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  • From the Portfolioist Book Shelf: Freefall by Joseph Stiglitz 0 comments
    Oct 28, 2011 11:04 AM

    Joseph Stiglitz received the 2001 Nobel Prize in Economics and shared the 2007 Nobel Peace Prize for his work with the Intergovernmental Panel on climate Change (NASDAQ:IPCC). He is a professor of Economics at Columbia University and was Chief Economist of the World Bank from 1997-2000.

    Freefall: America, Free Markets, and the Sinking of the World Economy, published in 2010, is Stiglitz’ analysis of what caused the recession of 2007-2009, what we have learned and what we should have learned (but apparently have not).

    We start with a straightforward world view in which we have markets, regulations, and intermediation. The purpose of banks is to facilitate payments between buyers and sellers and to make loans. Market participants are motivated by self-interest. The role of regulation is to set constraints on market participants in the interests of society. The crisis of the last several years was caused by a systemic failure across these realms.

    In a nutshell, changes in the financial services industry created incentives for a range of market participants—notably banks—to take very large risks with the prospects of short-term gains. Under the old model, a bank would make a mortgage loan and then hold that loan on its books. The bank had a strong incentive to make sure that the borrower could afford the loan. The bank made money from the interest payments on the debt. If the borrower defaulted, the bank would lose money. Under the new model, mortgage lenders got paid for originating loans but did not keep these loans. The mortgages were bundled up and sold to investors (this is the process of securitization). The mortgage lenders, in other words, made money on the origination, packaging, and sales of the mortgages but no longer had a stake in ensuring the long-term viability of the mortgage. This shift in the mortgage industry turned the old incentives upside down. Not surprisingly, the mortgage industry started to create less and less viable products and was far less discriminating about who qualified for a loan. The mortgage crisis simply confirms that most people will behave in the way that you give them incentives to behave.

    Stiglitz sees the financial innovation in the last decade or two as being directed almost entirely at creative new ways to generate short-term profits and to circumvent or at least game regulations. Banks took risky sub-prime mortgages and combined them into a portfolio that appeared to be of high quality. The process by which this occurred required that the ratings agencies and the regulators were somewhat lax.

    The problem of perverse incentives was nowhere as evident as with the banks which had grown ‘too big to fail.’ The banks were confident that the government would bail them out if they got into trouble, so they had a clear incentive to take the biggest risks they could get away with. Once again, the banks simply responded to the incentive structure that was created for them.

    Dr. Stiglitz is deeply concerned that public policy is entirely driven by special interests, who lobby entirely too successfully to create policies that benefit them at the expense of the broader society. This is an over-arching theme of the book. The financial sector has used its enormous financial might to influence policy and regulation in its own interest. Stiglitz posits that this situation poses an enormous long-term threat to the viability of the United States. In the last chapter of the book, he summarizes his position on this theme:

    It will be hard for American to achieve whatever vision it sees for itself when it is so blinded by campaign contributions and lobbyists and its system of revolving doors. Perhaps we will be able to muddle through, but at what costs to us today and at what costs to future generations? This crisis should be an awakening sign: the costs can be high, very high, beyond even what the richest country of the world can afford.

    How does all of this impact the people who make up the vast majority of the population? In light of the evidence, it is not surprising that the average person—with no access to the halls of power—is losing ground. Dr. Stiglitz provided an overview of his position on economic disparity in America in a widely read article published in May of 2011. The United States is becoming increasingly economically stratified. As more of our national wealth is concentrated in the hands of the very wealthy, Stiglitz sees it as an inescapable outcome that the lower and middle classes will see their standard of living decline in the coming years.

    This book provides ample evidence that people and companies act in ways that are directly responsive to theconomic incentives that apply to them. This is not surprising or new. What emerges, however, is the idea that people and companies are so entirely motivated by financial gain that they will often tend to act in ways that are enormously costly to society. Stiglitz concludes, ultimately, that the responses to the crisis are insufficient to reign in even the most egregious politics of self-interest, so his outlook for the future is not optimistic:

    In several critical areas, in the midst of the crisis, matters have already become worse. We have altered not only our institutions—but the very rules of capitalism. We have announced that for favored institutions there is to be little, or no, market discipline. We have created an ersatz capitalism with unclear rules—but with a predictable outcome: future crisis; undue risk taking at the public expense, no matter what the promise of a new regulatory regime; and greater inefficiency. We have lectured about the importance of transparency, but we have given the banks greater scope for manipulating their books. In earlier crises, there was worry about moral hazard, the adverse incentives provided by bailouts; but the magnitude of this crisis has given new meaning to the concept.

    This is a book well worth reading. I have not previously encountered such a complete and cogent analysis not only of our recent global financial crisis, but also of the development of forces that laid the groundwork for this crisis. For those who have not previously explored the drivers of the crash, this book will be an eye-opener.

    Other Reviews from the Portfolioist Book Shelf:
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