Saturday, September 27, 2008

Stiglitz: Who is to Blame for the Financial Crisis?

Nobel Laureate Joseph Stiglitz lays out the blame:
Many seem taken aback by the depth and severity of the current financial turmoil. I was among several economists who saw it coming and warned about the risks.

There is ample blame to be shared; but the purpose of parsing out blame is to figure out how to make a recurrence less likely. ...

One can say the Fed failed twice, both as a regulator and in the conduct of monetary policy. Its flood of liquidity (money made available to borrow at low interest rates) and lax regulations led to a housing bubble. When the bubble broke, the excessively leveraged loans made on the basis of overvalued assets went sour.

For all the new-fangled financial instruments, this was just another one of those financial crises based on excess leverage, or borrowing, and a pyramid scheme.

The new "innovations" simply hid the extent of systemic leverage and made the risks less transparent; it is these innovations that have made this collapse so much more dramatic than earlier financial crises. But one needs to push further: Why did the Fed fail?

First, key regulators like Alan Greenspan didn't really believe in regulation; when the excesses of the financial system were noted, they called for self-regulation — an oxymoron.

Second, the macro-economy was in bad shape with the collapse of the tech bubble. The tax cut of 2001 was not designed to stimulate the economy but to give a largesse to the wealthy — the group that had been doing so well over the last quarter-century.

The coup d'grace was the Iraq War, which contributed to soaring oil prices. Money that used to be spent on American goods now got diverted abroad. The Fed took seriously its responsibility to keep the economy going.

It did this by replacing the tech bubble with a new bubble, a housing bubble. Household savings plummeted to zero, to the lowest level since the Great Depression. It managed to sustain the economy, but the way it did it was shortsighted: America was living on borrowed money and borrowed time.

Finally, at the center of blame must be the financial institutions themselves. They — and even more their executives — had incentives that were not well aligned with the needs of our economy and our society.

They were amply rewarded, presumably for managing risk and allocating capital, which was supposed to improve the efficiency of the economy so much that it justified their generous compensation. But they misallocated capital; they mismanaged risk — they created risk.

They did what their incentive structures were designed to do: focusing on short-term profits and encouraging excessive risk-taking.

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