Joseph Stiglitz

Nobel economist: The coronavirus stimulus can't be a corporate bail-out. We need a new playbook for relief

Three years ago, in an ugly display of pigs feeding at the trough, there was a rush of special interests to take advantage of a secretive tax bill moving quickly through the Senate, with tens of billions of dollars going to certain industries, like real estate. We saw what happened: a short burst of economic growth that turned out to be remarkably weak, given the size of the deficit that it brought about. This year, growth was expected to decline to anemic levels—lower than 2 percent. While the predicted 1 trillion dollar deficits quickly emerged, the promised increases in investment and wages did not, as corporations paid out almost a trillion dollars in share buybacks.

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Economist Joseph Stiglitz: Trump's economy is an absolute disaster for people and the planet

It is becoming conventional wisdom that US President Donald Trump will be tough to beat in November, because, whatever reservations about him voters may have, he has been good for the American economy. Nothing could be further from the truth.

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6 Ways to Reform Our Corrupt Financial System

The following is an excerpt from the new book Rewriting the Rules of the American Economy by Joseph E. Stiglitz (W. W. Norton & Company, Inc., 2016):

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Inequality Is Killing Middle America

This week, Angus Deaton will receive the Nobel Memorial Prize in Economics “for his analysis of consumption, poverty, and welfare.” Deservedly so. Indeed, soon after the award was announced in October, Deaton published some startling work with Ann Case in the Proceedings of the National Academy of Sciences – research that is at least as newsworthy as the Nobel ceremony.

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Argentina Shows Greece There May Be Life After Default

When, five years ago, Greece's crisis began, Europe extended a helping hand. But it was far different from the kind of help that one would have wanted, far different from what one might have expected if there was even a bit of humanity, of European solidarity.

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How the TPP Amounts to a Corporate Takeover

NEW YORK - The United States and the world are engaged in a great debate about new trade agreements. Such pacts used to be called "free-trade agreements"; in fact, they were managed trade agreements, tailored to corporate interests, largely in the US and the European Union. Today, such deals are more often referred to as "partnerships,"as in the Trans-Pacific Partnership (TPP). But they are not partnerships of equals: the US effectively dictates the terms. Fortunately, America's "partners" are becoming increasingly resistant.

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Why Stupid Politics Is the Cause of Our Economic Problems

NEW YORK -- In 2014, the world economy remained stuck in the same rut that it has been in since emerging from the 2008 global financial crisis. Despite seemingly strong government action in Europe and the United States, both economies suffered deep and prolonged downturns. The gap between where they are and where they most likely would have been had the crisis not erupted is huge. In Europe, it increased over the course of the year.

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In the U.S., Downward Mobility and Vulnerability Is a Widely Shared Experience

NEW YORK -- Two new studies show, once again, the magnitude of the inequality problem plaguing the United States. The first, the U.S. Census Bureau's annual income and poverty report, shows that, despite the economy's supposed recovery from the Great Recession, ordinary Americans' incomes continue to stagnate. Median household income, adjusted for inflation, remains below its level a quarter century ago.

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Joe Stiglitz: The People Who Break the Rules Have Raked in Huge Profits and Wealth and It's Sickening Our Politics

The following is taken from a transcript of Joseph Stiglitz's remarks to the AFL-CIO convention in Los Angeles on September 8.

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We're Living in an Obama World -- Here's Why

Reprinted with kind permission from Project Syndicate

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Joseph Stiglitz: The Price of Inequality

What happened to America, land of opportunity? In his new book, which hit the shelves yesterday, Nobel Prize-winning economist Joseph Stiglitz takes up that burning question. Taking a long, hard look at the global specter of inequality, Stiglitz describes what causes it, why the trend endangers our future and what to do about it. Stiglitz begins by describing the broader failures of our economic system and how these failures have led to a widespread sense of unfairness and reduced opportunity for most of us. [Reprinted from The Price of Inequality by Joseph Stiglitz. Copyright © 2012 by Joseph Stiglitz. With the permission of the publisher, W.W. Norton & Company, Inc.]

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The U.S. Response to 9/11 Cost Us Far More Than the Attacks Themselves

The September 11, 2001, attacks by al-Qaeda were meant to harm the United States, and they did, but in ways that Osama bin Laden probably never imagined. President George W Bush’s response to the attacks compromised the United States’ basic principles, undermined its economy, and weakened its security.

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How to Tame the Rapacious Finance Industry?

NEW YORK - It was not long ago that we could say, "We are all Keynesians now." The financial sector and its free-market ideology had brought the world to the brink of ruin. Markets clearly were not self-correcting. Deregulation had proven to be a dismal failure.

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The Great American Bank Robbery, Part II

The following is Part II of a two-part excerpt from Freefall: America, Free Markets, and the Sinking of the World Economy by Joseph Stiglitz (W.W. Norton & Co., 2010). Click here for part I.

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The Great American Bank Robbery

The following is Part I of a two-part excerpt from Freefall: America, Free Markets, and the Sinking of the World Economy by Joseph Stiglitz ( W.W. Norton & Co., 2010). Read AlterNet's recent interview with Stiglitz by Zach Carter.

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9 Reasons Obama's Fiscal Plan Fails Both Markets and Taxpayers

Let's be clear: President Barack Obama inherited an economy in freefall and could not possibly have turned things around in the short time since his election. Unfortunately, what he is doing is not enough.

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The Only Way to Avoid Wasting Many Billions More: Take Over the Banks

The news that even Alan Greenspan and Senator Chris Dodd suggest that bank nationalization may be necessary shows how desperate the situation has become. It has been obvious for some time that a government takeover of our banking system -- perhaps along the lines of what Norway and Sweden did in the '90s -- is the only solution. It should be done, and done quickly, before even more bailout money is wasted.

The problem with America's banks is not just one of liquidity. Years of reckless behavior, including bad lending and gambling with derivatives, have left them, in effect, bankrupt. If our government were playing by the rules -- which require shutting down banks with inadequate capital -- many, if not most, banks would go out of business. But because faulty accounting practices don't force banks to mark down all their assets to current market prices, they may nominally meet capital requirements -- at least for a while.

No one knows for sure how big the hole is; some estimates put the number at $2 trillion or $3 trillion, or more. So the question is, Who is going to bear the losses? Wall Street would like nothing better than a steady drip of taxpayer money. But the experience in other countries suggests that when financial markets run the show, the costs can be enormous. Countries like Argentina, Chile and Indonesia spent 40 percent or more of their GDP to bail out their banks. For the United States, the worry is that the $700 billion appropriated for the bank bailout may turn out to be just a small down payment.

The cost to the government is especially important, given the legacy of debt from the Bush administration, which saw the national debt soar from $5.7 trillion to more than $10 trillion. Unless care is taken, government spending on the bailout will crowd out other vital government programs, from Social Security to future investments in technology.

There is a basic principle in environmental economics called "the polluter pays": polluters must pay for the cost of cleaning up their pollution. American banks have polluted the global economy with toxic waste; it is a matter of equity and efficiency that they must be forced, now or later, to pay the price of cleaning it up. As long as the banking sector feels that it will be bailed out of disasters -- even ones it created -- we will continue to have a moral hazard. Only by making sure that the sector pays the costs of its actions will efficiency be restored.

