November 19, 2008 – We had an overwhelming response to the call for questions for Joseph Stiglitz, the Nobel-winning economist and author who joins us from Columbia University. I grouped your questions together so that Professor Stiglitz could get to the topics you asked about most – and he has indeed given some very thorough answers! If you want to read more, visit his website and check out his books and articles. And as always, please feel free to leave your comments here.
Q. How long do you expect the current crisis to last, and what will its effects be on developing countries?
A. There is a growing consensus among economists that this is going to be the deepest and longest downturn in the last quarter century, and almost surely, since the Great Depression. (Direct comparisons between numbers – e.g. unemployment rates – may not be meaningful because of the change in the structure of the economy, away from manufacturing towards the service sector.)
Precisely how long it lasts will depend in part on the policies put into place by the United States and other governments. In the best of circumstances – given the mistakes already made – we are likely not to begin recovery until late 2009 or 2010. But the question is, even then, will it be a strong recovery, or will we enter an economic malaise, not unlike that of Japan?
The American economy has been sustained by a consumption binge fueled by a housing bubble. Savings rates are likely to increase from near zero to a much higher number. Even a “large” government stimulus, say two percent of gross domestic product, won’t fully offset this, and there are other downward pressures, e.g. the contraction of state and local expenditures as their tax revenues contract. The growth in net exports was particularly important in the second quarter. But with the spread of the downturn to the rest of the world, and the strengthening of the dollar, it is hard to see how even this can be sustained.
I always thought that the idea that there could be decoupling of the American economy from the rest of the world was a myth. The world has become too interconnected. Developing countries have benefits from being able to export large quantities to the advanced industrial countries, and their growth has, in many instances, been fueled by investments from those countries. But that means when there is a downturn in the advanced industrial countries, they will be affected.
They will be affected through several channels: declining trade, declining commodity prices, declining investments, increasing risk premiums, higher costs of capital and capital outflows. One of the ironies is that while the United States was the source of the global financial crisis, today money is flowing from developing countries to the United States, partly because, for all its weaknesses, a United States government guarantee on, say, a bank deposit is worth more than a similar guarantee from a developing country.
Moreover, the United States and Europe have been pursuing countercyclical policies (not necessarily totally effectively) – doing exactly the opposite of the procyclical policies imposed on East Asia in the last global crisis. But these differences mean that volatility may be higher in developing countries, another reason that they may suffer more.
Moreover, some developing countries have suffered from some of the same underlying problems (though to a less degree) that afflicted the United States. Some have had real estate and stock market bubbles, and in some, these bubbles have broken. Some countries, like Brazil, seem to have had much better bank regulation than the United States, and so have not had the kind of financial crisis that has afflicted the United States.
We can expect most countries to be affected, some more than others: those with large trade deficits, large debts that have to be refinanced and highly indebted firms, and those which are highly dependent on exports to the United States or on commodity prices are likely to be among those that are likely to suffer the most.
Q. Who was at fault for the crisis? Who was asleep at the switch? Were the indicators already visible in the 1997-98 financial crises? Could more monitoring have averted the problem? Are derivatives markets still viable?
A. This is a man-made crisis. It didn’t have to happen. It was the result of macro-economic policies in the United States – in particular, a tax cut for the rich which did not stimulate the economy – combined with the Iraqi war, which led to soaring oil prices. These put the burden of keeping the economy going on monetary policy. The Federal Reserve responded in a shortsighted way: it provided ample credit with low interest rates. Combined with lax regulations, it was an explosive mixture – and it exploded.
There were many elements that contributed to make it worse. The financial sector was rife with conflicts of interest and perverse incentives that led to shortsighted and excessively risky behavior. The rating agencies believed in financial alchemy, that they could convert F-rated sub prime mortgages into A-rated securities safe enough to be held in pension funds. Their ratings played a vital role in facilitating securitization, enabling money to go from cash rich sources (like pension funds) supposedly managing their money conservatively into risky mortgages, fueling the bubble.
