Joseph Stiglitz: Bankers Made Reckless Bets on the Economy, Knowing Taxpayers Were Going to Pick up the Tab
Nobel Prize-winning economist Joseph Stiglitz has served as the Chairman of President Bill Clinton's Council of Economic Advisers and Chief Economist for the World Bank. He has been a persistent critic of free-market economics, whose recent book Freefall: America, Free Markets, and the Sinking of the World Economy (W. W. Norton & Co., 2010) traces the roots of the financial crisis and details the government's flawed response. Dr. Stiglitz discussed the crash of '08 in an interview with AlterNet economics editor Zach Carter.
Zach Carter: How did we get here?
Joseph Stiglitz: Well, there are so many pieces that contributed to our getting here that it's hard to distill into something simple, but the bottom line is that the banks acted recklessly in their lending, in their gambling, in their management of risk. They made bad judgments about credit worthiness. In a sense, they failed their core societal function of allocating capital and managing risk. They misallocated capital and they mismanaged the risk. What I tried to do with the book is peel back the onion and ask – this is not the way capitalism supposed to work – why did things happen so badly? And here there are a number of factors. One of them was that the bankers had the incentive to engage in short-sighted behavior and excessive risk-taking. You have to ask, "Why is that?" And the answer has to do with problems of corporate governance and a host of other problems that I try to delineate in the book.
On the other side, though, they were allowed to get away with it. And here the issue was deregulation. We stripped away the regulations that had worked so well in the quarter century before 1980. We'd known about the potential for these problems for decades and we had figured out how to stop them, but then we stripped away those regulations. Then you have to ask why we did that, and it had to do with the ideology and with financial interests. The bankers wanted to be unrestrained and they painted the political process, shaped it to make sure they could get away with it. The economists provided some arguments for why it would be a good thing.
ZC: I want to focus on that word 'capitalism.' A lot of people who are advocates of financial reform are being described as 'populist' or 'socialist.' But it seems to me that one of the core thrusts of your book is that the system we had in place in the mid-'70s was a good system, and nobody was screaming about our socialist banking system at that time. What do you make of the current debate over the banks?
JS: What we have now is not real capitalism. I give it the name "ersatz capitalism" because what we're doing is socializing losses and privatizing gains. That's worse than real capitalism, of course, because it means that there are distorted incentives. So the banks can write these credit default swaps and crazy derivatives knowing that if things go bad, the taxpayer is going to pick up the tab. So the first point I want to make is that today's system is not real capitalism. It's gambling at the expense of the taxpayers.
The other point that I would make is about the use of the word "populism," which is used in a number of different ways. One meaning of populism is a government that responds to the concerns of the people. Of course, that is what democracy is supposed to be about, so reformers shouldn't worry about being labeled populist in that sense. But the other use of the word is much more negative in tone, and it describes a situation where political leaders promise things that are beyond the laws of economics.
In this crisis, I actually think of these bankers as being the populist figures in that sense. It was the bankers who tried to pretend that they could break the laws of economics. The things they were telling poor people -- borrow all this money, don't worry about your ability to replay, house prices are going to go up, you're going to be a wealthy person -- and by the way, you can share some of that wealth that you're going to get by giving us big fees -- well, that was unreality. There's no such thing as a free lunch and the bankers were promising a free lunch both for themselves and for everybody else. So the irony in all of this is that the people who ought to be most accused of that kind of populism, that out-of-touchness with reality, are the bankers themselves.
ZC: Speaking of reality, one of the most astonishing aspects of the deregulatory movement has been the popularity of these 'off-balance sheet vehicles' in finance. The banks actually refused to account for a lot of transactions and regulators just shrugged it off. You won your Nobel Prize for work on information asymmetries – where did this bogus accounting come from and is there any defense for it?
JS: One issue that I try to raise in my book Freefall is that good information is necessary for the functioning of a market economy. The banks' accountants were originally very clever in coming up with legal deceptions to avoid paying taxes -- you might call it "creative accounting." But then they discovered they could use some of the same techniques to deceive investors. And that's a lot of what all of this great, high-paid talent in the banking industry was up to over the last 20 years. They weren't trying to make our economy work more efficiently; they were engaged in what we call regulatory accounting and tax arbitrage. In other words, they were deceiving investors, deceiving the tax authorities and deceiving the regulators.