The full costs of those mistakes include not just the $700 billion bailout but the almost $3 trillion shortfall between the economy's potential output and its actual output resulting from the crisis. Since we are not forcing banks to pay these full costs imposed on society, we should hear no complaints from them about paying for the much smaller direct costs of the bailout.

The politicians responsible for the bailout keep saying, "We had no choice. We had a gun pointed at our heads. Without the bailout, things would have been even worse." This may or may not be true, but in any case the argument misses a critical distinction between saving the banks and saving the bankers and shareholders. We could have saved the banks but let the bankers and shareholders go. The more we leave in the pockets of the shareholders and the bankers, the more that has to come out of the taxpayers' pockets.

Principles and Goals

There are a few basic principles that should guide our bank bailout. The plan needs to be transparent, cost the taxpayer as little as possible and focus on getting the banks to start lending again to sectors that create jobs. It goes without saying that any solution should make it less likely, not more likely, that we will have problems in the future.

By these standards, the TARP bailout has so far been a dismal failure. Unbelievably expensive, it has failed to rekindle lending. Former Treasury Secretary Henry Paulson gave the banks a big handout; what taxpayers got in return was worth less than two-thirds of what we gave the big banks -- and the value of what we got has dropped precipitously since.

Since TARP facilitated the consolidation of banks, the problem of "too big to fail" has become worse, and therefore the excessive risk-taking that it engenders has grown worse. The banks carried on paying out dividends and bonuses and didn't even pretend to resume lending. "Make more loans?" John Hope III, chair of Whitney National Bank in New Orleans, said to a room full of Wall Street analysts in November. The taxpayers put out $350 billion and didn't even get the right to find out what the money was being spent on, let alone have a say in what the banks did with it.

TARP's failure comes as no surprise: incentives matter. Bankers won't restart lending unless they have a reason to do so or are forced. Receiving billions of dollars in bonus pay for racking up record losses is a peculiar "incentive" structure. Bankers have been accused of unbounded greed using hard-earned taxpayer dollars for bonuses and dividends, but economists more calmly observe: they were simply responding rationally to the incentives and constraints they faced.

Even if the banks had not poured out the money in bonuses as we were pouring it in, they might not have restarted lending; they might have just hoarded it. Recapitalization enables them to lend. But there is a difference between the ability to lend and the willingness to lend. With the economy plunging into deep recession, the risks of lending are enormous. TARP did nothing to require or create incentives for new lending, focusing instead on cleaning up past mistakes. We need to be forward-looking, reducing the risk of new lending. Just think of what new lending $700 billion could have financed. Leveraged on a modest ten-to-one basis, it could have supported $7 trillion of new lending -- more than enough to meet business's requirements.

Flawed Attempts to Restart Lending

Policy-makers have been flailing around, trying to figure out how to get lending restarted. It is not hard to do -- if the government bears all or most of the risk. The Federal Reserve is, in effect, making major loans to America's corporate giants, giving them a big advantage over traditional job creators, America's small- and medium-size enterprises. We have no idea if the Fed is doing a good job of assessing risk and whether interest rates commensurate with the risks are being charged. Given the Fed's recent record, there is no reason for confidence. But there is a consensus that whatever the Fed is doing, it is not enough.

The Obama administration has floated a number of ideas, from buying the bad assets and putting them into a "bad bank," leaving it to the government to dispose of them; to providing insurance to the banks; to assisting private investors (like hedge funds) to buy the bad assets, presumably by lending to investors on favorable terms. Because of the lack of details, the market greeted the Obama administration's announcement of its so-called plan with dismay. As this article goes to press, we can only guess that the administration's plan will be an amalgam of several of these ideas. The devil is in the details, and without the details we can't be sure how things will turn out.

An early idea floated by Paulson was for the government to buy the bad assets from the banks. Naturally, Wall Street was delighted with this idea. Who wouldn't want to offload their junk to the government at inflated prices? The banks could get rid of some of these bad assets now, but not at prices they would like. Then there are other assets that the private sector wouldn't touch with a ten-foot pole. Some of them are liabilities that can explode, eating up government funds like Pac-Man. On September 15 AIG said it was short $20 billion. The next day, its losses had grown to some $85 billion. A little later, when no one was looking, there was a further dole, bringing the total to $150 billion. Then on March 1, the government agreed to another $30 billion in taxpayer money for AIG -- the fourth intervention in less than six months.

Paulson's original proposal was thoroughly discredited, as the difficulties of pricing and buying thousands of assets became apparent. More recently a variant of this proposal, which involves government buying garbage in bulk, was broached. But the major difficulty with determining prices of toxic assets, whether singly or in bulk, remains: pay too much and the government will suffer huge losses; pay too little and the hole in the banks' balance sheets will still seem enormous, requiring another bailout to recapitalize the banks.

Most variants of the "cash for trash" proposal are based on putting the bad assets into a bad bank (advocates of the plan prefer the gentler term "aggregator bank"). But the banks holding only good assets would likely be short of cash, even after taxpayers had vastly overpaid for the trash. The hope is that the banks would then find private funds to further the recapitalization, though one suspects that the sovereign wealth funds, to whom many turned a little while ago, would be less interested, having been so badly burned before.

I believe that the bad bank, without nationalization, is a bad idea. We should reject any plan that involves "cash for trash." It is another example of the voodoo economics that has marked the financial sector -- the kind of alchemy that allowed the banks to slice and dice F-rated subprime mortgages into supposedly A-rated securities. Somehow, it is believed that moving the bad assets around into an aggregator bank will create value. But I suspect that Wall Street is enthusiastic about the plan not because bankers believe that government has a comparative advantage in garbage disposal but because they hope for a nontransparent bonanza from the Treasury in the form of high prices for their junk.

If the government takes over banks that don't meet the minimum capital requirements, placing them in federal conservatorship, then these pricing problems are no longer important. Under this scenario, pricing is just an accounting entry between two pockets of the government. Whether the government finds it useful to gather all the bad assets into a bad bank is a matter of management: Norway chose not to; Sweden chose to. But Sweden wasn't foolish enough to try to buy bad assets from private banks, as many in America are advocating. It was only under government ownership of the entire bank that the bad bank was created. Norway's experience was perhaps somewhat better, but the circumstances were different. Given the complexity and scale of the mess Wall Street has gotten us into, I suspect we will want to gather the problems together, net out the derivative positions (something that will be much easier to do under conservatorship and a significant achievement in its own right, with major benefits in risk reduction) and eventually restructure and dispose of the assets.

More recently, another idea has been put forward: the government would insure bank losses. By removing the risk of loss, the value of these toxic assets automatically increases, improving the banks' balance sheets. Bankers love this idea. The government can give them a big insurance policy at a small premium. Politicians love this idea too: there is at least a chance they will be out of Washington before the bills come due.

But that's precisely the problem with this approach: we won't know for years what it would do to the government's balance sheet. Six months ago, what the banks told us about their losses going forward was totally off the mark. AIG had to revise its losses by tens of billions of dollars within days. Real estate prices might fall only another 5 percent, or they could fall another 25 percent. With the insurance proposal, neither the government nor the banks have to admit the size of the hole in the banks' balance sheets. It's another example of those nontransparent transactions that got Wall Street into trouble.

