« We live in a global economy and we need a reform of the global reserve system »

Joseph Stiglitz’s speech at the conference « The Financial Crisis, the US Economy, and International Security in the New Administration », New York, 14th November 2008.

par Joseph E. Stiglitz

First let me say that I agree with almost everything Jamie said. In particular, I agree that we’re going to need not only a large stimulus but also a sustained effort. What I want to do in my remarks is to highlight a few of the issues going forward, the likely controversies, and what views I have on those. And I’ll come back to the issue of the size of the stimulus in a few minutes.

The first issue is the general framework that the Bush administration has taken to try to revive the economy. It has been, you might say, too little, too late and very badly designed. They didn’t want to believe that their economy policies had the disastrous effects that they did. As it is, I had argued that their tax cuts in 2001 and 2003 and the war in Iraq played an important role in leading to this crisis. Let me try to explain why.

The tax cut in 2001 and 2003 wasn’t designed to stimulate the economy. It was something that was already on the agenda. It was an attempt to lower the taxes of upper-income Americans to exacerbate the inequalities that had been growing for a long time. That’s not how they would put it; but still that was the effect. It didn’t stimulate the economy very much and it put the burden of adjusting, of responding to the breaking of the tech bubble, on monetary policy. The war made things worse, because it led to an increase in the price of oil. We were spending hundreds of billions of dollars importing oil. Money that would have gone to keep the American economy going was being sent abroad. So again, the American economy was weakened, and again the burden was placed on monetary policy.

They responded with reckless enthusiasm, low interest rates and lax regulation. Lowering interest rates was not enough; you had to basically lend to anybody who was not on a life-support system with liar loans, negative amortization loans, where at the end of the year you owed more than you did at the beginning of the year. They said, « Don’t worry if you’re getting more and more in debt because the house prices were going up », in a kind of pyramid scheme.

From an economic point of view, there were two obvious things that were wrong with this: First it was based on a notion that there was a free lunch. The more you borrowed, the richer you were going to be. Borrowing is not that difficult. It’s repaying that’s the problem. And it was really based on the notion that anybody who was « smart enough » to find a mortgage broker to give them money would be a rich person. There isn’t that much money lying on the street; but that’s what they believed.

The second thing, of course, was the notion that the prices of houses could keep going up while real incomes of most Americans were going down. Again, as I jokingly say, you don’t need a Nobel Prize to figure out you can’t spend much more than a hundred percent of your income on housing every year. It was just a matter of time before that particular set of ideas slammed into reality.

« You don’t need a Nobel Prize to figure out that you can’t spend more than a hundred percent of your income in housing. »

So the tax cuts and the war fed the housing bubble. The housing bubble fed a consumption boom. Savings fell to zero. We are now facing some of the consequences of that. But from a macro point of view, the profound question that we have to face is what will replace that as a stimulus to aggregate demand? There’s not likely to be another IT bubble, nor another housing bubble, which means that there may be a problem of insufficient aggregate demand for an extended period of time.

We live in a global economy and we need a reform of the global reserve system, because given the volatility of the current system coun- tries want to hold on to their reserves. Dollars are one of the forms in which they hold reserves. The result of that is that we’re exporting Treasury bills, rather than automobiles or other products. It’s fine to export Treasury bills, but Treasury bills don’t create a lot of jobs.

Then there is this structural problem in our global economy, a problem which we faced before - Keynes talked about it. When you look at it from a global point of view, part of the global deficiency in aggregate demand is caused by the surplus economies, economies that are taking income in and not spending it. Keynes had proposed - and in my book, Making Globalization Work, I revived that kind of idea - to penalize countries for having surpluses in order to dissuade them from accumulating them. The way we do that is to have an annual emission of a new global currency, and to decide that coun- tries with surpluses won’t get their share of that emission. It’s a way of rebalancing the global economy. Since the structural problem we face will be very difficult to solve in the United States alone. It will require a global solution over the long run.

