[URBANTH-L]NEWS: Reversal of Fortune, by Joseph Stiglitz

Angela Jancius jancius3022 at comcast.net
Sat Oct 11 23:10:57 EDT 2008

Reversal of Fortune

      Describing how ideology, special-interest
      pressure, populist politics, and sheer
      incompetence have left the U.S. economy on life
      support, the author puts forth a clear,
      commonsense plan to reverse the Bush-era follies
      and regain America's economic sanity.

By Joseph E. Stiglitz 
Vanity Fair 
November 2008


When the American economy enters a downturn, you often
hear the experts debating whether it is likely to be V-
shaped (short and sharp) or U-shaped (longer but
milder). Today, the American economy may be entering a
downturn that is best described as L-shaped. It is in a
very low place indeed, and likely to remain there for
some time to come.

Virtually all the indicators look grim. Inflation is
running at an annual rate of nearly 6 percent, its
highest level in 17 years. Unemployment stands at 6
percent; there has been no net job growth in the
private sector for almost a year. Housing prices have
fallen faster than at any time in memory-in Florida and
California, by 30 percent or more. Banks are reporting
record losses, only months after their executives
walked off with record bonuses as their reward.
President Bush inherited a $128 billion budget surplus
from Bill Clinton; this year the federal government
announced the second-largest budget deficit ever
reported. During the eight years of the Bush
administration, the national debt has increased by more
than 65 percent, to nearly $10 trillion (to which the
debts of Freddie Mac and Fannie Mae should now be
added, according to the Congressional Budget Office).
Meanwhile, we are saddled with the cost of two wars.
The price tag for the one in Iraq alone will, by my
estimate, ultimately exceed $3 trillion.

This tangled knot of problems will be difficult to
unravel. Standard prescriptions call for raising
interest rates when confronted with inflation, just as
standard prescriptions call for lowering interest rates
when confronted with an economic downturn. How do you
do both at the same time? Not in the way that some
politicians have proposed. With gasoline prices at all-
time highs, John McCain has called for a rollback of
gas taxes. But that would lead to more gas consumption,
raise the price of gas further, increase our dependence
on foreign oil, and expand our already massive trade
deficit. The expanding deficit would in turn force the
U.S. to continue borrowing gargantuan sums from abroad,
making us even more indebted. At the same time, the
higher imports of oil and petroleum-based products
would lead to a weaker dollar, fueling inflationary

Millions of Americans are losing their homes. (Already,
some 3.6 million have done so since the subprime-
mortgage crisis began.) This social catastrophe has
severe economic effects. The banks and other financial
institutions that own these mortgages face stunning
reverses; a few, such as Bear Stearns, have already
gone belly-up. To prevent America's $5.2 trillion home
financiers, Fannie Mae and Freddie Mac, from following
suit, Congress authorized a blank check to cover their
losses, but even that generosity failed to do the
trick. Now the administration has taken over the two
entities completely, a stunning feat for a supposedly
market-oriented regime. These bailouts contribute to
growing deficits in the short run, and to perverse
incentives in the long run. Market economies work only
when there is a system of accountability, but C.E.O.'s,
investors, and creditors are walking away with
billions, while American taxpayers are being asked to
pick up the tab. (Freddie Mac's chairman, Richard
Syron, earned $14.5 million in 2007. Fannie Mae's
C.E.O., Daniel Mudd, earned $14.2 million that same
year.) We're looking at a new form of public-private
partnership, one in which the public shoulders all the
risk, and the private sector gets all the profit. While
the Bush administration preaches responsibility, the
words are addressed only to the less well-off. The
administration talks about the impact of 'moral hazard'
on the poor 'speculator' who borrowed money and bought
a house beyond his ability to pay. But moral hazard
somehow isn't an issue when it comes to the high-stakes
speculators in corporate boardrooms.

How Did We Get into This Mess?

A unique combination of ideology, special-interest
pressure, populist politics, bad economics, and sheer
incompetence has brought us to our present condition.

Ideology proclaimed that markets were always good and
government always bad. While George W. Bush has done as
much as he can to ensure that government lives up to
that reputation-it is the one area where he has
overperformed-the fact is that key problems facing our
society cannot be addressed without an effective
government, whether it's maintaining national security
or protecting the environment. Our economy rests on
public investments in technology, such as the Internet.
While Bush's ideology led him to underestimate the
importance of government, it also led him to
underestimate the limitations of markets. We learned
from the Depression that markets are not self-
adjusting-at least, not in a time frame that matters to
living people. Today everyone-even the
president-accepts the need for macro-economic policy,
for government to try to maintain the economy at near-
full employment. But in a sleight of hand, free-market
economists promoted the idea that, once the economy was
restored to full employment, markets would always
allocate resources efficiently. The best regulation, in
their view, was no regulation at all, and if that
didn't sell, then 'self-regulation' was almost as good.