Even worse, the insurance proposal exacerbates incentive distortions -- it moves us from a zero-sum world into a negative-sum world, where increased taxpayer losses are greater than Wall Street's gains. The insurance proposal may even inhibit banks from restructuring mortgages, worsening the problem that gave rise to the crisis in the first place. If they restructure the mortgage, they have to book a loss. If they keep the mortgage and things get worse (the likely scenario), the taxpayer picks up most of the downside risk; but if things get better and prices improve, the banks keep the gains.

Still worse are proposals to try to enlist the private sector to buy the trash. Right now, the prices the private sector is willing to pay are so low that the banks aren't interested -- it would make apparent the size of the hole in banks' balance sheets. But if the government insures private-sector investors -- and even makes loans at favorable terms -- they'll be willing to pay a higher price. With enough insurance and favorable enough loan terms, presto! We can make our banks solvent.

But there is a sleight-of-hand here: go back to the zero-sum principle. The private sector is not going to provide money for nothing. It expects a return for providing capital and bearing risk. But its cost of capital is far higher than that of government. The losses are real, and the private sector won't bear them without full compensation. This means that the amount the government is likely to have to pay in the end is all the greater.

This proposal, like so many others emanating from the banking community, is based partially on the hope that if banks make things sufficiently complex and nontransparent, no one will notice the gift to the banking sector until it is too late. It appears as if they are at last getting the high market prices that they hoped they would get all along. But it would be a misnomer to call these market prices, since the government has taken away the downside risk. This proposal has, of course, the further advantage of drumming up support from the hedge funders, who so far have not received any of the TARP bonanza.

There is an underlying problem facing all these proposals: the hole in the banks' balance sheets is bigger than the $700 billion Congress has approved -- and much of what has been spent so far has been wasted. So the financial wizards are turning to tried and true gimmicks -- the same ones that got us into the mess. One strategy is to hide the costs in nontransparent accounting (easier under the insurance proposal). The other combines this trickery with the magic of leveraging and pretends that leveraging carries no risk. The government sets up a "special investment vehicle" using, say, $100 billion of TARP as the "equity." It then borrows another $900 billion from the Fed -- which in rapid succession has been tripling and quadrupling its balance sheet. Of course, in doing so the Fed is risking taxpayers' money -- but without having to ask permission of Congress. At best, this is a deliberate circumvention of democratic processes.

Is There an Alternative?

Firms often get into trouble -- accumulating more debt than they can repay. There is a time-honored way of resolving the problem, called "financial reorganization," or bankruptcy. Bankruptcy scares many people, but it shouldn't. All that happens is that the financial claims on the firm get restructured. When the firm is in very bad trouble, the shareholders get wiped out, and the bondholders become the new shareholders. When things are less serious, some of the debt is converted into equity. In any case, without the burden of monthly debt payments, the firm can return to profitability. America is lucky in having a particularly effective way of giving firms a fresh start -- Chapter 11 of our bankruptcy code, which has been used repeatedly, for example, by the airlines. Airplanes keep flying; jobs and assets are preserved. Under new management, and without the burden of debt, the airline can go on making a contribution to our society.

Banks differ in only one respect. The failure of a bank results in particular hardship to depositors and can lead to broader problems in the economy. These are among the reasons that the government has provided deposit insurance. But this means that when banks fail, the government comes in to pick up the pieces -- and this is different from when the local pizza parlor fails. Worse still, long experience has taught us that when banks are at risk of failure, their managers engage in behaviors that risk losing even more taxpayer money. They may, for instance, undertake big bets: if they win, they keep the proceeds; if they lose, so what? -- they would have died anyway. That's why we have laws that say when a bank's capital is low, it should be shut down. We don't wait for the till to be empty. Because the government is on the hook for so much money, it has to take an active role in managing the restructuring; even in the case of airline bankruptcy, courts typically appoint someone to oversee the restructuring to make sure that the claimants' interests are served.

Usually, the process is done smoothly. The government finds a healthy bank to take over the failed bank. To get the healthy bank to do this, it often has to "fill in the hole," making up for the difference between the value of what the bank owes depositors and the value of the bank's assets. It's no different from an ordinary takeover or merger, except the government facilitates the process. Typically, in the process, shareholders get wiped out, and often the government and/or private investors may put in additional money.

Occasionally, the government can't find a healthy bank to take over the failed bank. Then it has to take over the failed bank itself. Usually, it restructures the bank, shutting down many of the branches and lending departments with particularly bad track records. Then it sells the bank. We can call this "temporary nationalization" if we want. But whatever we call it, it's no big deal. Not surprisingly, the banks are trying to scare us into believing that it would be the end of the world as we know it. Of course, it can be done badly (Lehman Brothers, for example). But there are far more examples of it being done well.

The current situation is only slightly different. There are few healthy banks to take over the very many unhealthy banks, and the banks are in such a mess -- and the economy is in such a downturn -- that we don't really know how much money would be needed. We don't know if claims by depositors are greater than the value of assets, and if so, by how much. The banks may claim, If we hold the assets long enough, and if the real estate market recovers, and if our recession isn't too deep or long, then we can meet all our obligations. We are "solvent." We just can't get the cash we need.

Those are big ifs. That's why governments typically make judgments based on market values. Right now, the suspicion is that the banks don't meet their capital requirements with current market values, let alone the market values in the future, as real estate prices continue to fall and the downturn gets worse. (If banks don't have enough capital, we would give them short notice: either come up with additional capital, or you can't continue to operate as you are. We either find someone to take you over, or we run you, restructure and sell.)

The banks obviously don't want the government to play by the rules. They want to delay the day of reckoning. They want what is called forbearance. They say, Allow us a little slack now, because we are fundamentally sound. Of course they would say that. Of course banks claim that market prices underestimate true values. We learned the hard way in the S&L crisis, however, that delay is very costly. We are on track to learn that lesson again.

The Obama administration seems to be proposing a way out of this muddle: we will "stress test." We will see how well you fare. If you pass the test, we will help you get out of your temporary difficulties. Stress testing involves using mathematical models to see what happens under various scenarios. The banks were supposed to have been stress testing themselves on an on-going basis. Their models said everything was fine and dandy.

We know those models failed. What we don't know is whether the models the administration will use will be any better. Will they use the old, failed models? We have been told that it will take time to do the stress test, and while we wait, will we pour more money into failing institutions, with good money chasing bad, ever widening our national debt. We know, too, that the worst-case scenarios that will be used in the stress test are nowhere near the worst-case scenarios that some economists are depicting -- implying that even banks that pass the stress test may need more funding down the line.

Gradually America is realizing that we must do something -- now. We already have a framework for dealing with banks whose capital is inadequate. We should use it, and quickly, with perhaps some modifications to take care of the unusual nature of today's problems. There are several ways we can proceed. One innovative proposal (variants of which have been floated by Willem Buiter at the London School of Economics and by George Soros) entails the creation of a Good Bank. Rather than dump the bad assets on the government, we would strip out the good assets -- those that can be easily priced. If the value of claims by depositors and other claims that we decide need to be protected is less than the value of the assets, then the government would write a check to the Old Bank (we could call it the Bad Bank). If the reverse is true, then the government would have a senior claim on the Old Bank. In normal times, it would be easy to recapitalize the Good Bank privately. These are not normal times, so the government might have to run the bank for a while.