The rest of my remarks will focus on the shorter run, on the United States and on our failed response. As I said, in our failed res- ponse, in February, we had a tax cut, again - the all-purpose solution for the Bush administration to any economy problem. I and many other people thought it would not work. With the mountain of debt, the anxieties going forward, people would not spend much of their money. And that turned out to be the case. Different studies give different numbers - 20 percent, 50 percent - but still, it didn’t stimulate the economy very much. That’s why we need now a much larger stimulus.

What the US administration has been doing so far is another version of trickle-down economics. Throw enough money at Wall Street, and some of it will trickle down to the rest of the economy. It didn’t work - and in a way, predictably so.

One of the reasons it didn’t work is that, to use another analogy, it’s like giving a massive blood transfusion to somebody suffering from internal hemorrhaging, internal hemorrhaging of foreclosures. We’re not doing anything or very much about the foreclosures; in fact, the administration, in a perverse way, says: « we don’t want to help ordinary Americans, we don’t want to help foreclosures. We need to help the core of the American economy, the American bankers, investment banks particularly, who got us into the mess ». It is not surprising that things have not been working very well, because who do we put in charge? The same people who got us in the mess. As for the foreclosures: what should be done? We have to do something. If we don’t, even if we give more money to the banks today, there’s going to be more defaults, and their holes in the balance sheets are going to open up. It won’t solve the problem.

I see three things we can do. The first is to help homeowners. For instance, right now we subsidy 50 percent of the housing cost of homeowners, who are upper-income homeowners, in New York State. We subsidy it through tax deductions on interest, mortgage interest and real estate taxes. We pay 50 percent for upper-income and nothing for lower income people. It’s not only inefficient, but also obviously inequitable. If we converted the tax deduction into a tax credit it would make housing more affordable. As a general principle, the housing subsidy has been questioned by economists as distorting the resource allocation in our society. That’s a debatable question about whether you want to encourage home ownership; and that is the main misgiving I have about this kind of proposal. But if we do want to promote home ownership, we should be helping it at the bottom end, not at the top.

There is one thing the British government does that I think we ought to give serious consideration to: For people who are long-term unemployed, the government picks up paying for the mortgage as part of the unemployment program. They recognize that when people lose their jobs, it’s not just about the flow of income, it is a real anxiety. So they try to make life more bearable. There’s no moral hazard here. Nobody is going to say, « I want to be fired in order for you to pick up my mortgage ». It seems to me an interesting idea.

The second thing we can do is to reform our bankruptcy law. We changed the bankruptcy law a couple of years ago in a perverse way, and I think it actually may have had a part in the crisis. Because what it did was to make it more difficult for people to discharge their debt. And by making it more difficult, it encouraged the bankers to lend more, because they said, « we have them over a barrel ». A minimum-income person making about $14,000 a year can have 25 percent of his wages garnished to pay a debt. That seems to me to at least raise very serious issues. It’s more difficult for a homeowner to restructure his debt than it is for someone who owns a yacht. We deliberately made it more difficult. And I think we ought to do it just the opposite. I call for a homeowner’s Chapter 11. Chapter 11 is designed to allow firms to restructure their debt in a quick way so they stay in business - avoiding loss of jobs and Organizational capital. You can think of the home as a similar kind of thing, and we should allow people whose homes are under water - that is to say, the value of the mortgage is greater than the value of the home - to go through an expedited process of Chapter 11 bankruptcy, right down with the amount of debt, convert in effect the debt to equity. The bank would then get a large share, perhaps all of the capital gains in the home. That would separate speculators from homeowners. The homeowners are not buying the home for the capital gains; they’re buying it to stay in it.

A third proposal would be to use some of the funds that have been made available at low-cost by the government to help ordinary Americans to own their homes. In effect, what we are doing now is using the government’s ability to borrow to help Wall Street, but not using it to help the rest of America. We already have the required legislative framework, we just have to expand it - and we could discuss the exact terms. It wouldn’t cost the government anything. It wouldn’t add to the deficit to lend and to restructure the mortgages, to make them more affordable for ordinary Americans.

