Nobel Laureate: How to Get Out of the Financial Crisis
The amount of bad news over the past weeks has been bewildering for many people in the world. Stock markets have plunged, banks have stopped lending to one another, and central bankers and treasury secretaries appear daily on television looking worried. Many economists have warned that we are facing the worst economic crisis the world has seen since 1929. The only good news is that oil prices have finally started to come down.
While these times are scary and strange for many Americans, a number of people in other countries feel a sense of deja vu. Asia went through a similar crisis in the late 1990s, and various other countries (including Argentina, Turkey, Mexico, Norway, Sweden, Indonesia and South Korea) have suffered through banking crises, stock-market collapses and credit crunches.Capitalism may be the best economic system that man has come up with, but no one ever said it would create stability. In fact, over the past 30 years, market economies have faced more than 100 crises. That is why I and many other economists believe that government regulation and oversight are an essential part of a functioning market economy. Without them, there will continue to be frequent severe economic crises in different parts of the world. The market on its own is not enough. Government must play a role.
It's good news that Treasury Secretary Henry Paulson seems to finally be coming around to the idea that the U.S. government needs to help recapitalize our banks and should receive stakes in the banks that it bails out. But more must be done to prevent the crisis from spreading around the world. Here's what it will take.
How We Got Here
The troubles we now face were caused largely by the combination of deregulation and low interest rates. After the collapse of the tech bubble, the economy needed a stimulus. But the Bush tax cuts didn't provide much stimulus to the economy. This put the burden of keeping the economy going on the Fed, and it responded by flooding the economy with liquidity. Under normal circumstances, it's fine to have money sloshing around in the system, since that helps the economy grow. But the economy had already overinvested, and so the extra money wasn't put to productive use. Low interest rates and easy access to funds encouraged reckless lending, the infamous interest-only, no-down-payment, no-documentation ("liar") subprime mortgages. It was clear that if the bubble got deflated even a little, many mortgages would end up under water — with the price less than the value of the mortgage. That has happened — 12 million so far, and more every hour. Not only are the poor losing their homes, but they are also losing their life savings.
The climate of deregulation that dominated the Bush-Greenspan years helped the spread of a new banking model. At its core was securitization: mortgage brokers originated mortgages that they sold on to others. Borrowers were told not to worry about paying the ever mounting debt, because house prices would keep rising and they could refinance, taking out some of the capital gains to buy a car or pay for a vacation. Of course, this violated the first law of economics — that there is no such thing as a free lunch. The assumption that house prices could continue to go up at a rapid pace looked particularly absurd in an economy in which most Americans were seeing their real incomes declining.
The mortgage brokers loved these new products because they ensured an endless stream of fees. They maximized their profits by originating as many mortgages as possible, with frequent refinancing. Their allies in investment banking bought them, sliced and diced the risk and then passed them on — or at least as much as they could. Our bankers forgot that their job was to prudently manage risk and allocate capital. They became gambling casinos — gambling with other people's money, knowing that the taxpayer would step in if the losses were too great. They misallocated capital, with massive amounts going into housing that was ultimately unaffordable. Loose money and light regulation were a toxic mixture. It exploded.
A Global Crisis
What made America's recklessness truly dangerous is that we exported it. A few months ago, some talked about decoupling — that Europe would carry on even as the U.S. suffered a downturn. I always thought that decoupling was a myth, and events have proven that right. Thanks to globalization, Wall Street was able to sell off its toxic mortgages around the world. It appears that about half the toxic mortgages were exported. Had they not been, the U.S. would be in even worse shape. Moreover, even as our economy went into a slowdown, exports kept the U.S. going. But the weaknesses in America weakened the dollar and made it more difficult for Europe to sell its goods abroad. Weak exports meant a weak economy, and so the U.S. exported our downturn just as earlier we had exported our toxic mortgages.
But now the problems are ricocheting back. The bad mortgages are contributing to forcing many European banks into bankruptcy. (We exported not only bad loans but also bad lending and regulatory practices; many of Europe's bad loans are to European borrowers.) And as market participants realized that the fire had spread from America to Europe, there was panic. Part of the concern is psychological. But part of it is because our financial and economic systems are closely intertwined. Banks all over the world lend and borrow from each other; they buy and sell complicated financial instruments — which is why bad regulatory practices in one country, leading to bad loans, can infect the global system.
