The global economic The global economic crisis and Alternatives to crisis and Alternatives to

Rebuild the EconomyRebuild the EconomyJoseph E. StiglitzJoseph E. Stiglitz

RioRioMay, 2009May, 2009

The future is bleakThe future is bleak

The most serious economic disturbance The most serious economic disturbance since Great Depressionsince Great Depression• Most downturns since have been inventory Most downturns since have been inventory

cyclescycles Economy recovers as soon as excess inventories are Economy recovers as soon as excess inventories are

decumulateddecumulated

• Or a result of Central Bank stepping on brakes Or a result of Central Bank stepping on brakes too hardtoo hard

Economy recovers as soon as Central Bank discovers Economy recovers as soon as Central Bank discovers its mistake, removes its foot from brakeits mistake, removes its foot from brake

• This economic downturn is a result of major This economic downturn is a result of major financial mistakesfinancial mistakes

Akin in many ways to frequent financial crises in Akin in many ways to frequent financial crises in developing countriesdeveloping countries

America’s economy has been sustained by America’s economy has been sustained by consumption boom, fueled by a housing bubbleconsumption boom, fueled by a housing bubble• Savings fell to zeroSavings fell to zero• That game is overThat game is over• Posing a global problem: America’s consumption boom Posing a global problem: America’s consumption boom

sustained the global economysustained the global economy The storm is just beginningThe storm is just beginning

• Rising unemploymentRising unemployment• More foreclosures, as house prices continue to fallMore foreclosures, as house prices continue to fall

3.6 million so far, 2 million expected in next year3.6 million so far, 2 million expected in next year 12 million mortgages underwater and numbers rising12 million mortgages underwater and numbers rising

• Credit constraints likely to persist—poorly designed bail-Credit constraints likely to persist—poorly designed bail-outout

• Shouldn’t confuse end of free fall, or even slight Shouldn’t confuse end of free fall, or even slight recovery from bottom, with the beginnings of a robust recovery from bottom, with the beginnings of a robust recoveryrecovery

Each of components of aggregate Each of components of aggregate demand weakeningdemand weakening

States and localities cutting backStates and localities cutting back Households likely to increase savings Households likely to increase savings

substantiallysubstantially• May be good in short run, but “paradox of thrift” means May be good in short run, but “paradox of thrift” means

that national income will be reducedthat national income will be reduced• Restraints on ability and willingness to borrowRestraints on ability and willingness to borrow

Loss in wealthLoss in wealth Had been borrowing on assumption of rising house pricesHad been borrowing on assumption of rising house prices

Investment likely to slowInvestment likely to slow• Real estate has been main source of investment—Real estate has been main source of investment—

declining at record levels (overbuilding)declining at record levels (overbuilding)• Other firms face credit constraints, uncertainty, Other firms face credit constraints, uncertainty,

declining salesdeclining sales Exports have been major source of demandExports have been major source of demand

• But dollar is strengtheningBut dollar is strengthening• And downturn is spreadingAnd downturn is spreading

A Vicious CycleA Vicious Cycle

Weak economy, higher Weak economy, higher unemploymentunemployment

More foreclosures, more bad loans, More foreclosures, more bad loans, weaker banking system, more weaker banking system, more restricted lendingrestricted lending

Lower prices for housing, reduced Lower prices for housing, reduced consumption, weaker economyconsumption, weaker economy

Becoming a global slowdownBecoming a global slowdown Myth of decouplingMyth of decoupling Effects spreading to EuropeEffects spreading to Europe

• Partly because of major financial losses in EuropePartly because of major financial losses in Europe• Including in Eastern EuropeIncluding in Eastern Europe• Partly because of exchange rate adjustments, impact on Partly because of exchange rate adjustments, impact on

exportsexports• Both part of globalizationBoth part of globalization

Now spread to China, India, BrazilNow spread to China, India, Brazil• Even countries that did not make any of the mistakes Even countries that did not make any of the mistakes

that the U.S. did, had good regulatory and monetary that the U.S. did, had good regulatory and monetary policiespolicies

