The Fall: A Chronicle of the Financial Crisis

Joseph E. Stiglitz

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The Crisis in Brief

Excess credit fed a housing bubble

– Problems exacerbated by poorly designed mortgages (low doc “liar loans,” zero or negative amortization loans, variable rate mortgages, teaser rates)

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The Crisis in Brief

Excess credit fed a housing bubble

– Securitization meant that originator did not bear costs of flawed mortgage products

Based on the principle that a “fool is born every moment” Globalization had opened up a global marketplace for fools Rating agencies’ flawed incentives and flawed models made

it all possible

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The crisis was predictable, and predicted

The bubble was not sustainable

– Savings rate had dropped to zero

– House prices were soaring, while most people’s incomes were declining

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The crisis was predictable, and predicted

When the bubble broke, it was inevitable that there would be long term consequences

– Excessive leverage on the part of households and banks

– Deleveraging is a slow process

– Bankruptcies destroy organizational capital

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This crisis is like many other crises around the world

Crises have marked capitalism since the beginning

– The only period in which there were not crises is the short period after the Great Depression when there was good regulation

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This crisis is like many other crises around the world

Since the deregulation movement began 30 years ago, there have been more than 100 crises, mostly in developing countries

– Governments and the IMF came to the rescue

– The wrong inference was made: markets worked, but only because they were rescued

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Crisis is like a slow train wreck

First, the rate of increases in housing prices slowed down

– Some mortgage products were designed to run into problems even then

Then housing prices crashed—with predictable consequences

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Crisis is like a slow train wreck

Banks had created complex, non-transparent products—which they and investors did not fully understand—and engaged in off balance sheet activities

– While some of the products were justified as helping to manage risk, they actually increased risk

– Meant that banks didn’t know their own balance sheet

– Couldn’t know that of others

– Credit markets froze

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Government to the rescue

Saved the banks, the bankers, their shareholders and bondholders

– Ersatz Capitalism—new level of moral hazard (socializing losses, privatizing gains)

– Repealing the ordinary rules of capitalism (entailing bankruptcy when debt obligations cannot be paid, putting banks into conservatorship)

– Increased concentration in the banking system—increasing the problems of too-big-to-fail

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Mortgages

Finally did something—but too little

Almost nothing about the underwater mortgages

Pace of foreclosures continues almost unabated

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The Stimulus

Worked—but for the stimulus, the unemployment rate would probably have peaked at close to 12%

But it was too small, and not well designed

Based on the hypothesis that the economy had hit a small bump, repair the financial system, and everything would return to normal

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Hypothesis was wrong

There were fundamental problems before the crisis—growth in America and around the world was largely supported by unsustainable American consumption

Even if America’s financial institutions were functioning perfectly, households unlikely to return profligate ways

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What will fill the gap?

Government has been doing this temporarily

– But ability and willingness to do this is limited

– Growing fiscal pressures are leading to more contractionary policies around the world, especially in Europe after the Greek crisis

– In US, states and localities are facing massive shortfalls of revenues—with balanced budget framework, negative stimulus to the economy

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What will fill the gap?

Monetary policy has little power to stimulate the economy

– Though it may succeed in creating bubbles in emerging markets

– It has not succeeded in encouraging lending by banks in the US and Europe

– Understandable, given their weak balance sheets

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The Crisis Continues

As government came to the rescue, its fiscal positions worsened

– In effect, debts were transferred to the government

– Assumed that government could manage them better

– Rescue policies did work—were it not for policies, there likely would have been a depression

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Again, following historical pattern

Sovereign debt crises often follow financial crises

Hope that this time things would be different

– Most crises are in developing countries, with limited ability to raise taxes and high debt to GDP ratios

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Again, following historical pattern

Hope that this time things would be different

– But European crisis shows that that is not the case

– Greece had high debt and deficit

– But many of the countries in Europe face similar problems

– Explanation for the Trillion Dollar Bailout Program

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Not Just a Matter of Profligacy

Spain had a budget surplus before the crisis

Spain had only a 60% debt/GDP ratio

Spain had better bank regulation (at least in some dimensions) than the US and most other countries

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Not Just a Matter of Profligacy

Yet today, Spain stands at the precipice

– Huge deficit

– 20% unemployment

– More than 40% youth unemployment

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The world faces a dilemma

Response demanded of Spain and other countries with large deficits is to cut back spending (or raise taxes)

The effect could be massively contractionary

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The world faces a dilemma

The improvement in the deficit will be minimal

– Reminiscent of Argentinean death spiral

– Disappointment with size of improvement in deficit/GDP will cause higher interest rates, worsening the problem, leading to further cutbacks

– Even the rescue packages may not due the trick

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Global Perspectives

One bright spot is growth in Asia

– Partial decoupling—based on vast untapped domestic markets

– But too small to lead to recovery of US and Europe– And there is limited spillover from their expansion

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Global Perspectives

Problems of reserve accumulation (which weakens global aggregate demand) worsened

– Those countries with large reserves fared better

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But Europe’s problems will impact US

Irony: America exported its toxic mortgages and its recession to Europe

Now, Europe is likely to return favor

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But Europe’s problems will impact US

One hope for American recovery was strong exports

– Based on a weak dollar

– US had been winning “negative beauty contest”

– But it looks like Europe will take over, at least for a time

– Prospects of strong exports with a weak euro (strong dollar) and a weak Europe are bleak

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Prospects of a quick global recovery remain bleak

In U.S., problem is not that of a jobless recovery, but rather of an anemic recovery—too slow to create jobs for new entrants to the labor force, let alone to eliminate the job deficit

– One out of six Americans who would like a full time job still can’t get one

– Housing problems may impede recovery of labor market

– Middle of decade (at earliest) before return to “normal”

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Prospects of a quick global recovery remain bleak

In Europe, matters are even worse

Questions are raised: Will the euro survive? Will some European governments default?

– Will countries be willing to take cutbacks required by “markets”?

– Especially with prolonged high unemployment rates (including among the youth)

– Uncertainties will play on investors, force higher interest rates, and exacerbate the problems

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“Can it Happen Again?”

If history is our guide, not only can it happen again, it will happen again

– Though it may take slightly different form

– With slightly different instruments

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“Can it Happen Again?”

Question is: have we “learned the lessons,” so that the likelihood is reduced, the consequences mitigated?

The answer is almost surely no:

– We know that markets are not self-regulating

– We know that perverse incentives give rise to perverse behavior

– We know that regulations are required

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“Can it happen again?”

But so far the responses to the crisis have been mixed—little has been done about underlying problems

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“Can it happen again?”

And in some dimensions, matters are worse

– A more concentrated banking system—giving rise to greater problems of “too big to fail”

– The bailouts and the manner in which they were conducted exacerbated moral hazard problem

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“Can it happen again?”

And in some dimensions, matters are worse

– Prevalent incentive structures provide incentives for short sighted behavior and excessive risk taking.

– Open question still about derivatives regulations

– Some success in preventing worse mortgage abuses

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Regulation and Creativity

In some quarters, there are worries about whether new regulations will stifle creativity

But much of the sectors’ creative energy was directed at regulatory, tax, and accounting arbitrage

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Regulation and Creativity

This undermined the sector fulfilling its core functions of allocating capital (providing credit to small and medium sized enterprises) managing risk, running an efficient payments system, all at low transactions cost

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Regulation and Creativity

A good regulatory system holds out the promise of directing innovative energies of the sector in ways more consonant with its role in our society

Creating not only a more stable economy, but a more prosperous one.