Derivatives played a role: Derivatives were invented to help manage risk, but they became a gambling instrument, enabling banks to gamble billions of dollars of other people’s money with each other and with insurance companies like AIG. The trillions of dollars of exposure were totally out of line with what prudent risk management would have called for. Even when disclosed, they were so complex that not even those who created them fully understood their risk implications. Now, they and the other complex securities the banks invented contribute greatly to our problems. The banks know that they don’t know their own balance sheets, let alone that of anyone to whom they might lend. No wonder credit markets have frozen!
There is a failure in regulation—we should, for instance, have restricted incentive structures that encouraged shortsighted and excessively risky behavior, including excessive leverage. We stripped away regulations and didn’t adopt new regulations to respond to the changing financial environment (curbing abuses of derivatives). We allowed the banks to grow so big that they were too big to fail, and this too encouraged excessively risky behavior; they could gamble, knowing that if they won, they walked off with the profits, and if they lost, taxpayers would pick up the tab. Behind the failure in incentives is a failure in corporate governance – the chief executives and management enriched themselves at the expense of others, even their shareholders.
But even when we had good regulations, they were not enforced. We appointed as regulators people (like Alan Greenspan) who didn’t believe in regulation.
It is hard to believe that so many believed in the notion that markets were self-regulating – given the history of capitalism. But evidently some did, and some in positions of responsibility. A little late, even the high priest of laissez-faire capitalism, Alan Greenspan, former chairman of the Federal Reserve, has admitted he may have made a mistake – a mistake which has imposed vast costs on taxpayers in the trillions, homeowners in lost homes, workers in lost jobs, retirees in an impoverished old age, and millions of Americans in dashed dreams for a better life.
The Administration and the Fed were remarkably slow in seeing the problem coming, and when they did, they responded at first inadequately, and then with panic. The stimulus package passed in February predictably failed to stimulate – the Administration again thought that a tax cut was an all purpose cure to any ill, but in the circumstances, with a heavy burden of debt and an uncertain future, Americans saved most of the money.
The Fed and Treasury veered recklessly in their bailout strategies, bailing out some, not others, demanding harsh terms on some, not on others. They have made what would in any case have been difficult even worse. For those of us who had lived through the East Asia crisis, the decision not to bail out Lehman Brothers brought on memories of the mismanagement of the Indonesian crisis. There, the IMF (under the influence of the United States Treasury) shut down 16 banks, made it clear that there were more to follow, wouldn’t say which ones, but made it clear that there would be at most only limited deposit insurance. They succeeded in killing the private banking system; the next day there was panic.
Q. What’s the best way to solve the problems of the crisis, in the short and long terms? Keynesian fiscal measures? Aid for individual investors? Capital controls and Tobin taxes? Or should government get out of the way and simply let businesses and investors be wiped out, in the spirit of creative destruction?
A. Government has to take strong actions. If we don’t, the downturn will get worse. It might recover in the long run – but in the long run, we are all dead. No one, not even President George w. Bush, thinks doing nothing is the right action. Unfortunately, the actions taken by the Bush Administration, while very costly, have not been very effective.
The Bush Administration has been relying on a massive blood transfusion to a patient dying from internal hemorrhaging; nothing is being done to stem the wave of foreclosures. Already millions of Americans have lost their home, and millions more will in coming months. We have a human tragedy, not just an economic crisis. We need to put in place strong and effective policies, such as bankruptcy reform and aid to low income households for home ownership (we pay a substantial fraction of those costs for higher income individuals through tax deductions).
Beyond that, we need a strong fiscal stimulus. Given the huge legacy of debt being left by Bush, some are asking, can we afford it? The answer is, we cannot afford not to do it. If we don’t provide a strong stimulus, the economy will decline further, tax revenues will decrease, and the deficit will increase in any case.