Will affect most countries Will affect most countries • Through effects on global financial Through effects on global financial

markets markets Highly indebted countries, with large trade Highly indebted countries, with large trade

deficits, likely to be most affecteddeficits, likely to be most affected Also through investmentAlso through investment Financial market protectionismFinancial market protectionism

• Through prices of commoditiesThrough prices of commodities• Through tradeThrough trade• Through remittancesThrough remittances

““Periphery” likely to be greatly Periphery” likely to be greatly affectedaffected

Heavy dependence on exportsHeavy dependence on exports• Declines in exports greater than anticipatedDeclines in exports greater than anticipated• Partly explained by lack of trade creditPartly explained by lack of trade credit• Partly explained by inventory adjustmentPartly explained by inventory adjustment• Partly explained by large fall of demand for durables, Partly explained by large fall of demand for durables,

investmentinvestment Heavy dependence on foreign direct investmentHeavy dependence on foreign direct investment Heavy dependence on foreign borrowingHeavy dependence on foreign borrowing Some with heavy dependence on remittancesSome with heavy dependence on remittances Less resources to combat downturn and its effectsLess resources to combat downturn and its effects Even countries with “good” economic policies are being Even countries with “good” economic policies are being

affectedaffected Irony: money is flowing back to USIrony: money is flowing back to US

• Even though it was source of problemEven though it was source of problem• Because of Because of relative confidence relative confidence in US government guaranteein US government guarantee

Brazil is in a Good PositionBrazil is in a Good Position Monetary policy has given it room to Monetary policy has given it room to

maneuver—maneuver—• Unlike the U.S.Unlike the U.S.• Which has been forced to engage in risky Which has been forced to engage in risky

strategies, with uncertain long term strategies, with uncertain long term consequencesconsequences

• And little short run impacts—other than And little short run impacts—other than preventing the crisis from going into freefallpreventing the crisis from going into freefall

But will be important to use all available But will be important to use all available instrumentsinstruments

As large economy, more room for effective As large economy, more room for effective stimulus spending stimulus spending

BROAD GENERAL LESSONSBROAD GENERAL LESSONS

Need to rethink what are “good” policies Need to rethink what are “good” policies and institutionsand institutions• Most would have thought that the U.S. had Most would have thought that the U.S. had

good policies and institutionsgood policies and institutions Evidently notEvidently not Problems are pervasive and deep-seatedProblems are pervasive and deep-seated So question is: What are good policies and So question is: What are good policies and

institutions?institutions?

• Deregulatory policies of U.S. were similar to Deregulatory policies of U.S. were similar to those advocated under Washington Consensus those advocated under Washington Consensus by IMF and U.S. Treasuryby IMF and U.S. Treasury

September 15: A WatershedSeptember 15: A Watershed

The fall of the Berlin Wall marked the end The fall of the Berlin Wall marked the end of Communism and the belief in that of Communism and the belief in that economic systemeconomic system

The massive bail-outs in the US marked The massive bail-outs in the US marked the end of market fundamentalism, belief the end of market fundamentalism, belief in unfettered marketsin unfettered markets• Markets are not self-adjusting, self-correctingMarkets are not self-adjusting, self-correcting• At least in the relevant time frameAt least in the relevant time frame• America’s response is being called “Socialism America’s response is being called “Socialism

with American Characteristics”with American Characteristics”

America’s financial markets have America’s financial markets have failed and failed massivelyfailed and failed massively

Supposed to mobilize savings, allocate capital, Supposed to mobilize savings, allocate capital, manage riskmanage risk

Didn’t mobilize savings: encouraged living on Didn’t mobilize savings: encouraged living on credit cardcredit card

Misallocated capitalMisallocated capital Created riskCreated risk But failed to create products that would help But failed to create products that would help

ordinary American households and firms manage ordinary American households and firms manage the risks which they facedthe risks which they faced

High transactions costs—and resisted creating an High transactions costs—and resisted creating an efficient Electronic Payments Mechanismefficient Electronic Payments Mechanism

Underlying market failuresUnderlying market failures Underlying problem: Lack of congruence between Underlying problem: Lack of congruence between

social returns and private rewardssocial returns and private rewards Net return 2004 to date negativeNet return 2004 to date negative

