Joseph Stiglitz excoriates the economics profession (along with Wall Street, Greenspan, and Bernanke) in a talk delivered in Germany on October 3, 2008. I've managed to misplace the link, but here are my notes:
Of Bernanke: “To destroy the financial system in so few years was an achievement. Only somebody who had studied the Great Depression could have done it so quickly."
The models that economic students study, Stiglitz says, are irrelevant to the current crisis: “You can’t have a debt crisis in a representative agent model. The model that our students have been studying for the last umpteen years has nothing to say about the current crisis.” Imagine a student studying in a leading American university who is asked the question, “‘What do you think about the current crisis?,’ and he says, ‘Well, I haven’t even thought about that, it’s not in our models. That’s a different subject. We don’t study that in our university.’” Stiglitz says that it’s an embarrassment to the economics profession “that our leading model in macro has absolutely nothing to say about these issues.”
Stiglitz then goes on to microeconomics, just to be “even-handed.” Most economists, he comments, still believe in the neo classical synthesis, which says: “Once we solve the macro problems, the market solves efficiently the allocation problems, the micro allocation problems.” He goes on to reject the assumption that failures only come in huge doses and identifies plenty of massive inefficiencies at the micro level, such as General Motors spending $100 billion and ending up with a company worth $10 billion. (Alas, he said that on October 3. Its market value was in the next week sliced in half). After commenting on some of his early academic work showing inefficiencies in how corporations approach taxation (doing that which is economically less advantageous in order to please unknowing shareholders), he comes to the main course: the massive misallocation of resources that preceded the bust in housing especially, but across other credit markets as well.
“What are financial markets supposed to do? They’re supposed to mobilize capital, allocate capital, manage risk, and in return for that, for providing those social services, they get compensated. Well, they got compensated; in recent years they’ve gotten over thirty percent of corporate profits….but that doesn’t include executive pay and bonuses, which themselves were huge.” While reaping immense rewards, the industry failed in its essential tasks of rational capital allocation and the management of risk.
Stiglitz notes that the financial services industry resisted innovations that would make the economy more efficient, that the incentive structures were fubared (a rough translation), and that the investors who bought those securitized mortgages with AAA ratings acted irrationally. There was an "irrationality and stupidity" that was pervasive and that “goes beyond information asymmetry.” The bizarre feature of the situation is that Wall Street had living proof, in the collapse of Long Term Capital Management in 1998, of the dangers of placing credence in the “probability distributions” hawked as science in the models. But the experience taught Wall Street nothing.
There was a logical contradiction here. The inventors of these sophisticated instruments claimed that they were creating new products to manage risk that transformed financial markets. But they used data collected before the creation of the products. “So they believed that their model had changed the world, but they used prices as if it had not changed the world.”
Stiglitz notes the ways in which securitization created a new moral hazard problem and failed to provide real diversification. “You don’t get diversification if you have correlated systemic risk.” Bad models as used by credit rating agencies and banks, with the idea that they were managing risk, did nothing of the kind.
He also makes an excellent point about the intellectual incoherence of Wall Street. The idea behind securitization was that it made markets more efficient. “As you slice and dice models, you don’t change fundamentals, you just bring down transaction costs.” That was the economic theory. In practice, however, Wall Street made enormous profits from the fees derived from securitization. In other words, they were raising transaction costs!
Stiglitz asks why Wall Street didn’t act in a more prudent way and failed to see that the originators had an incentive to write bad mortgages. By lending, say $100,000 in a nonrecourse mortgage, which would allow the buyer to walk away if the price went down, banks were in effect giving options to poor people. Since it’s not the normal practice of banks to give money away to poor people, it didn’t make sense. But very few on Wall Street saw it, until nearly the bitter end.
Stiglitz doesn’t comment here on the Paulson Plan, but he does look toward ways in which the financial sector should be regulated. The leading ideas are that asymmetric short term incentive structures should not be allowed, that we need a “Financial Products Safety Commission” that would bar “weapons of mass destruction inside our financial system,” and that speed limits need to be placed on the rapid expansion of financial institutions, because experience shows that this invariably causes net losses when they bust at the end of the day.
There is more, but this gives the main points.
Anatole Kaletsky also weighs in on the need for an intellectual revolution in the economics profession.
Q&A with David Einhorn
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