creativity
 This undermined the sector fulfilling its core
functions of allocating capital (providing credit to
small and medium sized enterprises) managing
risk, running an efficient payments system, all at
low transactions cost
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Regulation and Creativity
 A good regulatory system holds out the promise of
directing innovative energies of the sector in ways
more consonant with its role in our society
 Creating not only a more stable economy, but a
more prosperous one.
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