Like a pathologist who examines cells and tissue to determine what ails the patient, economist Joseph Stiglitz has been dissecting the U.S. economy to find out what caused its spiral into recession.
The Nobel prize-winning economist admonished regulators and Wall Street for not paying enough attention to the lessons of history during a speech before almost 200 students Jan. 22, at Stanford GSB.
“The Great Depression led to new insights into how periods of unemployment could persist and led to the conclusion that markets are not self-adjusting,” he said.
Yet the idea that something might be wrong with unchecked free markets was forgotten during the tech bubble and the housing bubble that saw high employment rates. “It raises questions: are markets as efficient and innovative as market advocates claim?”
Stiglitz, now a professor at Columbia University, in 2001 was awarded the Nobel Prize in economics for his analyses of markets with asymmetric information. Sharing the honor were former Business School Dean Michael Spence and George A. Akerlof of the University of California, Berkeley. The threesome’s idea was that the “invisible hand” of the market cannot always be relied upon to get prices right.
They proved markets aren’t always fully informed. “The invisible hand often seems invisible because it’s not there,” Stiglitz said. “Markets are not totally efficient.”
In this recent economic crisis, financial markets misallocated capital and mismanaged risk, he said. The notion that allowing people to take on more risk propels the economy forward didn’t work.
Stiglitz excoriated lenders for selling mortgages that pushed homeowners into taking risks that set them up for failures, such as negative amortization loans. “The more you borrow the richer you’ll be?” he asked incredulously. And mortgages offered to people who clearly couldn’t afford them? “Giving away money to low-income individuals is usually not the standard business model for most banks.”
Wall Street and regulators didn’t pay attention to economic fundamentals during the housing boom, he said. “Americans’ income was going down as the price of housing was going up. Eventually you were going to run into problems.”
The United States exported some of its toxic mortgages; had it not sent some of them to Europe via complex securitization, its downturn would have been far worse, Stiglitz wrote in Newsweek late last year.
He likened bundling bad products (low-rated securities) into good ones to create profitable products, to turning lead into gold. “The problem was one of intellectual incoherence. They created new products to transform financial markets yet based the risk assessment on data from before the creation of new products,” he said.
Along with financial markets that misallocated capital and transferred risk to those less able to bear it, Stiglitz blamed the economic crisis on the failure of regulators to act to stem spendthrift patterns. “There was a party going on and no one wanted to be a party pooper.” But along with bad lending and bad monetary policy, there were three other contributory factors at the corporate level: poorly designed incentives, inadequate compensation and nontransparency into accounting policies and products.
He called for fundamental reform, starting with the banks that have received federal bailout funds being forced to sell foreclosures that give homebuyers a fair chance. Changing the current situation where imports exceed exports is the only way to address reform globally, he added.
Long-term, he was pessimistic about some of the steps the U.S. government has taken to stem the downturn, such as injecting capital into the banking system. “It’s very worrisome that some of the ways we are getting out of the crisis is exacerbating the problem. Making banks bigger should make us uneasy,” he said. And making the Federal Reserve, whose balance sheet has risen to $3 trillion from $800 billion, the lender of first — instead of last — resort is “deeply troubling to our political and economic processes.”
More recently, Stiglitz has written several opinion pieces arguing that tax breaks for business — except when closely linked to additional investment — shouldn’t be part of a stimulus package. What’s needed, he told the audience, is “regulatory change in incentives so those in the financial markets don’t engage in the same bad behavior.”
Stiglitz’ appearance was as part of the Business School’s Global Management Program’s Global Speaker Series. His most recent book is, The Three Trillion Dollar War: The True Cost of the Iraq Conflict, co-authored with Linda Bilmes.