Incentive systemsIncentive systems• Encouraged excessive risk taking, myopic behaviorEncouraged excessive risk taking, myopic behavior• Encouraged lack of transparency, greater complexityEncouraged lack of transparency, greater complexity

Lack of transparency, excessive complexityLack of transparency, excessive complexity• Underlying cause of credit crunchUnderlying cause of credit crunch

Too big to fail—encouraged excessive risk takingToo big to fail—encouraged excessive risk taking Underlying problems in corporate governanceUnderlying problems in corporate governance

Rating AgenciesRating Agencies Believed in financial alchemy—could convert F Believed in financial alchemy—could convert F

rated subprime mortgages into A rated securities rated subprime mortgages into A rated securities safe enough for pension funds; played an safe enough for pension funds; played an essential role in securitization processessential role in securitization process

Played key role: facilitated flow of funds into bad Played key role: facilitated flow of funds into bad lendinglending

Conflicts of interest—paid by those they ratedConflicts of interest—paid by those they rated Competition made it worse: race to the bottomCompetition made it worse: race to the bottom Failed to assess risks accurately—flawed modelsFailed to assess risks accurately—flawed models

• Underestimated correlations, likelihood of small Underestimated correlations, likelihood of small probability events, risk of price declinesprobability events, risk of price declines

• Reinforced mistakes of the banksReinforced mistakes of the banks• Failures were predictable and predictedFailures were predictable and predicted

Not for the first time (also failed in East Asia Not for the first time (also failed in East Asia crisis)crisis)

SecuritizationSecuritization

Allowed greater diversification of risk and Allowed greater diversification of risk and risk spreadingrisk spreading

But created new asymmetries of But created new asymmetries of informationinformation

Incentives for lower quality of lendingIncentives for lower quality of lending Banks and rating agencies failed to take Banks and rating agencies failed to take

into account the effects of new into account the effects of new asymmetries of information and new risky asymmetries of information and new risky products on foreclosure ratesproducts on foreclosure rates

Derivatives, CDS, and other Derivatives, CDS, and other risky productsrisky products

Double-edged swordDouble-edged sword Could help manage riskCould help manage risk But also could be used as new high power But also could be used as new high power

gambling instrumentgambling instrument Contributed to lack of transparencyContributed to lack of transparency Which in turn contributed to credit crisisWhich in turn contributed to credit crisis Risk recognizedRisk recognized Fight over regulation in the 90sFight over regulation in the 90s

• Financial markets won short-run battleFinancial markets won short-run battle• They, the American economy, and the world They, the American economy, and the world

lost in the long runlost in the long run

Underlying public failuresUnderlying public failures Macro - excessive liquidity, low interest rateMacro - excessive liquidity, low interest rate

• Partially in response to breaking of tech bubble, soaring oil Partially in response to breaking of tech bubble, soaring oil pricesprices

Followed example of Latin America in the 70sFollowed example of Latin America in the 70s• Should have designed better fiscal policiesShould have designed better fiscal policies• But cheap credit should be a “good thing”—basis of rapid But cheap credit should be a “good thing”—basis of rapid

growth, if well used—real problem with financial markets and growth, if well used—real problem with financial markets and regulationregulation

Deregulation, failure to enforce existing regulation, to adopt Deregulation, failure to enforce existing regulation, to adopt new regulations to respond to changing financial landscapenew regulations to respond to changing financial landscape• Deregulation philosophyDeregulation philosophy• Regulators who didn’t believe in regulationRegulators who didn’t believe in regulation

Loose money and lax regulations were an explosive mixtureLoose money and lax regulations were an explosive mixture Failure to enforce competition laws contributed to “too big Failure to enforce competition laws contributed to “too big

to fail”to fail”

Flawed bail-outFlawed bail-out Non-transparent, unaccountableNon-transparent, unaccountable Cash for trash could not be done quicklyCash for trash could not be done quickly Is it enough?Is it enough?