The Bush Administration has also been relying on its old recipe of trickle down economics – throw enough money at Wall Street, and a few crumbs will trickle down to the rest of the economy. It has been clear that the Fed and the Bush Administration simply didn’t know what to do. They panicked as the market panicked. They veered from one plan to another. Fortunately, they abandoned the cash-for-trash proposal, but the delay was costly. But then they took a good idea, equity injections, and showed that even a good idea could be perverted. The intent of Congress in giving money to the banks was to encourage lending. But because they didn’t impose adequate restrictions or incentives, as money was pouring into the banks, they were pouring it out in dividends and bonuses, and even making plans to buy up other healthy banks. The credit contraction did not seem to be arrested.
But we won’t restore confidence unless we change bank behavior. All we have done is give them more money. But we have kept in place the perverse incentives. We need strong regulation, not just to restore confidence, but to make it less likely that we will again have such a crisis.
Q. What responsibility does the war in Iraq bear for the current economic situation in the United States?
A. I believe the war played a large role in the current crisis, in two ways (explained more fully in my book with Linda Bilmes, The Three Trillion Dollar War). First, it contributed greatly to the run-up of oil prices. Different economists may differ about precisely how much it contributed, but none think that it did not have an important role. The price of oil was $23 dollars a barrel before the war, and futures markets predicted that they would remain around that level for a decade. They understood that there would be large increases in demand (from China, India, even the U.S.), but they anticipated concomitant increases in supply, especially from the low cost producers in the Middle East. The war upset that equation.
High oil prices meant Americans were spending hundreds of billions of dollars abroad to import oil – money that otherwise would have been spent at home. That weakened the American economy. The Fed took on its responsibility to maintain the economy reasonably near full employment, in an admittedly shortsighted manner. A flood of liquidity and lax regulations led to a housing bubble, which fueled a consumption binge. Savings fell to zero. It enabled America to forestall the necessary adjustments – but at a high cost. It was, in many ways, analogous to how Latin America responded to the oil price shock of the 70s. They too borrowed (it was called “recycling petrodollars”), beyond their ability to pay. In the early 80s, country after country went into default, leading to the lost decade of the 80s.
The housing bubble and consumption binge might have occurred without the war; but undoubtedly, the war encouraged the Fed to keep interest rates lower and to engage in more lax regulation than it otherwise would. The result was a bubble that was bigger, and a crash that was deeper.
The war had another effect on the economy: Because it was financed totally on the credit card, America’s deficit and national debt soared. That meant that the room to maneuver when the crisis hit was reduced. Even Ben Bernanke has pointed this out as one of the big differences between the recession of 2001 and today: then we had a 2% of GDP surplus, ample funds to finance a strong stimulus. Last (fiscal) year’s deficit of nearly a half trillion set a new record, and next year’s will be much, much larger – even before counting in the cost of the bailouts and the bills to be paid for the returning disabled veterans (likely to number 40 to 50 percent of the 1.7 million troops that have been deployed). Worries about the mounting debt will lead some to argue for a circumscribed fiscal response. If they succeed, almost surely, the downturn will be deeper and longer lasting than it otherwise would have been.
Was it a war to defend the dollar?
No one really understands why we went to war in Iraq. The purported reasons make no sense. There were no weapons of mass destruction, and that was known to be the case (with a high degree of reliability). There was no connection with Al Qaeda; it was in Afghanistan, a war which has been going badly, partly because we diverted our attention and resources away from it. (Now, of course, Al Qaeda has moved into Iraq.)
Some think we went to war to promote democracy throughout the region. If so, it has been a dismal failure. Some think we went to war to get cheap oil. If so, it has again been a dismal failure. But even the idea was strange: We live in the 21st century, not the 19th. In the 19th century, a country could march into another and seize its resources. But we signed the Hague convention, which requires that an occupying power treat the resources of the country as a fiduciary. Iraq’s oil would be Iraq’s, not America’s.
Will future wars rely so much on costly private armies of contractors?
Hopefully not. The contractors have not only been costly; they have often undermined our mission, in many ways. Maximizing profits is not necessarily consistent with maximizing America’s strategic objectives.
We used contractors because the Bush Administration wanted Americans to believe that we could have a war for free. They didn’t want to impose a draft, and the war was unpopular, which made recruitment difficult. Without the contractors, we would have had to expand our military significantly.