The underlying idea was, on the face of it, absurd:
that market failures come only in macro doses, in the
form of the recessions and depressions that have
periodically plagued capitalist economies for the past
several hundred years. Isn't it more reasonable to
assume that these failures are just the tip of the
iceberg? That beneath the surface lie a myriad of
smaller but harder-to-assess inefficiencies? Let me
venture an analogy from biology: A patient arrives at a
hospital in serious condition. Now, it may be that the
patient has simply fallen victim to one of those
debilitating ailments that go around from time to time
and can be cured by a massive dose of antibiotics. In
this case we have a macro problem with a macro
solution. But it could instead be that the patient is
suffering from a decade of serious abuse-smoking,
drinking, overeating, lack of exercise, a fondness for
crystal meth-and that it has not only taken a
catastrophic toll but also left him open to
opportunistic infections of every kind. In other words,
a buildup of micro problems has led to a macro problem,
and no cure is possible without addressing the
underlying issues. The American economy today is a
patient of the second kind.

We are in the midst of micro-economic failure on a
grand scale. Financial markets receive generous
compensation-in the form of more than 30 percent of all
corporate profits-presumably for performing two
critical tasks: allocating savings and managing risk.
But the financial markets have failed laughably at
both. Hundreds of billions of dollars were allocated to
home loans beyond Americans' ability to pay. And rather
than managing risk, the financial markets created more
risk. The failure of our financial system to do what it
is supposed to do matches in destructive grandeur the
macro-economic failures of the Great Depression.

Economic theory-and historical experience-long ago
proved the need for regulation of financial markets.
But ever since the Reagan presidency, deregulation has
been the prevailing religion. Never mind that the few
times 'free banking' has been tried-most recently in
Pinochet's Chile, under the influence of the
doctrinaire free-market theorist Milton Friedman-the
experiment has ended in disaster. Chile is still paying
back the debts from its misadventure. With massive
problems in 1987 (remember Black Friday, when stock
markets plunged almost 25 percent), 1989 (the savings-
and-loan debacle), 1997 (the East Asia financial
crisis), 1998 (the bailout of Long Term Capital
Management), and 2001-02 (the collapses of Enron and
WorldCom), one might think there would be more
skepticism about the wisdom of leaving markets to

The new populist rhetoric of the right-persuading
taxpayers that ordinary people always know how to spend
money better than the government does, and promising a
new world without budget constraints, where every tax
cut generates more revenue-hasn't helped matters.
Special interests took advantage of this seductive
mixture of populism and free-market ideology. They also
bent the rules to suit themselves. Corporations and the
wealthy argued that lowering their tax rates would lead
to more savings; they got the tax breaks, but America's
household savings rate not only didn't rise, it dropped
to levels not seen in 75 years. The Bush administration
extolled the power of the free market, but it was more
than willing to provide generous subsidies to farmers
and erect tariffs to protect steelmakers. Lately, as we
have seen, it seems willing to write blank checks to
bail out its friends on Wall Street. In each of these
cases there are clear winners. And in each there are
clear losers-including the country as a whole.

What Is to Be Done?

As America attempts to work its way out of the present
crisis, the danger is that we will listen to the same
people on Wall Street and in the economic establishment
who got us into it. For them, our current predicament
is another opportunity: if they can shape the
government response appropriately, they stand to gain,
or at least stand to lose less, and they may be willing
to sacrifice the well-being of the economy for their
own benefit-just as they did in the past.

There are a number of economic tools at the country's
disposal. As noted, they can yield contradictory
results. The sad truth is that we have reached the
limits of monetary policy. Lowering interest rates will
not stimulate the economy much-banks are not going to
be willing to lend to strapped consumers, and consumers
are not going to be willing to borrow as they see
housing prices continue to fall. And raising interest
rates, to combat inflation, won't have the desired
impact either, because the prices that are the main
sources of our inflation-for food and energy-are
determined in international markets; the chief
consequence will be distress for ordinary people. The
quandaries that we face mean that careful balancing is
required. There is no quick and easy fix. But if we
take decisive action today, we can shorten the length
of the downturn and reduce its magnitude. If at the
same time we think about what would be good for the
economy in the long run, we can build a durable
foundation for economic health.