• We don’t know—banks too non-transparentWe don’t know—banks too non-transparent• But what would have been enough one month ago is not But what would have been enough one month ago is not

enough todayenough today• Bail-outs getting larger and larger—to little effectBail-outs getting larger and larger—to little effect• But exposing taxpayers to increasing riskBut exposing taxpayers to increasing risk• Massive blood transfusion to a patient suffering from Massive blood transfusion to a patient suffering from

internal hemorrhaging internal hemorrhaging Finally beginning to do somethingFinally beginning to do something But not enough—need write down of principleBut not enough—need write down of principle

• Need to address real economyNeed to address real economy Stimulus not enoughStimulus not enough Badly designedBadly designed

Flawed bail-outFlawed bail-out

Will it ensure resumption of lending?Will it ensure resumption of lending?• Probably notProbably not• Didn’t stop banks from distributing Didn’t stop banks from distributing

money to shareholders, even as money to shareholders, even as government was pumping money in government was pumping money in (contrast with U.K.)(contrast with U.K.)

• Didn’t provide adequate oversight Didn’t provide adequate oversight (contrast with U.K.)(contrast with U.K.)

Flawed bail-outFlawed bail-out

Will it restore confidence?Will it restore confidence?• Probably only to a limited extentProbably only to a limited extent• No change in those in charge (contrast No change in those in charge (contrast

to U.K.), no sense of accountabilityto U.K.), no sense of accountability• So far, no change in regulations and So far, no change in regulations and

regulatory structuresregulatory structures Worry about “cosmetic reform”Worry about “cosmetic reform”

• Increase in guarantees helpful, but still Increase in guarantees helpful, but still insufficientinsufficient

Flawed bail-outFlawed bail-out Did the taxpayer get a good deal?Did the taxpayer get a good deal?

• One question for which there is a clear answerOne question for which there is a clear answer—taxpayers got a raw deal—taxpayers got a raw deal

Prices of shares after announcementPrices of shares after announcement Pricing of preferred shares, termsPricing of preferred shares, terms Contrast with Buffett, U.K.Contrast with Buffett, U.K. Congressional Oversight Panel—taxpayers badly Congressional Oversight Panel—taxpayers badly

cheatedcheated More recent bail-outs worseMore recent bail-outs worse CBO estimates massive lossesCBO estimates massive losses

• Important: growing national debt will make Important: growing national debt will make taking appropriate actions more and more taking appropriate actions more and more difficultdifficult

The result…The result…

Economic downturn will be longer Economic downturn will be longer and deeper than it otherwise would and deeper than it otherwise would have beenhave been

And America’s national debt will be And America’s national debt will be much larger than it otherwise would much larger than it otherwise would have beenhave been

Both will have global consequencesBoth will have global consequences

Incipient controversiesIncipient controversies

Second round of a stimulus?Second round of a stimulus?• Size of national debt may impose Size of national debt may impose

constraintsconstraints• Before economy is on robust recoveryBefore economy is on robust recovery• Irony: worries about size of deficit likely Irony: worries about size of deficit likely

to come from financial sector, but only to come from financial sector, but only after after they have had their bail-outthey have had their bail-out

Incipient ControversiesIncipient Controversies How extensive should bail-outs be? And under How extensive should bail-outs be? And under

what terms? what terms? • Government could have resuscitated economy much Government could have resuscitated economy much

more effectively with less money by creating new more effectively with less money by creating new institutions, rather than saving old institutionsinstitutions, rather than saving old institutions

Debate reminiscent of debates in the economies in Debate reminiscent of debates in the economies in transitiontransition

• What is best way to save old institutions?What is best way to save old institutions? Bankruptcy (especially chapter 11) simply changes Bankruptcy (especially chapter 11) simply changes

management and financial claims; real assets don’t management and financial claims; real assets don’t disappeardisappear

Are we bailing out auto industry, or Wall Street Are we bailing out auto industry, or Wall Street bondholders?bondholders?

