Reversal of Fortune

By Joseph E. Stiglitz

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

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%, 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% 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 US 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 pressures.

Millions of Americans are losing their homes. This social catastrophe has severe economic effects. The banks and other financial institutions that own these mortgages face stunning reverses. 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 CEO’s, investors, and creditors are walking away with billions, while American taxpayers are being asked to pick up the tab. 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. 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.

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% 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.

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.

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 mindset 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. 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