ZC: In Freefall there's a paragraph where you're talking about Henry Paulson coming to Congress with a three-page TARP bill and demanding the bailout money with no strings attached. You say it looked like a classic problem in developing nations where the financial sector basically uses the government to steal from the public. When has this taken place before and what does it look like?
JS: Oh, it's happened in many emerging markets. Mexico was one of the cases where it happened, and that was just before I arrived at the World Bank and we were seeing some of the consequences there. But what happens in the process of bailouts is that money goes from public purse to somewhere else. And you have to trace the money and what you discover is the money goes from the public, from the taxpayer, and it inevitably winds up in the hands of some of the same people who caused the crisis. And it's often done in a very obscure way, just like the creation of the crisis itself, into things that are hard to detect -- off-balance sheet transactions and the like.
What has absolutely amazed me about this crisis is the lack of transparency that created it is now being reflected in the lack of transparency in the bailouts. And the Federal Reserve is saying that it's not subjected even to the Freedom of Information Act. Here we have a public organization that is refusing to disclose where the money went.
ZC: The public's money, at that.
JS: That's right. Bloomberg [News] had to sue, Bloomberg won the suit and rather than saying, "We made a judgement call that wasn't right," the Fed said, "No, we're going to appeal because we don't want people to know." It's not like anyone has been advocating to have every scrap of information immediately available in the moment of the crisis. That obviously could cause a little bit of a turmoil. But now we're more than a year after Lehman Brothers. It's no longer a question of market stability but a question of accountability.
ZC: Are other central banks this secretive?
JS: This is part of the mentality of central banks. Remember, the central bankers are often people from the banking community, the same community that has been involved in the inventive, creative use of these off-balance-sheet kinds of non-transparent vehicles. So they know that information is money, and the best way to profit is to try and keep everything quiet.
ZC: 'Too big to fail' has become a household term, but how did things really play out when Lehman Brothers went under? If policymakers had just looked at Lehman's involvement in the commercial paper market, it's at least conceivable that the bankruptcy could have been managed without so much fallout. Could Lehman have gone through a prepackaged bankruptcy similar to what Chrysler and GM experienced? And if so, what would it have looked like?
JS: Clearly, we could have managed an orderly resolution for Lehman. You know, there have been big financial companies – Continental Illinois – that have gone bankrupt without any trauma to our economic system. And so we know how to manage these things. There is a little bit of a question about whether there was legal authority to do it because Lehman was an investment bank not a commercial bank, so the ordinary FDIC process wouldn't apply.
ZC: Well, Lehman was a lot bigger than Continental Illinois, but we still managed to come up with something for Chrysler and GM, and the FDIC process didn't apply to them.
JS: The point I was going to make is that everybody knew that there was going to be a problem with Lehman Brothers several months before it actually went under. If there really wasn't any legal authority to deal with it, Bernanke and Paulson should have gone to Congress and said they needed it. So the fact is, this legal authority issue was just an excuse for policymakers. The bailouts of AIG and Bear Stearns involved very unusual measures. These guys were willing to bend the law, and they could have done a lot more than they did on Lehman Brothers. But they were in the business of picking winners and losers. There were a lot of discussions about how they decided who to bail out and who to not, and the sheer recklessness of the process is just inexcusable.
ZC: But what do we do now? After Lehman, the government can say it will let these mega-banks fail, but the credit markets won't buy it. The big banks are still able to raise money at lower interest rates and take bigger risks because investors think the government will spare them from losses. Is there a way to establish a fair playing field in finance that doesn't involve breaking up these banks?
JS: It's very difficult. You know, the studies have shown very clearly that the very big banks, the banks that we call too big to fail, have a competitive advantage not because they are more efficient, but because they can get access to capital at lower costs. Everybody knows that they're effectively guaranteed by the U.S. government. And that really tilts the playing field and leads to a very adverse dynamic in which the big banks actually get bigger. The bigger you are, the better the implied government insurance, and that accelerates the process of concentration in a few banks. It's very, very unhealthy from an economic standpoint. It undermines competition and drives up interest rates. We want low interest rates to get our economy recovering. This goes in exactly the opposite direction because it weakens competition.
So in my mind you have to do something. Both because of this distorted playing field, but also because the too-big-to-fail banks have this bias toward risk-taking. If they gamble and they win they walk off with the profits. They lose, we, the taxpayers, pick up the losses.