Confusing saving banks with saving bankers, bondholders, Confusing saving banks with saving bankers, bondholders, and shareholdersand shareholders

Debt to equity swaps would enhance financial stability, Debt to equity swaps would enhance financial stability, confidenceconfidence

Incipient controversiesIncipient controversies

How extensive should the regulations be?How extensive should the regulations be?• Some worry that the pendulum will swing too Some worry that the pendulum will swing too

far, innovation will be stifledfar, innovation will be stifled• But most of innovation was involved in But most of innovation was involved in

regulatory, accounting, and tax arbitrage, had regulatory, accounting, and tax arbitrage, had little social valuelittle social value

Little innovation to help ordinary Americans manage Little innovation to help ordinary Americans manage the important risks they face (stay in their own the important risks they face (stay in their own homes)homes)

• Good regulation may actually enhance “good” Good regulation may actually enhance “good” innovation and contribute to a more productive innovation and contribute to a more productive economyeconomy

Incipient ControversiesIncipient Controversies

Who should pay for the bail-outs of the Who should pay for the bail-outs of the financial sector?financial sector?• Originally, they claimed the bail-outs would Originally, they claimed the bail-outs would

pay for themselvespay for themselves• As size has increased, likelihood has decreasedAs size has increased, likelihood has decreased• Current estimates are very large lossesCurrent estimates are very large losses• Some suggest making them pay would Some suggest making them pay would

discourage attracting private capitaldiscourage attracting private capital• Others argue matter of efficiency and equityOthers argue matter of efficiency and equity

Similar to polluter pays principle in environmental Similar to polluter pays principle in environmental economicseconomics

Big Questions TodayBig Questions Today

Where is economy going? Will proposed Where is economy going? Will proposed stimulus and bank bail-out work? And stimulus and bank bail-out work? And what will things be like at the other end?what will things be like at the other end?

Growing consensusGrowing consensus• Even large stimulus not likely to make up for Even large stimulus not likely to make up for

shortfall in aggregate demandshortfall in aggregate demand• Unless something dramatic is done, when we Unless something dramatic is done, when we

emerge from recession, likely to emerge into emerge from recession, likely to emerge into “malaise” rather than into strong growth“malaise” rather than into strong growth

What is to be done?What is to be done? Problem is global, not just AmericanProblem is global, not just American

• America has been the source of global aggregate America has been the source of global aggregate demanddemand

Alternative sources of increased aggregate Alternative sources of increased aggregate demanddemand1.1. Redistribution—offsetting marked increased inequality Redistribution—offsetting marked increased inequality

in recent yearsin recent years2.2. Responding to the needs of global warming—huge Responding to the needs of global warming—huge

investments requiredinvestments required3.3. Reforming the global financial system—new global Reforming the global financial system—new global

reserve system, annual creation of SDR’sreserve system, annual creation of SDR’s4.4. Assistance to developing countriesAssistance to developing countries

Don’t have resources for stimulus, protect banks, provide Don’t have resources for stimulus, protect banks, provide safety netsafety net

Lessons for other countriesLessons for other countries Washington Consensus model didn’t Washington Consensus model didn’t

even work in Washingtoneven work in Washington• We are all Keynesians nowWe are all Keynesians now

But not all Keynesians are the sameBut not all Keynesians are the same Keynesian economics can be abused and Keynesian economics can be abused and

used for special interests, just as any other used for special interests, just as any other economic doctrineeconomic doctrine

• We will be redesigning our corporate We will be redesigning our corporate governance and regulatory systemsgovernance and regulatory systems

There will be resistance from those who There will be resistance from those who benefited from old systembenefited from old system

Lessons for other countriesLessons for other countries

Design regulatory structures Design regulatory structures assuming that others are not doing assuming that others are not doing their jobtheir job• Ring-fence core financial systemRing-fence core financial system• Regulation has to be comprehensiveRegulation has to be comprehensive

Little point in having transparency in just a Little point in having transparency in just a part of the systempart of the system

• Host country has to play central role in Host country has to play central role in regulationregulation

Need strong consumer protection, Need strong consumer protection, anti-trust, safety and soundness, and anti-trust, safety and soundness, and access regulationsaccess regulations• Speed limitsSpeed limits• Consumer protectionConsumer protection• Worse lending combined risky and Worse lending combined risky and

predatory lendingpredatory lending• Key function of finance is to provide Key function of finance is to provide

credit, especially to small and medium credit, especially to small and medium sized firmssized firms

CRA requirements to encourage finance to CRA requirements to encourage finance to underserved groups, imposed on all underserved groups, imposed on all

Rethinking Monetary PolicyRethinking Monetary Policy

Stability is necessary for growthStability is necessary for growth• But price stability is not the only aspect But price stability is not the only aspect

of stabilityof stability• Excessive focus on price stability part of Excessive focus on price stability part of

key mistake of Central Banks around the key mistake of Central Banks around the worldworld