That’s one set of issues. The second set of issues concerns restructuring TARP. When Henry Paulson first came forward with his proposal, almost every economist said: « This is a stupid idea. It will never be able to be implemented quickly, and something has to be done quickly. » This turned out to be right, and he finally gave in. The Congress refused initially to put in this provision of equity injection, which is what they’re doing right now. But, as always, the devil is in the details, and if you want to mismanage something, you can even mismanage a good idea; and that’s what Paulson managed to do.

« TARP has thus to be restructured."

You can see that by contrasting what the UK did and what the U.S. did. The UK designed its plan so to make sure that the money went to recapitalize the banks, to create more lending - and they were very careful with the way they did it. I don’t have the time to go into it in detail, but basically they did things like the following: They said there has to be some accountability, so the CEO’s had to go. They also said « we aren’t going to pour money in while you’re pouring money out; you can’t pay dividends until you’ve repaid us ». They didn’t care about the usual argument used against cutting dividends, the one that claims that it would be a back-signal. And rightly so, since this is the most absurd argument that I’ve ever heard: that somehow they’re going to discover some problem in the bank because they’re cutting the dividends. What’s remarkable is rather the idea that a company that has no profits would even be considering giving a dividend, let alone giving bonuses.

TARP has thus to be restructured. That is going to be one of the big issues facing the next president, because there will be many peo- ple in the financial markets, including some of his potential advisors, who will be saying, « A deal’s a deal ». Paulson made a bad deal, but now we have to honor it.

The opposite view is that every contract has unspecified terms. Everybody understood what the intent of the Congress was. All the time the Fed is giving gifts to the banks that were not part of the contract. No one ever said that the Fed had to take junk as collateral, which is what they’ve been doing. You can just say to the banks: « If you don’t do what you’re supposed to do, you’ll lose access to the Fed window where junk is accepted as collateral ». I think there are a variety of ways in which the regulator can help in providing incentives for them behaving better than they’ve been behaving. There’s a little bit of evidence that they’re doing that.

Finally, let me just make a remark about one other issue, which is going to be a contentious issue; and that is regulation. In his speech yesterday, President Bush seemed to suggest that we have to be careful about overreacting. And that is the mantra that went off and that we’re beginning to hear: Regulation will stifle innovation. Well, what is very clear is that innovation in the financial sector has been what we might call self-referential, like a lot of research in academia. It can only be explained as talking to other academics. This is a case where the only benefit was for financial sector. It did increase their profits to the point where they’re at 30 percent of all corporate profits. But shouldn’t the financial sector be a means to an end, the end being to make our economy more efficient? If an economy has a huge financial sector, that’s a sign that something is wrong - except if it’s exporting it to other foolish people. In the United Kingdom you can justify it, because they found a lot of other foolish people to buy their services. And we do a little bit of that, but most of the time, we’re selling it to ourselves. So what we are doing is having this means to an end becoming an end in itself. But as an end in itself, it didn’t do what it was suppo- sed to do; it didn’t manage risk and it didn’t allocate capital well. And yet, it took an enormous amount of money away from the rest of the economy.

I’m head of a commission called the Commission of the Measurement of Economic Performance and Social Progress. One of the issues that we’ve been discussing is whether we should include, or rather how much of the financial sector we should include, in GDP. The point is that most financial innovation was engaged in repertory arbitrage, accounting arbitrage; that is in methods trying to get around the regulation. They succeeded, but at great cost to the rest of us. So it was innovation; but they didn’t do what they should have done, since what do people care most about in risk management? The ability to stay in their homes. But 3.6 million Americans have lost their homes. Clearly, the financial sector didn’t innovate in the ways that would make our economy more efficient.

Good and strong regulation will encourage people to use their creativity, rather than trying to figure out how to scam the rest of us. It will encourage them to use their creativity to create products that will help our economy manage risk and allocate capital better.

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