Joseph Stiglitz: No Real Reform of Wall Street by Obama

Sitiglitz argues that there has been no real regulation by Obama that would stop financial institutions from again taking on very risky investments. In fact since some financial institutions are now too big to fail these investments are in effect underwritten by the taxpayer! At the same time instead of breaking up financial institutions with huge power they are growing ever larger.


For All Obama's Talk of Overhaul, the US Has Failed to Wind in Wall StreetWith a blank cheque from taxpayers and no real reform the perverse incentives for risk-taking are bigger than ever
By Joseph E. StiglitzSeptember 15, 2009
"The Guardian" --
What went wrong? Have the right lessons been learned? Could it happen again? The anniversary of the Lehman Brothers' bankruptcy and the freezing of the credit markets that followed is an occasion for reflection. I fear that our collective response has been mistaken and inadequate - that we may just have made matters worse.
The financial sector would like us to believe that if only the Federal Reserve and the Treasury had leapt to the rescue of Lehmans all would have been fine. Sheer nonsense. Lehmans was not a cause but a consequence: a consequence of flawed lending practices, and of inadequate oversight by regulators.
Financial markets had lent on the basis of a bubble - a bubble in large part of their making. They had incentive structures that encouraged excessive risk-taking and shortsighted behaviour. And that was no accident. It was the fruit of vigorous lobbying, which strived equally hard to prevent regulation of changes in the financial structure, new products like credit default swaps - which, while supposedly designed to manage risk, actually created it - and ingenious devices to exploit poor and uninformed borrowers and investors. The sector may not have made good economic investments, but its political investments paid off handsomely.
Lehmans was allowed to fail, we were told at the time, because its failure did not pose systemic risk. The systemic consequences its failure entailed, of course, were used as an excuse for the massive bailouts for the banks. Thus the Lehmans example became at best a scare tactic; at worst it became an excuse, a tool, to extract as much as possible for the banks and the bankers that brought the world to the brink of economic ruin.
Had more thought gone into how to deal with Lehmans, the Treasury and Fed might have realised that it played an important role in the shadow banking system, and that it was important to protect the integrity of the shadow system which had come to play such an important role in the US and global financial payments system. But many of Lehmans' activities had no systemic importance. The administration could have found a path between the false dichotomy of abandonment or bailout. That would have protected the payments system, providing the minimum amount of taxpayer money. Shareholders and long-term bondholders would have been wiped out before any public money had to be put in.
Bailing out the US banks need not have meant bailing out the bankers, their shareholders, and bondholders. We could have kept the banks as ongoing institutions, even if we had played by the ordinary rules of capitalism which say that when a firm can't meet its obligations to creditors, the shareholders lose everything.
Unquestionably we should not have allowed banks to become so big and so intertwined that their failure would cause a crisis. But the Obama administration has created a new concept: institutions too big to be resolved, too big for capital markets to provide the necessary discipline. The perverse incentives for excessive risk-taking at taxpayers' expense are even worse with the too-big-to-be-resolved banks than they are at the too-big-to-fail institutions. We have signed a blank cheque on the public purse. We have not circumscribed their gambling - indeed, they have access to funds from the Fed at close to zero interest rates, and it appears that "trading profits" have (besides "accounting" changes) become the major source of returns.
Last night Barack Obama defended his administration's response to the financial crisis, but the reality is that a year on from Lehmans' collapse, it has failed to take adequate steps to restrict institutions' size, their risk-taking, and their interconnectedness. Indeed, it has allowed the big banks to become even bigger - just as it has failed to stem the flow of profligate executive bonuses. Obama's call on Wall Street yesterday to support "the most ambitious overhaul of the financial system since the Great Depression" is welcome - but the devil, as ever, will be in the detail.
There remain many institutions willing and able to engage in gambling, trading and speculation. There is no justification for this to be done by institutions underwritten by the public. The implicit guarantee distorts the market, providing them a competitive advantage and giving rise to a dynamic of ever-increasing size and concentration. Only their own managerial competence, demonstrated amply by a few institutions, provides a check on the whole process.
The Lehmans episode demonstrates that incompetence has a price. That there would be serious problems in our financial institutions was apparent since early 2007, with the bursting of the bubble. Self-deception led those who had allowed the bubble to develop, who had looked the other way as bad lending practices became routine, to think that the problems were niche or temporary. But after the fall of Bear Stearns, with rumours that Lehmans was next, the Fed and the Treasury should have done a serious job of figuring out how to manage an orderly shutdown of a large, complex institution; and if they determined that they lacked adequate legal authority, they should have requested it.
They appear, remarkably, to have been repeatedly caught off-guard. They claim in the exigency of the moment they were doing the best they could. There was no time for thought. And that explains how they veered from one solution to another: after saying that they did not want to bail out Lehmans because of a concern about moral hazard, they extended the government's safety net further than it had ever been. Bear Stearns extended it to investment banks, and AIG to all financial institutions. Perhaps they were doing the best they could at the time; but that is no excuse for not having anticipated the problems and been better prepared.
Lehman Brothers was a symptom of a dysfunctional financial system and regulatory failure. It should have taught us that preventing problems is easier, and certainly less costly, than dealing with them when they become virtually intractable.
© 2009 Guardian News and Media Limited