Meanwhile, the Old Bank would be left with the task of disposing of its toxic assets as best it can. Because the Old Bank's capital is inadequate, it couldn't take deposits, unless it found enough capital privately to recapitalize itself. How much shareholders and bondholders got would depend on how well management did in disposing of these assets -- and how well they did in ensuring that management didn't overpay itself.

The Good Bank proposal has the advantage of avoiding the N-word: nationalization. Some believe a more polite term, "conservatorship" as it was called in the case of Fannie Mae, may be more palatable. It should be clear, though, that whatever it is called, the Good Bank proposal entails little more than playing by longstanding rules, a variant of standard practices to deal with firms whose liabilities exceed their assets.

Those who say the government cannot be trusted to allocate capital efficiently sound unconvincing these days. After all, it's not as though the private sector did a very good job. No peacetime government has wasted resources on the scale of America's private financial system. Wall Street's incentives structures were designed to encourage shortsighted and excessively risky behavior. The bankers were supposed to understand risk, but they did not understand the most elementary principles of information asymmetry, risk correlation and fat-tailed distributions. Most of them, while they may have been ethically challenged, were really guided in their behavior by the perverse incentives they championed. The result was that they did not even serve their shareholders well; from 2004 to 2008, net profits of many of the major banks were negative.

There is every reason to believe that a temporarily nationalized bank will behave much better -- even if most of the employees are still the same -- simply because we will have changed the perverse incentives. Besides, a government-run bank might spend some time and money teaching its employees about risk management, good lending practices, social responsibility and ethics. The experience elsewhere, including in the Scandinavian countries, shows that the whole process can be done well -- and when the economy is eventually restored to prosperity, the profitable banks can be returned to the private sector. What is required is not rocket science. Banks simply need to get back to what they were supposed to do: lending money, on a prudent basis, to businesses and households, based not just on collateral but on a good assessment of the use to which borrowers will put the money and their ability to repay it.

Meanwhile, there needs to be an orderly plan for disposing of the old bad assets. There is no magic in moving them around from one owner to another. In some countries, government agencies (often hiring private subcontractors) have done a good job of selling off the assets. Other countries (including some hit in the East Asia crisis a decade ago) have had an unfortunate experience, bringing in investment banks and hedge funds to dispose of their assets. These institutions simply held them for the short time it took the economy to recover and made a huge capital gain at the expense of the country's taxpayers. To add insult to injury, some even took advantage of tax havens to avoid paying taxes on those huge profits. These experiences suggest caution in turning to hedge funds and other investment firms.

Every downturn comes to an end. Eventually we will be able to sell the restructured banks at a good price -- though, one hopes, not one based on the irrational exuberant expectation of another financial bubble. The notion that we will make a profit from the bailouts -- which the financial sector tried to convince us were "investments" -- seems to have dropped from public discourse. But at least we can use the proceeds of the eventual sale of the restructured banks to pay down the huge deficit that this financial debacle will have brought onto our nation.

Is the Entire Bailout Strategy Flawed? Let's Rethink This Before It's Too Late

America's recession is moving into its second year, with the situation only worsening.

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The Seven Deadly Deficits: What the Bush Years Really Cost Us

When President George W. Bush assumed office, most of those disgruntled about the stolen election contented themselves with this thought: Given our system of checks and balances, given the gridlock in Washington, how much damage could be done? Now we know: far more than the worst pessimists could have imagined. From the war in Iraq to the collapse of the credit markets, the financial losses are difficult to fathom. And behind those losses lie even greater missed opportunities.

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Chapter 11 Is the Right Road for US Carmakers

The debate about whether or not to bail out the Big Three carmakers has been mischaracterised. It has been described as a package to help the undeserving dinosaurs of Detroit. In fact, a plan to bail out the carmakers would benefit shareholders and bondholders as much as anybody else. These are not the people that need help right now. In fact they contributed to the problem.

Financial markets are supposed to allocate capital and monitor that it is used to good effect. They are supposed to be rewarded when they do that job well, but bear the consequences when they fail. The markets failed. Wall Street's focus on quarterly returns encouraged the short-sighted behaviour that contributed to their own demise and that of America's manufacturing, including the automotive industry. Today, they are asking to escape accountability. We should not allow it.

What needs to be done is to help the automakers get a fresh start and allow them to focus on producing good cars rather than trying to juggle their books to meet past obligations.

The US car industry will not be shut down, but it does need to be restructured. That is what Chapter 11 of America's bankruptcy code is supposed to do. A variant of pre-packaged bankruptcy - where all the terms are set before going before the bankruptcy court - can allow them to produce better and more environmentally sound cars. It can also address legacy retiree obligations. The companies may need additional finance. Given the state of financial markets, the US government may have to provide that at terms that give the taxpayers a full return to compensate them for the risk. Government guarantees can provide assurances, as they did two decades ago when Chrysler faced its crisis.

With financial restructuring, the real assets do not disappear. Equity investors (who failed to fulfil their responsibility of oversight) lose everything; bondholders get converted into equity owners and may lose substantial amounts. Freed of the obligation to pay interest, the carmakers will be in a better position. Taxpayer dollars will go far further. Moral hazard - the undermining of incentives - will be averted: a strong message will be sent.

Some will talk of the pension funds and others that will suffer. Yes, but that is true of every investment that has diminished. The government may need to help some pension funds but it is better to do so directly, than via massive bail-outs hoping that a little of the money trickles down to the "widows and orphans". Some will say that bankruptcy will undermine confidence in America's cars. It is the cars and carmakers themselves - and the dismal performance of their executives - that have undermined confidence. With industry experts saying $125bn (94bn, 84bn) or more will be needed, with bail-out fatigue setting in, why should US consumers believe that a $15bn gift will do the trick of a turnround?

It is more plausible that confidence will be restored if the industry is freed of the burden of interest payments and is given a fresh start. Modern cars are complex technological products and the US has demonstrated its strength in advanced technology. US workers, working for Japanese carmakers, have shown their hard work can produce cars that are desirable. America's managers too have demonstrated their managerial skills in many other areas.

The failure lies with the managers of US carmakers and America's financial markets, which failed in their oversight and encouraged short-sighted behaviour. The "bridge loan to nowhere" - the down payment on what could be a sinkhole of enormous proportions - is another example of the short-sighted behaviour that got us into this mess.

As the bailouts continue, numbers that once looked huge are starting to seem almost normal. Hundreds of billons are being given to banks and insurance companies. AIG got $150bn. Compared with that $34bn, or even $125bn, for the automotive industry seems a modest request. Even so, we should not forget that a few months ago, President George W. Bush said there was not enough money for health insurance for poor children although it cost just a few billion dollars.

5 Disastrous Decisions That Got Us into This Economic Mess

There will come a moment when the most urgent threats posed by the credit crisis have eased and the larger task before us will be to chart a direction for the economic steps ahead. This will be a dangerous moment. Behind the debates over future policy is a debate over history -- a debate over the causes of our current situation. The battle for the past will determine the battle for the present. So it's crucial to get the history straight.