• Need to focus more on financial stabilityNeed to focus more on financial stability

New global landscapeNew global landscape Problem was “made in America,” and so far, Problem was “made in America,” and so far,

America’s political system’s response to crisis has America’s political system’s response to crisis has been disappointing been disappointing • Even in contrast to “old Europe”Even in contrast to “old Europe”

America is still largest economyAmerica is still largest economy• But America is no longer largest source of savingsBut America is no longer largest source of savings• America has lost dominance in manufacturingAmerica has lost dominance in manufacturing• America may now lose pre-eminence in financial America may now lose pre-eminence in financial

marketsmarkets Role in financial intermediation based on presumption of Role in financial intermediation based on presumption of

“better institutions,” comparative advantage in managing “better institutions,” comparative advantage in managing risk and allocating capitalrisk and allocating capital

Latin America, Africa increasingly turning to China Latin America, Africa increasingly turning to China as a source of financeas a source of finance

New Global LandscapeNew Global Landscape Old international governance structure failedOld international governance structure failed

• IMF, Financial Stability Forum didn’t do much to prevent IMF, Financial Stability Forum didn’t do much to prevent crisiscrisis

Imposed large number of conditionsImposed large number of conditions Including counterproductive pro-cyclical macro-policiesIncluding counterproductive pro-cyclical macro-policies Encouraged financial sector deregulation which played such Encouraged financial sector deregulation which played such

a big role in creating the crisis—and even in its propagationa big role in creating the crisis—and even in its propagation Encouraged capital market liberalization, which too played Encouraged capital market liberalization, which too played

key role in the spread of the crisiskey role in the spread of the crisis• Led to greater riskLed to greater risk• Without any greater growthWithout any greater growth

Promoted monetary policies that didn’t pay sufficient Promoted monetary policies that didn’t pay sufficient attention to financial stabilityattention to financial stability

Underlying problems political and ideologicalUnderlying problems political and ideological• Proposed governance reforms not likely to make much Proposed governance reforms not likely to make much

difference, though steps in the right direction. difference, though steps in the right direction.

• Yet they are the only institutions we haveYet they are the only institutions we have

UN CommissionUN Commission

UN Commission emphasizing need for UN Commission emphasizing need for additional funds and recommending: additional funds and recommending: • new credit facilities new credit facilities • new global regulatory authority,new global regulatory authority,• new global economic coordinating councilnew global economic coordinating council• new global reserve systemnew global reserve system

Key to restoring global aggregate demandKey to restoring global aggregate demand Institutions created in first half of 20Institutions created in first half of 20thth

century not up to tasks of 21century not up to tasks of 21stst century century• And many have a legacy of pushing failed And many have a legacy of pushing failed

ideology that may impair effectivenessideology that may impair effectiveness

BIG QUESTIONS AHEADBIG QUESTIONS AHEAD

What kind of financial system do we What kind of financial system do we want when the economy emerges want when the economy emerges from crisis?from crisis?• Can’t, shouldn’t go back to pre-crisis Can’t, shouldn’t go back to pre-crisis

structurestructure• Recovery strategy should be based on Recovery strategy should be based on

long term visionlong term vision Bail-outs have reinforced old problems, Bail-outs have reinforced old problems,

money disproportionately going to too big to money disproportionately going to too big to fail institutionsfail institutions

BIG QUESTIONS AHEADBIG QUESTIONS AHEAD

Crisis is forcing rethinking about what kind Crisis is forcing rethinking about what kind of society, economy works bestof society, economy works best• Need to get the balance between the market Need to get the balance between the market

and the government (and other non-state and the government (and other non-state actors) rightactors) right

• Markets were unstable, inefficient, exploitiveMarkets were unstable, inefficient, exploitive They discovered there was money at the bottom of They discovered there was money at the bottom of

the pyramid and did everything they could to make the pyramid and did everything they could to make sure it didn’t remain theresure it didn’t remain there

Silver lining on this cloud: Societies all Silver lining on this cloud: Societies all over the world are beginning to rethink over the world are beginning to rethink