Stiglitz on corporate welfarism for the big banks

Stiglitz has no definition of socialism. He seems to see it as helping out ordinary individuals. No doubt it would but surely he should know as an economist that socialism is the socialisation of the means of production distribution and exchange through worker or some type of collective ownership and production on the basis of need rather than profit.
What some commentators are calling socialism with American characteristics is not socialism at all but a form of corporate welfare where costs are socialised and profits privatised. As some have put it, it is "socialism" for the rich.

© The Berkeley Electronic Press
The Economists’ Voice
www.bepress.com/ev
Joseph E. Stiglitz

With all the talk of “green shoots” of economic recovery, America’sbanks are pushing back on efforts to regulate them. While politicians talk about their commitment to regulatory reform to prevent arecurrence of the crisis, this is one area where the devil really isin the details—and the banks will muster what muscle they have left toensure that they have ample room to continue as they have in the past.The old system worked well for the bankers (if not for theirshareholders), so why should they embrace change? Indeed, the effortsto rescue them devoted so little thought to the kind of post-crisisfinancial system we want that we will end up with a banking systemthat is less competitive, with the large banks that were too big tofail even larger.It has long been recognized that those of America’s banks that are toobig to fail are also too big to be managed. That is one reason thatthe performance of several of them has been so dismal. Becausegovernment provides deposit insurance, it plays a large role inrestructuring (unlike other sectors). Normally, when a bank fails, thegovernment engineers a financial restructuring; if it has to put inmoney, it, of course, gains a stake in the future. Officials know thatif they wait too long, zombie or near zombie banks—with little or nonet worth, but treated as if they were viable institutions—are likelyto “gamble on resurrection.” If they take big bets and win, they walkaway with the proceeds; if they fail, the government picks up the tab.This is not just theory; it is a lesson we learned, at great expense,during the Savings & Loan crisis of the 1980s. When the ATM machinesays, “insufficient funds,” the government doesn’t want this to meanthat the bank, rather than your account, is out of money, so itintervenes before the till is empty. In a financial restructuring,shareholders typically get wiped out, and bondholders become the newshareholders. Sometimes, the government must provide additional funds;sometimes it looks for a new investor to take over the failed bank.The Obama administration has, however, introduced a new concept: toobig to be financially restructured. The administration argues that allhell would break loose if we tried to play by the usual rules withthese big banks. Markets would panic. So, not only can’t we touch thebondholders, we can’t even touch the shareholders—even if most of theshares’ existing value merely reflects a bet on a government bailout.I think this judgment is wrong. I think the Obama administration hassuccumbed to political pressure and scare-mongering by the big banks.As a result, the administration has confused bailing out the bankersand their shareholders with bailing out the banks.Restructuring gives banks a chance for a new start: new potentialinvestors (whether in equity or debt instruments) will have moreconfidence, other banks will be more willing to lend to them, and theywill be more willing to lend to others. The bondholders will gain froman orderly restructuring, and if the value of the assets is trulygreater than the market (and outside analysts) believe, they willeventually reap the gains.But what is clear is that the Obama strategy’s current and futurecosts are very high—and so far, it has not achieved its limitedobjective of restarting lending. The taxpayer has had to pony upbillions, and has provided billions more in guarantees—bills that arelikely to come due in the future.Rewriting the rules of the market economy— in a way that has benefitedthose that have caused so much pain to the entire global economy—isworse than financially costly. Most Americans view it as grosslyunjust, especially after they saw the banks divert the billionsintended to enable them to revive lending to payments of outsizedbonuses and dividends. Tearing up the social contract is somethingthat should not be done lightly.But this new form of ersatz capitalism, in which losses are socializedand profits privatized, is doomed to failure. Incentives aredistorted. There is no market discipline. Thetoo-big-to-be-restructured banks know that they can gamble withimpunity—and, with the Federal Reserve making funds available atnear-zero interest rates, there are ample funds to do so.Some have called this new economic regime “socialism with Americancharacteristics.” But socialism is concerned about ordinaryindividuals. By contrast, the United States has provided little helpfor the millions of Americans who are losing their homes. Workers wholose their jobs receive only 39 weeks of limited unemploymentbenefits, and are then left on their own. And, when they lose theirjobs, most lose their health insurance, too.America has expanded its corporate safety net in unprecedented ways,from commercial banks to investment banks, then to insurance, and nowto automobiles, with no end in sight. In truth, this is not socialism,but an extension of long standing corporate welfarism. The rich andpowerful turn to the government to help them whenever they can, whileneedy individuals get little social protection.We need to break up the too-big-to-fail banks; there is no evidencethat these behemoths deliver societal benefits that are commensuratewith the costs they have imposed on others. And, if we don’t breakthem up, then we have to severely limit what they do. They can’t beallowed to do what they did in the past—gamble at others’ expenses.This raises another problem with America’s too-big-to-fail,too-big-to-be-restructured banks: they are too politically powerful.Their lobbying efforts worked well, first to deregulate, and then tohave taxpayers pay for the cleanup. Their hope is that it will workonce again to keep them free to do as they please, regardless of therisks for taxpayers and the economy. We cannot afford to let thathappen.