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Here's a Better Bailout Plan

The champagne bottle corks were popping as Treasury Secretary Henry Paulson announced his trillion-dollar bailout for the banks, buying up their toxic mortgages. To a skeptic, Paulson's proposal looks like another of those shell games that Wall Street has honed to a fine art. Wall Street has always made money by slicing, dicing and recombining risk. This "cure" is another one of these rearrangements: somehow, by stripping out the bad assets from the banks and paying fair market value for them, the value of the banks will soar.

There is, however, an alternative explanation for Wall Street's celebration: the banks realized that they were about to get a free ride at taxpayers' expense. No private firm was willing to buy these toxic mortgages at what the seller thought was a reasonable price; they finally had found a sucker who would take them off their hands -- called the American taxpayer.

The administration attempts to assure us that they will protect the American people by insisting on buying the mortgages at the lowest price at auction. Evidently, Paulson didn't learn the lessons of the information asymmetry that played such a large role in getting us into this mess. The banks will pass on their lousiest mortgages. Paulson may try to assure us that we will hire the best and brightest of Wall Street to make sure that this doesn't happen. (Wall Street firms are already licking their lips at the prospect of a new source of revenues: fees from the US Treasury.) But even Wall Street's best and brightest do not exactly have a credible record in asset valuation; if they had done better, we wouldn't be where we are. And that assumes that they are really working for the American people, not their long-term employers in financial markets. Even if they do use some fancy mathematical model to value different mortgages, those in Wall Street have long made money by gaming against these models. We will then wind up not with the absolutely lousiest mortgages, but with those in which Treasury's models most underpriced risk. Either way, we the taxpayers lose, and Wall Street gains.

And for what? In the S&L bailout, taxpayers were already on the hook, with their deposit guarantee. Part of the question then was how to minimize taxpayers' exposure. But not so this time. The objective of the bailout should not be to protect the banks' shareholders, or even their creditors, who facilitated this bad lending. The objective should be to maintain the flow of credit, especially to mortgages. But wasn't that what the Fannie Mae/Freddie Mac bailout was supposed to assure us?

There are four fundamental problems with our financial system, and the Paulson proposal addresses only one. The first is that the financial institutions have all these toxic products -- which they created -- and since no one trusts anyone about their value, no one is willing to lend to anyone else. The Paulson approach solves this by passing the risk to us, the taxpayer -- and for no return. The second problem is that there is a big and increasing hole in bank balance sheets -- banks lent money to people beyond their ability to repay -- and no financial alchemy will fix that. If, as Paulson claims, banks get paid fairly for their lousy mortgages and the complex products in which they are embedded, the hole in their balance sheet will remain. What is needed is a transparent equity injection, not the non-transparent ruse that the administration is proposing.

The third problem is that our economy has been supercharged by a housing bubble which has now burst. The best experts believe that prices still have a way to fall before the return to normal, and that means there will be more foreclosures. No amount of talking up the market is going to change that. The hidden agenda here may be taking large amounts of real estate off the market -- and letting it deteriorate at taxpayers' expense.

The fourth problem is a lack of trust, a credibility gap. Regrettably, the way the entire financial crisis has been handled has only made that gap larger.

Paulson and others in Wall Street are claiming that the bailout is necessary and that we are in deep trouble. Not long ago, they were telling us that we had turned a corner. The administration even turned down an effective stimulus package last February -- one that would have included increased unemployment benefits and aid to states and localities -- and they still say we don't need another stimulus. To be frank, the administration has a credibility and trust gap as big as that of Wall Street. If the crisis was as severe as they claim, why didn't they propose a more credible plan? With lack of oversight and transparency the cause of the current problem, how could they make a proposal so short in both? If a quick consensus is required, why not include provisions to stop the source of bleeding, to aid the millions of Americans that are losing their homes? Why not spend as much on them as on Wall Street? Do they still believe in trickle-down economics, when for the past eight years money has been trickling up to the wizards of Wall Street? Why not enact bankruptcy reform, to help Americans write down the value of the mortgage on their overvalued home? No one benefits from these costly foreclosures.

The administration is once again holding a gun at our head, saying, "My way or the highway." We have been bamboozled before by this tactic. We should not let it happen to us again. There are alternatives. Warren Buffet showed the way, in providing equity to Goldman Sachs. The Scandinavian countries showed the way, almost two decades ago. By issuing preferred shares with warrants (options), one reduces the public's downside risk and insures that they participate in some of the upside potential. This approach is not only proven, it provides both incentives and wherewithal to resume lending. It furthermore avoids the hopeless task of trying to value millions of complex mortgages and even more complex products in which they are embedded, and it deals with the "lemons" problem -- the government getting stuck with the worst or most overpriced assets.

Finally, we need to impose a special financial sector tax to pay for the bailouts conducted so far. We also need to create a reserve fund so that poor taxpayers won't have to be called upon again to finance Wall Street's foolishness.

If we design the right bailout, it won't lead to an increase in our long-term debt -- we might even make a profit. But if we implement the wrong strategy, there is a serious risk that our national debt -- already overburdened from a failed war and eight years of fiscal profligacy -- will soar, and future living standards will be compromised. The president seemed to think that his new shell game will arrest the decline in house prices, and we won't be faced holding a lot of bad mortgages. I hope he's right, but I wouldn't count on it: it's not what most housing experts say. The president's economic credentials are hardly stellar. Our national debt has already climbed from $5.7 trillion to over $9 trillion in eight years, and the deficits for 2008 and 2009 -- not including the bailouts -- are expected to reach new heights. There is no such thing as a free war -- and no such thing as a free bailout. The bill will be paid, in one way or another.

Perhaps by the time this article is published, the administration and Congress will have reached an agreement. No politician wants to be accused of being responsible for the next Great Depression by blocking key legislation. By all accounts, the compromise will be far better than the bill originally proposed by Paulson but still far short of what I have outlined should be done. No one expects them to address the underlying causes of the problem: the spirit of excessive deregulation that the Bush Administration so promoted. Almost surely, there will be plenty of work to be done by the next president and the next Congress. It would be better if we got it right the first time, but that is expecting too much of this president and his administration.

At All Costs, We Must Avoid a 'Surge' in Afghanistan


The Iraq war has been replaced by the declining economy as the most important issue in America's presidential election campaign, in part because Americans have come to believe that the tide has turned in Iraq: the troop "surge" has supposedly cowed the insurgents, bringing a decline in violence. The implications are clear: a show of power wins the day.

It is precisely this kind of macho reasoning that led America to war in Iraq in the first place. The war was meant to demonstrate the strategic power of military might. Instead, the war showed its limitations. Moreover, the war undermined America's real source of power -- its moral authority.

Recent events have reinforced the risks in the Bush administration's approach. It was always clear that the timing of America's departure from Iraq might not be its choice -- unless it wanted to violate international law once again. Now, Iraq is demanding that American combat troops leave within 12 months, with all troops out in 2011.

To be sure, the reduction in violence is welcome, and the surge in troops may have played some role. Yet the level of violence, were it taking place anywhere else in the world, would make headlines; only in Iraq have we become so inured to bloodshed that it is a good day if only 25 civilians get killed.

