[R-G] [BillTottenWeblog] Reversal of Fortune

[Bill Totten]

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.

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 six percent, its highest level in seventeen years.
Unemployment stands at six 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 thirty
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 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. (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
CEO'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 CEO,
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 thirty 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 themselves.

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 dimension.

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 fifty-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 deficits.

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.

http://www.vanityfair.com/politics/features/2008/11/stiglitz200811


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