So something has to be done. Taxes can make a big difference, they can help level the playing field, and there have been proposals for that. I'm not sure, though, that that's going to be enough, and here's why. Those who run the banks have interests that are not necessarily coincident with the banks' shareholders and bondholders. We saw that over and over and over again. The bankers have done very well, but the shareholders and bondholders have not always done so well. So we probably need to go further than tax policy.
I argue that we need a three-pronged approach. Higher taxes and higher capital adequacy requirements to level the playing field are the first prong. The second thing we need to do is take serious structural measures like breaking them up. We should not allow banks that accept deposits to engage in proprietary trading. We shouldn't allow them to own insurance companies, and so forth either. By forcing companies to focus on one thing rather than allowing them to conduct four different kinds of financial business, we will actually increase the efficiency of our economy. And finally, at the end, we have to make sure that they don't undertake excessive risk.
ZC: Paul Volcker wants to ban proprietary trading by commercial banks, but said recently that he's not in favor of bringing back the Glass-Steagall separation between commercial banking and investment banking. Is that enough?
JS: Well, I'm in absolute agreement that you have to ban proprietary trading and he's seen the risk of that. But I think you need to go a lot further than he seems to be willing to go at the current time. First, we have to do something about the too-big-to-fail investment banks. Goldman Sachs, we'll bail it out, AIG we'll bail it out. We need to make sure that our reforms don't just address the depository institutions, but all of the large financial institutions that pose the problem. Back in the 1990s we even engineered a bailout for the largest hedge fund, Long-Term Capital Management. So you have to go beyond the depository institutions, beyond traditional commercial banks.
And secondly, there are lots of forms of risk-taking. Proprietary trading is one, but for instance, the big banks are issuing these derivatives, these credit default swaps that brought down AIG. And that means if they're issuing them, the U.S. taxpayer is underwriting them because we underwrite the commercial banks. That means we, ultimately, are bearing the risk. We shouldn't be participating in this kind of gambling.
ZC: As soon as Goldman Sachs got its bank holding company status in 2008, the first thing it did was move all its derivatives operations under the commercial bank unit. It was very clear it wanted to use deposits to fund that business.
ZC: We've talked a lot about banks so far, but there is more to the economy than banking. It's been a really bad year for American households. Do we need a second stimulus? If so, what should it look like?
JS: We clearly need a second stimulus. There are a couple of ways of seeing this. When the Obama administration first moved on the stimulus, it posed a scenario that was not really rosy, but one that proved a little too optimistic. It expected unemployment without the stimulus it would be around 10 percent, with the stimulus it would be brought down to 8 percent. Others like me thought things were going to be much worse, that without the stimulus, unemployment would be around 12 percent and with the stimulus, it would be about 10 percent. And the pessimists were right. Well, when the world turns out to be worse than you thought it would, you have to adjust what you do.
But even a much bigger stimulus would have only brought the unemployment rate down to about 8 percent, which is still totally unacceptable. So right now I am very much in favor of a second round of stimulus. Hopefully, it will be better designed and more targeted to job creation and actually stimulating the economy. The tax cuts in the first round weren't designed really to stimulate the economy very much and didn't work very effectively.
ZC: And what do you do to create jobs? Are we talking fiscal aid to states? Unemployment benefits? A new WPA?
JS: The first thing I would do is aid to the states. The states have balanced budget frameworks. The revenues are down by around $200 billion because of the recession. If they don't get aid, they have to either raise taxes—which is very hard in the current environment—or cut back expenditures. And what they inevitably cut are teachers, nurses, firefighters and a whole set of crucial public services which are all the more important in an economic recession.
So the first thing is to provide states with money, and that spending goes right to the economy very quickly. You don't have to set up new programs and it really does save jobs. I would also do one of the things that Obama is pushing now which are job credits to encourage companies to hire more workers. Focus a little bit more direct attention on jobs. We don't know how effective these are going to be. There is some debate, but it seems to me that if we don't try we're not going to get anywhere.
The forecast right now is that it will be the middle of the decade before unemployment returns to normal—that should be very worrying. That kind of situation should be completely unacceptable because it creates severe long-term problems. If you have young people who remain unemployed for extended periods of time, they lose their job skills. Economic studies show very clearly that their lifetime incomes will be significantly lower than if they had been able to get jobs and enter the labor force.