And the role of the troop surge in reducing violence in Iraq is not clear. Other factors were probably far more important, including buying off Sunni insurgents so that they fight with the United States against al-Qaida. But that remains a dangerous strategy. The US should be working to create a strong, unified government, rather than strengthening sectarian militias. Now the Iraqi government has awakened to the dangers, and has begun arresting some of the leaders whom the American government has been supporting. The prospects of a stable future look increasingly dim.

That is the key point: the surge was supposed to provide space for a political settlement, which would provide the foundations of long-term stability. That political settlement has not occurred. So, as with the arguments used to justify the war, and the measures of its success, the rationale behind surge, too, keeps shifting.

Meanwhile, the military and economic opportunity costs of this misadventure become increasingly clear. Even if the US had achieved stability in Iraq, this would not have assured victory in the "war on terrorism," let alone success in achieving broader strategic objectives. Things have not been going well in Afghanistan, to say the least, and Pakistan looks ever more unstable.

Moreover, most analysts agree that at least part of the rationale behind Russia's invasion of Georgia, reigniting fears of a new Cold War, was its confidence that, with America's armed forces pre-occupied with two failing wars (and badly depleted because of a policy of not replacing military resources as fast as they are used up), there was little America could do in response. Russia's calculations proved correct.

Even the largest and richest country in the world has limited resources. The Iraq war has been financed entirely on credit; and partly because of that, the US national debt has increased by two-thirds in just eight years.

But things keep getting worse: the deficit for 2009 alone is expected to be more than a half-trillion dollars, excluding the costs of financial bail-outs and the second stimulus package that almost all economists now say is urgently needed. The war, and the way it has been conducted, has reduced America's room for manoeuvre, and will almost surely deepen and prolong the economic downturn.

The belief that the surge was successful is especially dangerous because the Afghanistan war is going so poorly. America's European allies are tiring of the endless battles and mounting casualties. Most European leaders are not as practiced in the art of deception as the Bush administration; they have greater difficulty hiding the numbers from their citizens. The British, for example, are well aware of the problems that they repeatedly encountered in their imperial era in Afghanistan.

America will, of course, continue to put pressure on its allies, but democracy has a way of limiting the effectiveness of such pressure. Popular opposition to the Iraq war made it impossible for Mexico and Chile to give in to American pressure at the United Nations to endorse the invasion; the citizens of these countries were proven right.

But back in America, the belief that the surge "worked" is now leading many to argue that more troops are needed in Afghanistan.

True, the war in Iraq distracted America's attention from Afghanistan. But the failures in Iraq are a matter of strategy, not troop strength. It is time for America, and Europe, to learn the lessons of Iraq -- or, rather, relearn the lessons of virtually every country that tries to occupy another and determine its future.

Why You Want a Progressive to Be Running the Economy

Both the left and the right say they stand for economic growth. So should voters trying to decide between the two simply look at it as a matter of choosing alternative management teams?

If only matters were so easy! Part of the problem concerns the role of luck. America's economy was blessed in the 1990s with low energy prices, a high pace of innovation, and a China increasingly offering high-quality goods at decreasing prices, all of which combined to produce low inflation and rapid growth.

President Clinton and then-chairman of the US Federal Reserve, Alan Greenspan, deserve little credit for this--though, to be sure, bad policies could have messed things up. By contrast, the problems faced today --high energy and food prices and a crumbling financial system --have, to a large extent, been brought about by bad policies.

There are, indeed, big differences in growth strategies, which make different outcomes highly likely. The first difference concerns how growth itself is conceived. Growth is not just a matter of increasing GDP. It must be sustainable: growth based on environmental degradation, a debt-financed consumption binge, or the exploitation of scarce natural resources, without reinvesting the proceeds, is not sustainable.

Growth also must be inclusive; at least a majority of citizens must benefit. Trickle-down economics does not work: an increase in GDP can actually leave most citizens worse off. America's recent growth was neither economically sustainable nor inclusive. Most Americans are worse off today than they were seven years ago.

But there need not be a trade-off between inequality and growth. Governments can enhance growth by increasing inclusiveness. A country's most valuable resource is its people. So it is essential to ensure that everyone can live up to their potential, which requires educational opportunities for all.

A modern economy also requires risk-taking. Individuals are more willing to take risks if there is a good safety net. If not, citizens may demand protection from foreign competition. Social protection is more efficient than protectionism.

Failures to promote social solidarity can have other costs, not the least of which are the social and private expenditures required to protect property and incarcerate criminals. It is estimated that within a few years, America will have more people working in the security business than in education. A year in prison can cost more than a year at Harvard. The cost of incarcerating two million Americans -- one of the highest per capita rates (pdf) in the world -- should be viewed as a subtraction from GDP, yet it is added on.

A second major difference between left and right concerns the role of the state in promoting development. The left understands that the government's role in providing infrastructure and education, developing technology, and even acting as an entrepreneur is vital. Government laid the foundations of the internet and the modern biotechnology revolutions. In the 19th century, research at America's government-supported universities provided the basis for the agricultural revolution. Government then brought these advances to millions of American farmers. Small business loans have been pivotal in creating not only new businesses, but whole new industries.

The final difference may seem odd: the left now understands markets, and the role that they can and should play in the economy. The right, especially in America, does not. The new right, typified by the Bush-Cheney administration, is really old corporatism in a new guise.

These are not libertarians. They believe in a strong state with robust executive powers, but one used in defense of established interests, with little attention to market principles. The list of examples is long, but it includes subsidies to large corporate farms, tariffs to protect the steel industry, and, most recently, the mega-bailouts of Bear Stearns, Fannie Mae, and Freddie Mac. But the inconsistency between rhetoric and reality is long-standing: protectionism expanded under Reagan, including through the imposition of so-called voluntary export restraints on Japanese cars.

By contrast, the new left is trying to make markets work. Unfettered markets do not operate well on their own -- a conclusion reinforced by the current financial debacle. Defenders of markets sometimes admit that they do fail, even disastrously, but they claim that markets are "self-correcting." During the Great Depression, similar arguments were heard: the government need not do anything, because markets would restore the economy to full employment in the long run. But, as John Maynard Keynes famously put it, in the long run we are all dead.

Markets are not self-correcting in the relevant time frame. No government can sit idly by as a country goes into recession or depression, even when caused by the excessive greed of bankers or misjudgment of risks by security markets and rating agencies. But if governments are going to pay the economy's hospital bills, they must act to make it less likely that hospitalization will be needed. The right's deregulation mantra was simply wrong, and we are now paying the price. And the price tag -- in terms of lost output -- will be high, perhaps more than $1.5trn in the US alone.

The right often traces its intellectual parentage to Adam Smith, but while Smith recognized the power of markets, he also recognized their limits. Even in his era, businesses found that they could increase profits more easily by conspiring to raise prices than by producing innovative products more efficiently. There is a need for strong anti-trust laws.

It is easy to host a party. For the moment, everyone can feel good. Promoting sustainable growth is much harder. Today, in contrast to the right, the left has a coherent agenda, one that offers not only higher growth, but also social justice. For voters, the choice should be easy.

Cost of Occupation in Iraq: $3 Trillion Estimate Was Too Low

President Bush has tried to give the impression that the $3 trillion dollar estimate of the total cost of the war that we provide in our new book may be exaggerated.