To go back to that patient in the emergency room: we
need to address the underlying causes. Most of the
treatment options entail painful choices, but there are
a few easy ones. On energy: conservation and research
into new technologies will make us less dependent on
foreign oil, reduce our trade imbalance, and help the
environment. Expanding drilling into environmentally
fragile areas, as some propose, would have a negligible
effect on the price we pay for oil. Moreover, a policy
of 'drain America first' will make us more dependent on
foreigners in the future. It is shortsighted in every

Our ethanol policy is also bad for the taxpayer, bad
for the environment, bad for the world and our
relations with other countries, and bad in terms of
inflation. It is good only for the ethanol producers
and American corn farmers. It should be scrapped. We
currently subsidize corn-based ethanol by almost $1 a
gallon, while imposing a 54-cent-a-gallon tariff on
Brazilian sugar-based ethanol. It would be hard to
invent a worse policy. The ethanol industry tries to
sell itself as an infant, needing help to get on its
feet, but it has been an infant for more than two
decades, refusing to grow up. Our misguided biofuel
policy is taking land used for food production and
diverting it to energy production for cars; it is the
single most important factor contributing to higher
grain prices.

Our tax policies need to be changed. There is something
deeply peculiar about having rich individuals who make
their money speculating on real estate or stocks paying
lower taxes than middle-class Americans, whose income
is derived from wages and salaries; something peculiar
and indeed offensive about having those whose income is
derived from inherited stocks paying lower taxes than
those who put in a 50-hour workweek. Skewing the tax
rates in the other direction would provide better
incentives where they count and would more effectively
stimulate the economy, with more revenues and lower

We can have a financial system that is more stable-and
even more dynamic-with stronger regulation. Self-
regulation is an oxymoron. Financial markets produced
loans and other products that were so complex and
insidious that even their creators did not fully
understand them; these products were so irresponsible
that analysts called them 'toxic.' Yet financial
markets failed to create products that would enable
ordinary households to face the risks they confront and
stay in their homes. We need a financial-products
safety commission and a financial-systems stability
commission. And they can't be run by Wall Street. The
Federal Reserve Board shares too much of the mind-set
of those it is supposed to regulate. It could and
should have known that something was wrong. It had
instruments at its disposal to let the air out of the
bubble-or at least ensure that the bubble didn't over-
expand. But it chose to do nothing.

Throwing the poor out of their homes because they can't
pay their mortgages is not only tragic-it is pointless.
All that happens is that the property deteriorates and
the evicted people move somewhere else. The most
coldhearted banker ought to understand the basic
economics: banks lose money when they foreclose-the
vacant homes typically sell for far less than they
would if they were lived in and cared for. If banks
won't renegotiate, we should have an expedited special
bankruptcy procedure, akin to what we do for
corporations in Chapter 11, allowing people to keep
their homes and re-structure their finances.

If this sounds too much like coddling the
irresponsible, remember that there are two sides to
every mortgage-the lender and the borrower. Both enter
freely into the deal. One might say that both are,
accordingly, equally responsible. But one side-the
lender-is supposed to be financially sophisticated. In
contrast, the borrowers in the subprime market consist
mainly of people who are financially unsophisticated.
For many, their home is their only asset, and when they
lose it, they lose their life savings. Remember, too,
that we already give big homeowner subsidies, through
the tax system, to affluent families. With tax
deductions, the government is paying in some states
almost half of all mortgage interest and real-estate
taxes. But many lower-income people, whose deductions
are meaningless because their tax bill is too small,
get no help. It makes much more sense to convert these
tax deductions into cashable tax credits, so that the
fraction of housing costs borne by the government for
the poor and the rich is the same.

About these matters there should be no debate-but there
will be. Already, those on Wall Street are arguing that
we have to be careful not to 'over-react.' Over-
reaction, we are told, might stifle 'innovation.' Well,
some innovations ought to be stifled. Those toxic
mortgages were certainly innovative. Other innovations
were simply devices to circumvent
regulations-regulations intended to prevent the kinds
of problems from which our economy now suffers. Some of
the innovations were designed to tart up the bottom
line, moving liabilities off the balance sheet-charades
designed to blur the information available to investors
and regulators. They succeeded: the full extent of the
exposure was not clear, and still isn't. But there is a
reason we need reliable accounting. Without good
information it is hard to make good economic decisions.
In short, some innovations come with very high price
tags. Some can actually cause instability.