Joseph E. Stiglitz is a Professor of Economics at Columbia University,and a Nobel Laureate in economics. He chairs a Commission of Experts,appointed by the President of the U.N. General Assembly, on reforms ofthe international monetary and financial system. A new global reservecurrency system is discussed in his 2006 book, Making GlobalizationWork.

Bleakonomics

I have not had a chance to read Klein's book yet but this review seems more positive than some other recent reviews I have read. Some reviewers are quite upset and dismissive of Klein's views. However, Stiglitz is much more even handed perhaps because he himself of late has been also critical of the prevalent "theology" of free markets.
As I have mentioned in another post, Friedman's role is perhaps overemphasized although he was directly involved in Chile as an advisor to Pinochet. In Russia the shock was delivered more by a Harvard School featuring the likes of Jeffrey Sachs who not only delivered a privatisation shock but made themselves in some of the deals it would seem.
Stiglitz's term "bleakonomics" is a great neologism.

Bleakonomics


By JOSEPH E. STIGLITZ
Published: September 30, 2007
There are no accidents in the world as seen by Naomi Klein. The destruction of New Orleans by Hurricane Katrina expelled many poor black residents and allowed most of the city’s public schools to be replaced by privately run charter schools. The torture and killings under Gen. Augusto Pinochet in Chile and during Argentina’s military dictatorship were a way of breaking down resistance to the free market. The instability in Poland and Russia after the collapse of Communism and in Bolivia after the hyperinflation of the 1980s allowed the governments there to foist unpopular economic “shock therapy” on a resistant population. And then there is “Washington’s game plan for Iraq”: “Shock and terrorize the entire country, deliberately ruin its infrastructure, do nothing while its culture and history are ransacked, then make it all O.K. with an unlimited supply of cheap household appliances and imported junk food,” not to mention a strong stock market and private sector.

THE SHOCK DOCTRINE

The Rise of Disaster Capitalism.

By Naomi Klein.

558 pp. Metropolitan Books. $28.


Free-Market Mischief in Hot Spots of Disaster (September 10, 2007) “The Shock Doctrine” is Klein’s ambitious look at the economic history of the last 50 years and the rise of free-market fundamentalism around the world. “Disaster capitalism,” as she calls it, is a violent system that sometimes requires terror to do its job. Like Pol Pot proclaiming that Cambodia under the Khmer Rouge was in Year Zero, extreme capitalism loves a blank slate, often finding its opening after crises or “shocks.” For example, Klein argues, the Asian crisis of 1997 paved the way for the International Monetary Fund to establish programs in the region and for a sell-off of many state-owned enterprises to Western banks and multinationals. The 2004 tsunami enabled the government of Sri Lanka to force the fishermen off beachfront property so it could be sold to hotel developers. The destruction of 9/11 allowed George W. Bush to launch a war aimed at producing a free-market Iraq.