We believe that it is, in fact, conservative. Even the president would have to admit that the $50 to $60 billion estimate given by the administration before the war was wildly off the mark; there is little reason to have confidence in their arithmetic. They admit to a cost so far of $600 billion.

Our numbers differ from theirs for three reasons: first, we are estimating the total cost of the war, under alternative conservative scenarios, derived from the defense department and congressional budget office. We are not looking at McCain's 100-year scenario - we assume that we are there, in diminished strength, only through to 2017. But neither are we looking at a scenario that sees our troops pulled out within six months. With operational spending going on at $12 billion a month, and with every year costing more than the last, it is easy to come to a total operational cost that is double the $600 billion already spent.

Second, we include war expenditures hidden elsewhere in the budget, and budgetary expenditures that we would have to incur in the future even if we left tomorrow. Most important of these are future costs of caring for the 40 percent of returning veterans that are likely to suffer from disabilities (in excess of $600 billion; second world war veterans' costs didn't peak until 1993), and restoring the military to its prewar strength. If you include interest, and interest on the interest - with all of the war debt financed - the budgetary costs quickly mount.

Finally, our $3 trillion dollars estimate also includes costs to the economy that go beyond the budget, for instance the cost of caring for the huge number of returning disabled veterans that go beyond the costs borne by the federal government -- in one out of five families with a serious disability, someone has to give up a job. The macro-economic costs are even larger. Almost every expert we have talked to agrees that the war has had something to do with the rise in the price of oil; it was not just an accident that oil prices began to soar at the same time as the war began.

We have been criticized, but for being excessively conservative, for including only $5 to $10 of the $75 to $85 increase in the price of oil since then. Money spent on the war -- on a Nepalese contractor working in Iraq -- does not stimulate the economy as much as money spent on hospitals or research or schools at home. These contractionary effects were temporarily covered up, hidden, by the flood of liquidity and lax regulations that led to a housing bubble and a consumption boom - with household savings plummeting to zero. But this simply postponed paying these costs - and increased them.

With the exception of a few lonely surviving supply-siders, most economists believe that deficits matter, and the huge deficits to finance the war will have their toll in the long run. Deficits matter in both the short run and the long. They help crowd out private investment that would have stimulated the economy far more than the war expenditures; and the reduced investments reduce long-run productivity. With 40 percent of the funds borrowed from abroad, Americans will be sending interest payments abroad -- lowering living standards at home. Finally, even Fed Chair Bernanke (formerly the president's economic adviser) admits that the deficits have reduced the room to manoeuvre -- the ability of the government to respond to the looming economic crisis.

Spending so much on the war has economic consequences, even if you don't think there is any connection between the war and the economy's current woes.

In adding up the quantifiable costs of the war, it is hard not to come up with a number in excess of $3 trillion. In putting a $3 trillion price tag on the war, we believe we have been excessively conservative - a $4 or $5 trillion tag would be more reasonable. And remember - this is just the cost for America.

The Three Trillion Dollar War

The Bush Administration was wrong about the benefits of the war and it was wrong about the costs of the war. The president and his advisers expected a quick, inexpensive conflict. Instead, we have a war that is costing more than anyone could have imagined.

The cost of direct US military operations -- not even including long-term costs such as taking care of wounded veterans -- already exceeds the cost of the 12-year war in Vietnam and is more than double the cost of the Korean War.

And, even in the best case scenario, these costs are projected to be almost ten times the cost of the first Gulf War, almost a third more than the cost of the Vietnam War, and twice that of the First World War. The only war in our history which cost more was the Second World War, when 16.3 million U.S. troops fought in a campaign lasting four years, at a total cost (in 2007 dollars, after adjusting for inflation) of about $5 trillion. With virtually the entire armed forces committed to fighting the Germans and Japanese, the cost per troop (in today's dollars) was less than $100,000 in 2007 dollars. By contrast, the Iraq war is costing upward of $400,000 per troop.

Most Americans have yet to feel these costs. The price in blood has been paid by our voluntary military and by hired contractors. The price in treasure has, in a sense, been financed entirely by borrowing. Taxes have not been raised to pay for it -- in fact, taxes on the rich have actually fallen. Deficit spending gives the illusion that the laws of economics can be repealed, that we can have both guns and butter. But of course the laws are not repealed. The costs of the war are real even if they have been deferred, possibly to another generation.

On the eve of war, there were discussions of the likely costs. Larry Lindsey, President Bush's economic adviser and head of the National Economic Council, suggested that they might reach $200 billion. But this estimate was dismissed as "baloney" by the Defense Secretary, Donald Rumsfeld. His deputy, Paul Wolfowitz, suggested that postwar reconstruction could pay for itself through increased oil revenues. Mitch Daniels, the Office of Management and Budget director, and Secretary Rumsfeld estimated the costs in the range of $50 to $60 billion, a portion of which they believed would be financed by other countries. (Adjusting for inflation, in 2007 dollars, they were projecting costs of between $57 and $69 billion.) The tone of the entire administration was cavalier, as if the sums involved were minimal.

Even Lindsey, after noting that the war could cost $200 billion, went on to say: "The successful prosecution of the war would be good for the economy." In retrospect, Lindsey grossly underestimated both the costs of the war itself and the costs to the economy. Assuming that Congress approves the rest of the $200 billion war supplemental requested for fiscal year 2008, as this book goes to press Congress will have appropriated a total of over $845 billion for military operations, reconstruction, embassy costs, enhanced security at US bases, and foreign aid programs in Iraq and Afghanistan.

As the fifth year of the war draws to a close, operating costs (spending on the war itself, what you might call "running expenses") for 2008 are projected to exceed $12.5 billion a month for Iraq alone, up from $4.4 billion in 2003, and with Afghanistan the total is $16 billion a month. Sixteen billion dollars is equal to the annual budget of the United Nations, or of all but 13 of the US states. Even so, it does not include the $500 billion we already spend per year on the regular expenses of the Defense Department. Nor does it include other hidden expenditures, such as intelligence gathering, or funds mixed in with the budgets of other departments.

Because there are so many costs that the Administration does not count, the total cost of the war is higher than the official number. For example, government officials frequently talk about the lives of our soldiers as priceless. But from a cost perspective, these "priceless" lives show up on the Pentagon ledger simply as $500,000 -- the amount paid out to survivors in death benefits and life insurance. After the war began, these were increased from $12,240 to $100,000 (death benefit) and from $250,000 to $400,000 (life insurance). Even these increased amounts are a fraction of what the survivors might have received had these individuals lost their lives in a senseless automobile accident. In areas such as health and safety regulation, the US Government values a life of a young man at the peak of his future earnings capacity in excess of

$7 million -- far greater than the amount that the military pays in death benefits. Using this figure, the cost of the nearly 4,000 American troops killed in Iraq adds up to some $28 billion.

The costs to society are obviously far larger than the numbers that show up on the government's budget. Another example of hidden costs is the understating of US military casualties. The Defense Department's casualty statistics focus on casualties that result from hostile (combat) action -- as determined by the military. Yet if a soldier is injured or dies in a night-time vehicle accident, this is officially dubbed "non combat related" -- even though it may be too unsafe for soldiers to travel during daytime.

