Falling Down - The New Republic

Summary:
Jospeh Stiglitz blames the current crisis are the financial system's latest innovations, fee structures that were often far from transparent. Imperfections of information (resulting from the non-transparency) led to imperfections in competition. Allowed banks to generate enormous profits and private rewards that were not commensurate with social benefits. Worst problems (e.g. subprime mortgage market) occurred when non-transparent fee structures interacted with incentives for excessive risk-taking. Too much effort has been devoted to increasing profits, creating financial products that enhanced risk, and not enough to increasing real wealth. Financial markets frequently fail to do what they are supposed to do in allocating capital and managing risk. Painful lesson from the 1930s and today is that the invisible hand often seems invisible because it's not there. (Published: 10/09/08)

Notes:

• Adam Smith: the market leads the economy, as if by an invisible hand, to economic efficiency and societal wellbeing
• Great Depression
• 1 in 4 Americans out of a job
• Smith's self-regulating markets a fallacy?
• some economists: in the long run the market's restorative forces will take hold, and we will recover
• Keynes's retort: In the long run, we are all dead.
  
• i.e. could not afford to wait
• today, 75 years later: another shock
• unofficially in recession
  
• more than half year since jobs were created
• "If the Great Depression undermined our confidence in macroeconomics (the ability to maintain full employment, price stability, and sustained growth), it is our confidence in microeconomics (the ability of markets and firms to allocate labor and capital efficiently) that is now being destroyed."
• resources were misallocated and risks were mismanaged so severely that the private sector had to go running to the government for help, lest the entire system melt down
• cumulative gap between what our economy could have produced and what we will produce over the period of our slowdown estimated to be more than $1.5 trillion
• had we invested in actual businesses
• rather than e.g. mortgages for people who couldn't afford their homes
• financial markets rightly blamed
• it is their responsibility to allocate capital and manage risk, and their failure has revived several old concerns of the political (and economic) left
• increasing dependence on service sector
• including financial service
  
• decreasing reliance on manufacturing
• is the whole thing was a house of cards?
  
• i.e. aren't "hard objects" the "core" of the economy? And if so, shouldn't they represent a larger fraction of our national output?
• the food we eat, the houses we live in, the cars and airplanes that we use to transport us from one place to another, the gas and oil that provides heat and energy
• answer: no
• live in a knowledge economy, an information economy, an innovation economy
• because of our ideas, we can have all the food we can possibly eat with only 2 percent of the labor force employed in agriculture
• even with only 9 percent of our labor force in manufacturing, we remain the largest producer of manufactured goods
• better to work smart than to work hard
• our investments in education and technology have enabled us to enjoy higher standards of living than ever before
• we would do even better if we had more resources in these sectors
• but: our recent success may based on a house of cards
• in recent years financial markets created a giant rich man's casino, in which well-off players could take trillion dollar bets against each other
• weren't just gambling their own money
• were gambling other people's money
• were putting at risk the entire financial system, indeed, our entire economic system
• now we are all paying the price

• financial markets as the brain of the economy
• supposed to allocate capital and manage risk
• when they do their job well, economies prosper
• when they do their job badly everyone suffers
• financial markets are amply rewarded for their work
• in recent years, they have received over 30 percent of corporate profits
• standard mantra in economics was that these rewards were commensurate with their social return.
• i.e. financial wizards might walk off with a great deal of money but the rest of society is better off
  
• because our capital generates so much more productivity than in societies with less well-developed--and less rewarded--financial markets
• part of the rewards that accrue to financial markets are thus for encouraging innovation
• through venture capital firms and the like

• financial innovation to blame
  
• financial system's latest innovation was to devise fee structures that were often far from transparent and that allowed it to generate enormous profits
• private rewards that were not commensurate with social benefits
• imperfections of information (resulting from the non-transparency) led to imperfections in competition
• helps to explain why the usual maxim that competition drives profits to zero seemed not to hold
• the worst problems (e.g. subprime mortgage market) occurred when non-transparent fee structures interacted with incentives for excessive risk-taking
  
• financial managers got to keep high returns made one year, even if those returns were more than offset by losses the next
• had those in the financial sector allocated capital and risk in a way that fueled the economy, they would have had handsome profits
• but they wanted more
• so established incentive structures that encouraged gambling
• if they gambled and won, they could walk away with a share of the profits.
• if they gambled and lost, the investors would bear the consequences

• current woes in America's financial system are not an isolated accident
• more than one hundred financial crises worldwide in the last 30 years or so
• in each of these instances, financial markets failed to do what they were supposed to do in allocating capital and managing risk
• e.g. in the late '90s, for instance, so much capital was allocated to fiber optics that, by the time of the crash, it was estimated that 97 percent of fiber optics had seen no light
• problem with the U.S. economy is not that we have allocated too many resources to the "soft" areas and too few to the "hard" (i.e. services/knowledge vs. manufacturing)
  
• not necessarily the case that we have allocated too many resources to the financial sector and rewarded it too generously
• but:
  
• too little effort was devoted to managing real risks that are important
• i.e. enabling ordinary Americans to stay in their homes in the face of economic vicissitudes
• too much effort went into creating financial products that enhanced risk
• too much energy has been spent trying to make an easy buck
• too much effort has been devoted to increasing profits and not enough to increasing real wealth
• whether that wealth comes from manufacturing or new ideas
• painful lesson from the 1930s and today:
  
• The invisible hand often seems invisible because it's not there.
  
• at best, it's more than a little palsied.
  
• at worst, the pursuit of self-interest--corporate greed--can lead to the kind of predicament confronting the country today