Q. How would a stimulus package help the economy, especially private investment?
A. A well-designed stimulus package will increase demand, and that will lead to an increase in output and employment. That will, in turn, reduce the number of foreclosures and bankruptcies. That means that the banking system will be stronger than it otherwise would be. Returns to investment will be higher, and there will be more access to capital.
A temporary (incremental) investment tax credit could help stimulate investment even more.
Should General Motors receive a bailout?
The relevant question is, what is the best way to restructure America’s automobile industry? We need to be careful in identifying who is being bailed out. The Mexico bailout was, for instance, not a bail-out of Mexico, but of American (and other) investors who had invested in certain Mexican bonds. Like most of the other bailouts (and not unlike our current bailout), it was largely a Wall Street bailout.
We could restructure General Motors in a way that maintained and enhanced its productive capacity, and limited the necessity of putting in government money. Restructuring would probably wipe out shareholder value (which is not great in any case), and diminish greatly that of bondholders. We have to do it in a way that will maintain and increase confidence in GM’s products and improve its technology. I believe it can be done, though it might require special legislation (a form of pre-packaged restructuring). In fact, doing this (with accountability for the managers that have failed) might actually increase confidence in GM’s products.
The risk is that a bailout without financial and corporate restructuring will cost our hard-pressed taxpayers far more than necessary, will undermine the sense of accountability so necessary for the functioning of a market economy, and will fail to achieve its underlying objective of creating a sustainable, viable, and vibrant industry. It will simply lead to the need for further bailouts in the future.
Can the American middle class avoid ruin?
Yes, if we put in place the right policies. There is nothing inevitable about the hollowing out of the middle class. It, like the current economic downturn, is a result of flawed policies.
Can global imbalances be reversed in the midst of these challenges?
Some of the global imbalances will almost inevitably be reversed in the midst of the current downturn; indeed, we can view the global meltdown as part of the long-predicted “disorderly unwinding” of these global imbalances. America’s savings rate will increase, its investment rate will decrease, and its trade deficit will probably decrease.
Q. Is Barack Obama the right person to take on these problems? Is his election an economic positive in itself?
A. I believe Barack Obama is the right person to take on these problems. He has shown an enormous awareness of what needs to be done. He has, for instance, emphasized the need for a stimulus and to do something about the problem of foreclosures.
His real challenge will come as he faces some of the tough decisions. How big a stimulus – and how big a deficit? Fiscal conservatives will be arguing for a small package, urging caution. Too small a package will mean that foreclosures will continue apace, bankruptcies will continue to increase, banks’ balance sheets will continue to worsen, and the economy will remain weak. Some will argue against restructuring the Troubled Assets Relief Program, but we will have to make it work – Congress and the American people never intended to give hundreds of billions of dollars to the banks so that they could continue their dividends. It was intended that they sustain their lending. Some in the financial market will urge caution in introducing regulations. Caution, yes. But behavior has to be changed in fundamental ways. We have to regulate incentives and risk taking. We have to do something about derivatives and leverage. The banks have shown that we cannot rely on self-regulation.
Will he be able to help create an international regulator?
We will have to have global cooperation in regulation. We cannot allow “regulatory arbitrage,” where banks to go to some Caribbean island to escape regulation (or to enable those engaged in drug dealing, tax evasion, or corruption to launder their money). The world’s leaders have recognized this, and even without a global regulator, we can achieve enough global cooperation to prevent these abuses.
Q. Where will global growth come from in the next decade?
A. Growth in the next decade is again likely to come from emerging markets. It is possible that America will emerge from its problems reinvigorated. There is a great deal of excitement about converting into a green economy all over the world. But the next few years are likely to be difficult.
Will we have a new world order in global economic management, with more participation by developing countries?
We have already seen the beginning of the shift – President Bush called a meeting of the G-20 to deal with the global crisis, not the G-7. There, they agreed that there needed to be a change in global economic governance. But progress may be slow, unless the developing countries with the large pools of liquid money the world needs insist on the changes, if they are going to provide that money to the international financial institutions, or unless the United States and Europe come together committed to creating a more democratic global economic governance.