In fact, the Pentagon keeps two sets of books. The first is the official casualty list posted on the DOD website. The second, hard-to-find, set of data is available only on a different website and can be obtained under the Freedom of Information Act. This data shows that the total number of soldiers who have been wounded, injured, or suffered from disease is double the number wounded in combat. Some will argue that a percentage of these non-combat injuries might have happened even if the soldiers were not in Iraq. Our new research shows that the majority of these injuries and illnesses can be tied directly to service in the war.

From the unhealthy brew of emergency funding, multiple sets of books, and chronic underestimates of the resources required to prosecute the war, we have attempted to identify how much we have been spending -- and how much we will, in the end, likely have to spend. The figure we arrive at is more than $3 trillion. Our calculations are based on conservative assumptions. They are conceptually simple, even if occasionally technically complicated. A $3 trillion figure for the total cost strikes us as judicious, and probably errs on the low side. Needless to say, this number represents the cost only to the United States. It does not reflect the enormous cost to the rest of the world, or to Iraq.

From the beginning, the United Kingdom has played a pivotal role -- strategic, military, and political -- in the Iraq conflict. Militarily, the UK contributed 46,000 troops, 10 per cent of the total. Unsurprisingly, then, the British experience in Iraq has paralleled that of America: rising casualties, increasing operating costs, poor transparency over where the money is going, overstretched military resources, and scandals over the squalid conditions and inadequate medical care for some severely wounded veterans.

Before the war, Gordon Brown set aside £1 billion for war spending. As of late 2007, the UK had spent an estimated £7 billion in direct operating expenditures in Iraq and Afghanistan (76 percent of it in Iraq). This includes money from a supplemental "special reserve", plus additional spending from the Ministry of Defense.

The special reserve comes on top of the UK's regular defense budget. The British system is particularly opaque: funds from the special reserve are "drawn down" by the Ministry of Defense when required, without specific approval by Parliament. As a result, British citizens have little clarity about how much is actually being spent.

In addition, the social costs in the UK are similar to those in the US -- families who leave jobs to care for wounded soldiers, and diminished quality of life for those thousands left with disabilities.

By the same token, there are macroeconomic costs to the UK as there have been to America, though the long-term costs may be less, for two reasons. First, Britain did not have the same policy of fiscal profligacy; and second, until 2005, the United Kingdom was a net oil exporter.

We have assumed that British forces in Iraq are reduced to 2,500 this year and remain at that level until 2010. We expect that British forces in Afghanistan will increase slightly, from 7,000 to 8,000 in 2008, and remain stable for three years. The House of Commons Defense Committee has recently found that despite the cut in troop levels, Iraq war costs will increase by 2 percent this year and personnel costs will decrease by only 5 percent. Meanwhile, the cost of military operations in Afghanistan is due to rise by 39 per ent. The estimates in our model may be significantly too low if these patterns continue.

Houses of Cards

There are times when being proven right brings no pleasure. For several years, I argued that America's economy was being supported by a housing bubble that had replaced the stock market bubble of the 1990's. But no bubble can expand forever. With middle-class incomes in the United States stagnating, Americans could not afford ever more expensive homes.

As one of my predecessors as chairman of the US President's Council of Economic Advisers famously put it, "that which is not sustainable will not be sustained." Economists, as opposed to those who make their living gambling on stocks, make no claim to being able to predict when the day of reckoning will come, much less identifying the event that will bring down the house of cards. But the patterns are systematic, with consequences that unfold gradually, and painfully, over time.

There is a macro-story and a micro-story here. The macro-story is simple, but dramatic. Some, observing the crash of the sub-prime mortgage market, say, "Don't worry, it is only a problem in the real estate sector." But this overlooks the key role that the housing sector has played in the US economy recently, with direct investment in real estate and money taken out of houses through refinancing mortgages accounting for two-thirds to three-quarters of growth over the last six years.

Booming home prices gave Americans the confidence, and the financial wherewithal, to spend more than their income. America's household savings rate was at levels not seen since the Great Depression, either negative or zero.

With higher interest rates depressing housing prices, the game is over. As America moves to, say, a 4 percent savings rate (still small by normal standards), aggregate demand will weaken, and with it, the economy.

The micro-story is more dramatic. Record-low interest rates in 2001, 2002 and 2003 did not lead Americans to invest more - there was already excess capacity. Instead, easy money stimulated the economy by inducing households to refinance their mortgages, and to spend some of their capital.

It is one thing to borrow to make an investment, which strengthens balance sheets; it is another thing to borrow to finance a vacation or a consumption binge. But this is what Alan Greenspan encouraged Americans to do. When normal mortgages did not prime the pump enough, he encouraged them to take out variable-rate mortgages - at a time when interest rates had nowhere to go but up.

Predatory lenders went further, offering negative amortisation loans, so the amount owed went up year after year. Sometime in the future, payments would rise, but borrowers were told, again, not to worry: house prices would rise faster, making it easy to refinance with another negative amortisation loan. The only way (in this view) not to win was to sit on the sidelines. All of this amounted to a human and economic disaster in the making. Now reality has hit: newspapers report cases of borrowers whose mortgage payments exceed their entire income.

Globalisation implies that America's mortgage problem has worldwide repercussions. The first run on a bank occurred against the British mortgage lender Northern Rock. America managed to pass off bad mortgages worth hundreds of billions of dollars to investors (including banks) around the world. They buried the bad mortgages in complicated instruments, buried them so deep that no one knew exactly how badly they were impaired, and no one could calculate how to reprice them quickly. In the face of such uncertainty, markets froze.

Those in financial markets who believe in free markets have temporarily abandoned their faith. For the greater good of all (of course, it is never for their own selfish interests), they argued a bailout was necessary. While the US Treasury and the IMF warned East Asian countries facing financial crises 10 years ago against the risks of bail-outs and told them not to raise their interest rates, the US ignored its own lectures about moral hazard effects, bought up billions in mortgages, and lowered interest rates.


But lower short-term interest rates have led to higher medium-term interest rates, which are more relevant for the mortgage market, perhaps because of increasing worries about inflationary pressures. It may make sense for central banks (or Fannie Mae, America's major government-sponsored mortgage company) to buy mortgage-backed securities in order to help provide market liquidity. But those from whom they buy them should provide a guarantee, so the public does not have to pay the price for their bad investment decisions. Equity owners in banks should not get a free ride.

Securitisation, with all of its advantages in sharing risk, has three problems that were not adequately anticipated. While it meant that American banks were not hit as hard as they would otherwise, America's bad lending practices have had global effects.
Moreover, securitisation contributed to bad lending: in the old days, banks that originated bad loans bore the consequences; in the new world of securitisation, the originators could pass the loans onto others. (As economists would say, problems of asymmetric information have increased.)

In the old days, when borrowers found it impossible to make their payments, mortgages would be restructured; foreclosures were bad for both the borrower and the lender. Securitisation made debt restructuring difficult, if not impossible.

It is the victims of predatory lenders who need government help. With mortgages amounting to 95% or more of the value of the house, debt restructuring will not be easy. What is required is to give individuals with excessive indebtedness an expedited way to a fresh start - for example, a special bankruptcy provision allowing them to recover, say, 75% of the equity they originally put into the house, with the lenders bearing the cost.

There are many lessons for America, and the rest of the world; but among them is the need for greater financial sector regulation, especially better protection against predatory lending, and more transparency.

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