ZC: It's almost as if they aren't living in the same economy as everyone else. Changing gears a bit—how did every policymaker miss this? We had everybody at the Fed and the Treasury insisting as late as 2007 that everything was fine. How does the biggest credit bubble in history and the worst financial crisis in history just go unnoticed by every major public official?
JS: They didn't want to notice it. And they didn't want to notice it for two reasons. One was this absurd notion that if you can just keep the markets optimistic -- be a cheerleader -- the economy will keep going strong. The normal hope at Fed and Treasury is that you will be viewed as a great economic leader because you cheered the economy on. So political leaders start acting like cheerleaders and not as economic analysts, which is dangerous.
But the deeper problem is that our public officials – the Bush administration and the Federal Reserve – were very wedded to a particular ideology that could not conceive that the markets were not efficient. They actually argued that there was no such thing as a bubble, or that even if there was, you couldn't tell when it was happening. They actually argued that it was less expensive to clean up the mess afterward than to try to interfere with the magic of the market. It was crazy, but that made it intellectually easy to dismiss all the smart people who were talking about the housing bubble.
But of course, underneath all of that is the third reason. Lots of money was flowing to lots of people who were friends of these politicians. And no one wants to be a party pooper when so many people that they knew were making so much money. And so they were under pressure to keep the party going. But they weren't deceiving the American people in a sense, in that they actually, I think, believed what they were saying, which is all the more worrisome. Their role as cheerleaders, their ideology, their view that their friends were so smart and deserved to get all this money because it was making the economy go – all these went together and served as blinders on their eyes. And unfortunately, those same blinders have impeded a design of an effective response.
ZC: It's interesting to see similarities between the Obama administration's response and that of the Bush administration.
JS: Well, some of this is bipartisan. Wall Street is bipartisan. There are people in both parties that believed in deregulation. There were people in both parties that were making a lot of money. But there is a difference. The critics of the deregulation philosophy were much more vocal within the Democratic Party. When I was in the Clinton administration, there were several of us that were raising these issues very strongly. We didn't win out in the end, but there was at least a very vocal debate on the economic philosophy.
ZC: Can you go into that a little bit more? I think people are broadly aware of the conflict between Robert Reich and Robert Rubin on the budget deficit, but what was actually discussed when you were on the Clinton team?
JS: Well, the very issue that you were talking about before. The repeal of Glass-Steagall was one of those issues that was debated very extensively. And I described this in my book Freefall, that we had this big debate and I can say that I feel pleased that while I remained chairman of the Counsel of Economic Advisors the Glass-Steagall Act repeal wasn't approved, but I think it had more to do with Congressional politics than politics within the administration. The Treasury wanted it. Bob Rubin wanted it. And one can understand why.
ZC: He made a lot of money working at Citigroup after the repeal.
JS: I think there was genuine belief in this doctrine of deregulation, that markets could take care of themselves. Greenspan in his famous Congressional testimony, his mea culpa, he said that he thought banks could manage risk far better than they did. But what he didn't point out was that if I mismanage my risk, there are consequences for me and my family, but when a major bank mismanages risks, there are consequences for the entire economy. So it's not just an issue of risk management, it's an issue of catastrophic externalities. You shouldn't allow a bank to put the entire economy at risk.
ZC: But the debate is still all about regulating banks as private sector, for-profit companies. Given the clear public purpose that banks serve, why don't we just make finance a public utility?
JS: There are actually several problems that carry a long history with governments trying to run banks. In many countries, they have not done it very well because of the potential politicization of the lending process. And that's why I'm actually fairly supportive of the approach that we took in the years after the Great Depression where we had private banks, strong incentives, but we made sure that they don't engage in excessive risk-taking, that they were regulated to serve the public purpose so that we try to shape their behavior. This public/private interaction that I think has worked most effectively.
There is no one today who believes the government should not be involved in finance. Even the bankers acknowledge this when they ask for bailouts, and they're also very protective of the Federal Reserve system. There would be no mortgage market today without the government. What we need to do is find the right balance, the right kind of government involvement in finance, because right now we clearly don't have that. And the bankers are doing everything they can to keep the balance out of whack.
ZC: Will we get it right?
JS: There's no question that we'll get it wrong, the question is how wrong we will get it. Right now, I am not very optimistic. We lost the political moment. Something will happen, it will have substance, but I worry that it will still be more cosmetic than substantive.
AlterNet will be publishing a two-part excerpt from Freefall in the days ahead.