In an early chapter, Klein compares radical capitalist economic policy to shock therapy administered by psychiatrists. She interviews Gail Kastner, a victim of covert C.I.A. experiments in interrogation techniques that were carried out by the scientist Ewen Cameron in the 1950s. His idea was to use electroshock therapy to break down patients. Once “complete depatterning” had been achieved, the patients could be reprogrammed. But after breaking down his “patients,” Cameron was never able to build them back up again. The connection with a rogue C.I.A. scientist is overdramatic and unconvincing, but for Klein the larger lessons are clear: “Countries are shocked — by wars, terror attacks, coups d’état and natural disasters.” Then “they are shocked again — by corporations and politicians who exploit the fear and disorientation of this first shock to push through economic shock therapy.” People who “dare to resist” are shocked for a third time, “by police, soldiers and prison interrogators.”

In another introductory chapter, Klein offers an account of Milton Friedman — she calls him “the other doctor shock” — and his battle for the hearts and minds of Latin American economists and economies. In the 1950s, as Cameron was conducting his experiments, the Chicago School was developing the ideas that would eclipse the theories of Raul Prebisch, an advocate of what today would be called the third way, and of other economists fashionable in Latin America at the time. She quotes the Chilean economist Orlando Letelier on the “inner harmony” between the terror of the Pinochet regime and its free-market policies. Letelier said that Milton Friedman shared responsibility for the regime’s crimes, rejecting his argument that he was only offering “technical” advice. Letelier was killed in 1976 by a car bomb planted in Washington by Pinochet’s secret police. For Klein, he was another victim of the “Chicago Boys” who wanted to impose free-market capitalism on the region. “In the Southern Cone, where contemporary capitalism was born, the ‘war on terror’ was a war against all obstacles to the new order,” she writes.

One of the world’s most famous antiglobalization activists and the author of the best seller “No Logo: Taking Aim at the Brand Bullies,” Klein provides a rich description of the political machinations required to force unsavory economic policies on resisting countries, and of the human toll. She paints a disturbing portrait of hubris, not only on the part of Friedman but also of those who adopted his doctrines, sometimes to pursue more corporatist objectives. It is striking to be reminded how many of the people involved in the Iraq war were involved earlier in other shameful episodes in United States foreign policy history. She draws a clear line from the torture in Latin America in the 1970s to that at Abu Ghraib and Guantánamo Bay.

Klein is not an academic and cannot be judged as one. There are many places in her book where she oversimplifies. But Friedman and the other shock therapists were also guilty of oversimplification, basing their belief in the perfection of market economies on models that assumed perfect information, perfect competition, perfect risk markets. Indeed, the case against these policies is even stronger than the one Klein makes. They were never based on solid empirical and theoretical foundations, and even as many of these policies were being pushed, academic economists were explaining the limitations of markets — for instance, whenever information is imperfect, which is to say always.

Klein isn’t an economist but a journalist, and she travels the world to find out firsthand what really happened on the ground during the privatization of Iraq, the aftermath of the Asian tsunami, the continuing Polish transition to capitalism and the years after the African National Congress took power in South Africa, when it failed to pursue the redistributionist policies enshrined in the Freedom Charter, its statement of core principles. These chapters are the least exciting parts of the book, but they are also the most convincing. In the case of South Africa, she interviews activists and others, only to find there is no one answer. Busy trying to stave off civil war in the early years after the end of apartheid, the A.N.C. didn’t fully understand how important economic policy was. Afraid of scaring off foreign investors, it took the advice of the I.M.F. and the World Bank and instituted a policy of privatization, spending cutbacks, labor flexibility and so on. This didn’t stop two of South Africa’s own major companies, South African Breweries and Anglo-American, from relocating their global headquarters to London. The average growth rate has been a disappointing 5 percent (much lower than in countries in East Asia, which followed a different route); unemployment for the black majority is 48 percent; and the number of people living on less than $1 a day has doubled to four million from two million since 1994, the year the A.N.C. took over.

Some readers may see Klein’s findings as evidence of a giant conspiracy, a conclusion she explicitly disavows. It’s not the conspiracies that wreck the world but the series of wrong turns, failed policies, and little and big unfairnesses that add up. Still, those decisions are guided by larger mind-sets. Market fundamentalists never really appreciated the institutions required to make an economy function well, let alone the broader social fabric that civilizations require to prosper and flourish. Klein ends on a hopeful note, describing nongovernmental organizations and activists around the world who are trying to make a difference. After 500 pages of “The Shock Doctrine,” it’s clear they have their work cut out for them.

Joseph E. Stiglitz, a university professor at Columbia, was awarded the Nobel in economic science in 2001. His latest book is “Making Globalization Work.”