The free-market fundamentalists-who believe in the
miracles of markets-have not been averse to accepting
government bailouts. Indeed, they have demanded them,
warning that unless they get what they want the whole
system may crash. What politician wants to be blamed
for the next Great Depression, simply because he stood
on principle? I have been critical of weak anti-trust
policies that allowed certain institutions to become so
dominant that they are 'too big to fail.' The harsh
reality is that, given how far we've come, we will see
more bailouts in the days ahead. Now that Fannie Mae
and Freddie Mac are in federal receivership, we must
insist: not a dime of taxpayer money should be put at
risk while shareholders and creditors, who failed to
oversee management, are permitted to walk away with
anything they please. To do otherwise would invite a
recurrence. Moreover, while these institutions may be
too big to fail, they're not too big to be reorganized.
And we need to remember why we're bailing them out: in
order to maintain a flow of money into mortgage
markets. It's outrageous that these institutions are
responding to their near-monopoly position by raising
fees and increasing the costs of mortgages, which will
only worsen the housing crisis. They, and the financial
markets, have shown little interest in measures that
could help millions of existing and potential
homeowners out of the bind they're in.

The hardest puzzles will be in monetary policy
(balancing the risks of inflation and the risk of a
deeper downturn) and fiscal policy (balancing the risk
of a deeper downturn and the risk of an exploding
deficit). The standard analysis coming from financial
markets these days is that inflation is the greatest
threat, and therefore we need to raise interest rates
and cut deficits, which will restore confidence and
thereby restore the economy. This is the same bad
economics that didn't work in East Asia in 1997 and
didn't work in Russia and Brazil in 1998. Indeed, it is
the same recipe prescribed by Herbert Hoover in 1929.

It is a recipe, moreover, that would be particularly
hard on working people and the poor. Higher interest
rates dampen inflation by cutting back so sharply on
aggregate demand that the unemployment rate grows and
wages fall. Eventually, prices fall, too. As noted, the
cause of our inflation today is largely imported-it
comes from global food and energy prices, which are
hard to control. To curb inflation therefore means that
the price of everything else needs to fall drastically
to compensate, which means that unemployment would also
have to rise drastically.

In addition, this is not the time to turn to the old-
time fiscal religion. Confidence in the economy won't
be restored as long as growth is low, and growth will
be low if investment is anemic, consumption weak, and
public spending on the wane. Under these circumstances,
to mindlessly cut taxes or reduce government
expenditures would be folly.

But there are ways of thoughtfully shaping policy that
can walk a fine line and help us get out of our current
predicament. Spending money on needed
investments-infrastructure, education, technology-will
yield double dividends. It will increase incomes today
while laying the foundations for future employment and
economic growth. Investments in energy efficiency will
pay triple dividends-yielding environmental benefits in
addition to the short- and long-run economic benefits.

The federal government needs to give a hand to states
and localities-their tax revenues are plummeting, and
without help they will face costly cutbacks in
investment and in basic human services. The poor will
suffer today, and growth will suffer tomorrow. The big
advantage of a program to make up for the shortfall in
the revenues of states and localities is that it would
provide money in the amounts needed: if the economy
recovers quickly, the shortfall will be small; if the
downturn is long, as I fear will be the case, the
shortfall will be large.

These measures are the opposite of what the
administration-along with the Republican presidential
nominee, John McCain-has been urging. It has always
believed that tax cuts, especially for the rich, are
the solution to the economy's ills. In fact, the tax
cuts in 2001 and 2003 set the stage for the current
crisis. They did virtually nothing to stimulate the
economy, and they left the burden of keeping the
economy on life support to monetary policy alone.
America's problem today is not that households consume
too little; on the contrary, with a savings rate barely
above zero, it is clear we consume too much. But the
administration hopes to encourage our spendthrift ways.

What has happened to the American economy was
avoidable. It was not just that those who were
entrusted to maintain the economy's safety and
soundness failed to do their job. There were also many
who benefited handsomely by ensuring that what needed
to be done did not get done. Now we face a choice:
whether to let our response to the nation's woes be
shaped by those who got us here, or to seize the
opportunity for fundamental reforms, striking a new
balance between the market and government.

Joseph E. Stiglitz, a Nobel Prize-winning economist, is
a professor at Columbia University.

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