When even the New York Times, the venerable “Gray Lady”, not known for radical leanings, speaks well to the left of Obama, we need to finally accept the fact that the man, brilliant and smooth rhetoric aside, is far too conservative to handle this crisis to the benefit of working people.
The New York Times // By Joseph E. Stiglitz | Crosspost under Fair Use protocols March 31, 2009 || BONUS FEATURE: Interview with Stiglitz by Der Spiegel
The Obama administration’s $500 billion or more proposal to deal with America’s ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win – and taxpayers lose.
Treasury hopes to get us out of the mess by replicating the flawed system that the private sector used to bring the world crashing down, with a proposal marked by overleveraging in the public sector, excessive complexity, poor incentives and a lack of transparency.
Let’s take a moment to remember what caused this mess in the first place. Banks got themselves, and our economy, into trouble by overleveraging – that is, using relatively little capital of their own, they borrowed heavily to buy extremely risky real estate assets. In the process, they used overly complex instruments like collateralized debt obligations.
The prospect of high compensation gave managers incentives to be shortsighted and undertake excessive risk, rather than lend money prudently. Banks made all these mistakes without anyone knowing, partly because so much of what they were doing was “off balance sheet” financing.
In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” – including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.
The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.
Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!
Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest – $12 in “equity” plus $126 in the form of a guaranteed loan.
If, in a year’s time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.
Even in an imperfect market, one shouldn’t confuse the value of an asset with the value of the upside option on that asset.
But Americans are likely to lose even more than these calculations suggest, because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets that they think the market overestimates (and thus is willing to pay too much for).
But the market is likely to recognize this, which will drive down the price that it is willing to pay. Only the government’s picking up enough of the losses overcomes this “adverse selection” effect. With the government absorbing the losses, the market doesn’t care if the banks are “cheating” them by selling their lousiest assets, because the government bears the cost.
The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.
Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.
Some Americans are afraid that the government might temporarily “nationalize” the banks, but that option would be preferable to the Geithner plan. After all, the F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later), and Washington Mutual (seized last September, and immediately resold).
What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships – with the private sector in control – have perverse incentives, worse even than the ones that got us into the mess.
So what is the appeal of a proposal like this? Perhaps it’s the kind of Rube Goldberg device that Wall Street loves – clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.
But we are already suffering from a crisis of confidence. When the high costs of the administration’s plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder.
Joseph Eugene Stiglitz (born February 9, 1943) is an American economist and a professor at Columbia University. He is a recipient of the John Bates Clark Medal (1979) and the Nobel Memorial Prize in Economic Sciences (2001). He is also the former Senior Vice President and Chief Economist of the World Bank. He is known for his critical view of the management of globalization, free-market economists (whom he calls “free market fundamentalists“) and some international institutions like the International Monetary Fund and the World Bank.
Joseph Stiglitz: “It’s going to be bad, very bad”
In an interview, the Nobel Prize-winner and former chief economist at
the World Bank talks about the Great Depression, Obama’s stimulus
package and today’s financial crisis.
By Der Spiegel | Dateline: Apr. 03, 2009
Many people are comparing the financial crisis to the Great Depression. Will it really be that bad?
It’s going to be bad, very bad. We’re experiencing the worst downturn since the Great Depression, and we haven’t reached the bottom yet. I’m very pessimistic. Governments are indeed reacting better today than during the global economic crisis. They’re lowering interest rates and boosting the economy with economic stimulus plans. This is the right direction, but it’s not enough.
The American government has committed over a trillion dollars to save the banks and $789 billion to boost the economy. Do you think this is too little?
I do. More than $700 billion sounds like a lot, but it’s not. On the one hand, a large part of the money will first be given out next year, which is too late. On the other, a third of it is drained away by tax cuts. They don’t really stimulate consumption, because people will save the majority of that money. I fear that the effect of the American economic stimulus plan won’t be even half as big as expected.
At least governments worldwide are bracing themselves against the recession, as opposed to the global economic crisis where they accelerated the recession through their savings policy.
That’s right. That’s why I’m confident we’ll get off lighter than during the Great Depression. On the other hand, there’s a series of developments that make me very anxious. The state of our financial system, for example, is worse than it was 80 years ago.
Hundreds of banks collapsed in the U.S. at that time. Today most of them are being saved by the government. What’s so bad about that?
The banks that survived 80 years ago continued to lend money. Today many banks aren’t lending money anymore, above all the large investment banks. This will deepen the crisis.
The U.S. government’s emergency plan is supposed to prevent this, though. The banks receive money from the state so they can continue to give loans.
That’s the idea, but it doesn’t work. We’re just throwing money at them and they pay billions of it out in bonuses and dividends. We taxpayers are being robbed for all intents and purposes in order to reduce the losses that some wealthy people bear. This has to be changed.
What do you suggest?
We have to reorganize our bailout system for the financial sector. For one thing, any bank that actually lends should get money from the government; more money to small and medium-size banks in smaller towns and less to Wall Street institutions. The government must also accept the consequences when banks become insolvent …
… and let them go bankrupt?