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Stiglitz on the Credit Crunch

Of course to keep the economy booming Americans were encouraged to buy with cheap credit and terms that people should have known they could not continue to finance over the longer term or if the market declined.

A day of reckoning for Americans who lived beyond their means

By Joseph Stiglitz

08/12/07 "Taipei Tomes" -- -- The pessimists who have long forecast that the US economy was in for trouble finally seem to be coming into their own. Of course, there is no glee in seeing stock prices tumble as a result of soaring mortgage defaults. But it was largely predictable, as are the likely consequences for both the millions of Americans who will be facing financial distress and the global economy.

The story goes back to the recession of 2001. With the support of former Federal Reserve chairman Alan Greenspan, US President George W. Bush pushed through a tax cut designed to benefit the richest Americans but not to lift the economy out of the recession that followed the collapse of the Internet bubble.

Given that mistake, the Fed had little choice if it was to fulfill its mandate to maintain growth and employment. It had to lower interest rates, which it did in an unprecedented way -- all the way down to 1 percent.

It worked, but in a way fundamentally different from how monetary policy normally works. Usually, low interest rates lead firms to borrow more to invest more, and greater indebtedness is matched by more productive assets.

But given that overinvestment in the 1990s was part of the problem underpinning the recession, lower interest rates did not stimulate much investment. The economy grew, but mainly because American families were persuaded to take on more debt, refinancing their mortgages and spending some of the proceeds. And, as long as housing prices rose as a result of lower interest rates, Americans could ignore their growing indebtedness.

Even this did not stimulate the economy enough. To get more people to borrow more money, credit standards were lowered, fueling growth in so-called "sub?prime" mortgages. Moreover, new products were invented, which lowered upfront payments, making it easier for individuals to take bigger mortgages.

Some mortgages even had negative amortization: payments did not cover the interest due, so every month the debt grew more. Fixed mortgages, with interest rates at 6 percent, were replaced with variable-rate mortgages, whose interest payments were tied to the lower short-term T-bill rates.

What were called "teaser rates" allowed even lower payments for the first few years. They were teasers because they played off the fact that many borrowers were not financially sophisticated and didn't really understand what they were getting into.

And Greenspan egged them to pile on the risk by encouraging these variable-rate mortgages. On Feb. 23, 2004, he pointed out that "many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade."

But did Greenspan really expect interest rates to remain permanently at 1 percent -- a negative real interest rate? Did he not think about what would happen to poor Americans with variable-rate mortgages if interest rates rose, as they almost surely would?

Of course, Greenspan's behavior meant that, under his watch, the economy performed better than it otherwise would have done. But it was only a matter of time before that performance became unsustainable.

Fortunately, most Americans did not follow Greenspan's advice to switch to variable-rate mortgages. But even as short-term interest rates began to rise, the day of reckoning was postponed, as new borrowers could obtain fixed-rate mortgages at interest rates that were not increasing.

Remarkably, as short-term interest rates rose, medium and long-term interest rates did not, something that was referred to as a "conundrum."

One hypothesis is that foreign central banks that were accumulating trillions of dollars finally figured out that they were likely to be holding these reserves for years to come, and could afford to put at least some of the money into medium-term US treasury notes yielding -- initially -- far higher returns than T-bills.

The housing price bubble eventually broke and, with prices declining, some have discovered that their mortgages are larger than the value of their house. Others found that as interest rates rose, they simply could not make their payments.

Too many Americans built no cushion into their budgets, and mortgage companies, focusing on the fees generated by new mortgages, did not encourage them to do so.

Just as the collapse of the real estate bubble was predictable, so are its consequences: housing starts and sales of existing homes are down and housing inventories are up. By some reckonings, more than two-thirds of the increase in output and employment over the past six years has been real estate-related, reflecting both new housing and households borrowing against their homes to support a consumption binge.

The housing bubble induced Americans to live beyond their means -- net savings have been negative for the past couple of years. With this engine of growth turned off, it is hard to see how the US economy would not suffer from a slowdown. A return to fiscal sanity will be good in the long run, but it will reduce aggregate demand in the short run.

There is an old adage about how people's mistakes continue to live long after they are gone. That is certainly true of Greenspan. In Bush's case, we are beginning to bear the consequences even before he has departed.

Joseph Stiglitz, a Nobel laureate in economics, is professor of economics at Columbia University and was chairman of the Council of Economic Advisers under US president Bill Clinton and a chief economist and senior vice president at the World Bank. Copyright: Project Syndicate