No, they have to be saved, because the consequences to the monetary system would be incalculable. But as a countermeasure, these institutions have to be nationalized, which even Alan Greenspan is now demanding. Then the government can close those business segments that have nothing to do with lending and make sure that the banks no longer organize esoteric stock deals that they themselves do not understand.
Today the world is much more intertwined than in the 1920s or 1930s. Does this make the fight against the economic crisis easier?
On the contrary, it’s going to be more difficult. When a country introduces an economic stimulus plan, a large part of the stimulus goes abroad. For instance, a U.S. company receiving a road construction order from the state buys equipment from Germany, concrete from Mexico and engineering services from Great Britain. The incentive to profit from the economic situation of one’s neighbor is correspondingly great, while doing as little as you yourself can do. There is only one solution for this: Economic stabilization policy has to be coordinated internationally in order to diminish the already dangerous global imbalances.
What do you mean by that?
For years the U.S. was the economic powerhouse of the world. It imported more goods from abroad than it exported, to the joy of manufacturers in Asia or Europe. But this model no longer works. The Americans are completely over-indebted. They can’t increase their consumption, instead they have to save. This is why other global growth has to be increased.
Washington sees it that way, too. In particular, it wants countries with strong exports to offer further economic stimulus packages. Do you think that’s justified?
Absolutely. Export surpluses are counterproductive in times of economic crisis. They have to be reduced through economic stimulus programs, for example. Economist John Maynard Keynes was even of the opinion that surplus countries should be taxed during times of economic crisis.
Which might not go over so well.
That’s why we wouldn’t go that far. I propose that countries with a positive trade balance should stream part of their surplus to the International Monetary Fund. This can then stimulate the economy in developing countries or prevent the economy from collapsing in Eastern Europe.
The global economic crisis following 1929 only really began when governments sealed off their respective countries from international trade. Is there still a danger of this?
I think it’s unlikely that countries will again enter into open protectionism. What I do fear is indirect insulation measures like financial aid or subsidies. The consequences wouldn’t be less serious. There is the threat of secret commercial obstacles that could similarly greatly restrain global exchange, like tariff increases.
The leaders of the 20 largest industrial nations are meeting in London this week to discuss the regulation of financial markets. Will the meeting be successful?
I’m skeptical. The American government does talk a lot about stricter regulation of financial markets. I doubt that it’s serious, though. The Americans have always been masters at changing a supposed regulation measure into further deregulation.
Do you expect this of the new Obama administration as well?
Obama himself has made clear in many speeches that he wants to prevent prospecting in the American financial industry. But Obama is under pressure from Wall Street. Even within his own administration, there are a lot of officials who are only for cosmetic corrections.
The U.S. is against too much regulation in the financial markets, and Germany and Japan would prefer no further economic stimulus packages. Can much come out of the G20 summit?
The governments will find the words to put a positive spin on the conference. If they can do anything, they can do that. Everyone will say that more regulation is necessary and that balance is needed between national sovereignty and common action in a globalized world. But how much substance will lie behind their words? I’m skeptical.
The economic crisis has severely damaged the economic model of finance-driven turbo-capitalism. Will this lead to a renaissance in the state economy?
I don’t think so. The fall of the Berlin Wall really was a strong message that communism does not work as an economic system. The collapse of Lehman Brothers on Sept. 15 again showed that unbridled capitalism doesn’t work either.
Could authoritarian systems like China’s be the future?
Besides the two extremes of communism and capitalism, there are alternatives, such as Scandinavia or Germany. The Chinese model has succeeded very well for their people, but at the price of democratic rights. The German social model, however, has worked very well. It could also be a model for the U.S. administration.
The crisis began in America, spread to other industrialized nations and now threatens the emerging and developing countries. Is the target of the community of states to halve global poverty by 2015 still achievable?
Because we don’t know how long this crisis will last, it will become more difficult to keep to this promise. I’m also pessimistic, for example, now that the USA is discussing whether we can still afford development aid during the crisis. But there are countries like Japan and Germany that have raised their contributions to the IMF and World Bank to help the Third World.
Will Africa be the big loser in the crisis?
I’m fearful of that, because even the high growth of 6 percent in Africa in the last few years hasn’t been enough to permanently fight poverty. A lot of the countries on the continent which inherited a low standard of education, and no infrastructure from colonialism, have solely focused on increasing commodity prices. That was a risky strategy. The IMF’s structural development policies also contributed to deindustrialization. We haven’t managed to create a stable foundation for the African economies.
World Bank president Robert Zoellick has said that the industrialized nations should direct 0.7 percent of their stimulus packages to the developing countries.
That’s too little. Take the U.S. example. Each country would receive around $5.5 billion per year from $789 billion. It’s a lot more than nothing, but only a drop when compared to what the countries require, namely up to $700 billion in this year alone.
Mr. Stiglitz, thank you for this interview.