How to Fix It
We are now facing a liquidity problem, a solvency problem and a macroeconomic problem. We are in the first phase of a downward spiral. It is, of course, part of the inevitable process of adjustment: returning housing prices to equilibrium levels and getting rid of the excessive leverage (debt) that had kept our phantom economy going.
Even with the new capital provided by the government, banks won't want to, or be able to, lend as much as they did in their reckless past. Homeowners won't want to borrow so much. Savings, which have been near zero, will go up — good for the economy in the long run but bad for an economy going into recession. While some large firms may be sitting on a bundle of cash, small firms depend on loans not just for investment but even for the working capital to keep going. That's going to be harder to come by. And the investment in real estate, which played such an important role in our modest growth of the past six years, has reached lows not seen in 20 years.
The Administration has veered from one half-baked solution to another. Wall Street panicked, but so did the White House, and in that panic, they had a hard time figuring out what to do. The weeks that Paulson and Bush spent pushing Paulson's orignal bailout plan — in the face of massive opposition — were weeks that could have been spent actually fixing the problem. At this point, we need a comprehensive approach. Another failed faint attempt could be disastrous. Here's a five-step, comprehensive approach:
1. Recapitalize banks. With all the losses, banks have insufficient equity. Banks will have a hard time raising this equity under current circumstances. The government needs to provide equity. In return, it should have voting stakes in the banks it helps. But equity injections also bail out bondholders. Right now the market is discounting these bonds, saying there is a high probability of default. There needs to be a forced conversion of this debt to equity. If this is done, the amount of government assistance that will be required will be much reduced.
It's good news that Treasury Secretary Paulson seems to finally realize that his original proposal of buying what he euphemistically called distressed assets was flawed. That Secretary Paulson took so long to figure this out is worrying. He was so bound by the idea of a free-market solution that he was unable to accept what economists of all stripes were telling him: that he needed to recapitalize the banks and provide new money to make up for the losses they incurred on their bad loans.
The Administration is now doing this, but three questions are raised: Was it a fair deal to the taxpayer? The answer to that seems fairly clear: taxpayers got a raw deal, evident by comparing the terms of Warren Buffet's injection of $5 billion into Goldman Sachs, and the terms extracted by the Administration. Second, is there enough oversight and restrictions to make sure that the bad practices of the past do not recur and that new lending does occur? Again, comparing the terms demanded by the U.K. and by the U.S. Treasury, we got the short end of the stick. For instance, banks can continue to pay out money to shareholders, as the government pours money in. Thirdly, is it enough money? The banks are so nontransparent that no one can fully answer the question, but what we do know is that the gaps in the balance sheet are likely to get bigger. That is because too little is being done about the underlying problem.
2. Stem the tide of foreclosures. The original Paulson plan is like a massive blood transfusion to a patient with severe internal hemorrhaging. We won't save the patient if we don't do something about the foreclosures. Even after congressional revisions, too little is being done. We need to help people stay in their homes, by converting the mortgage-interest and property-tax deductions into cashable tax credits; by reforming bankruptcy laws to allow expedited restructuring, which would bring down the value of the mortgage when the price of the house is below that of the mortgage; and even government lending, taking advantage of the government's lower cost of funds and passing the savings on to poor and middle-income homeowners.
3. Pass a stimulus that works. Helping Wall Street and stopping the foreclosures are only part of the solution. The U.S. economy is headed for a serious recession and needs a big stimulus. We need increased unemployment insurance; if states and localities are not helped, they will have to reduce expenditures as their tax revenues plummet, and their reduced spending will lead to a contraction of the economy. But to kick-start the economy, Washington must make investments in the future. Hurricane Katrina and the collapse of the bridge in Minneapolis were grim reminders of how decrepit our infrastructure has become. Investments in infrastructure and technology will stimulate the economy in the short run and enhance growth in the long run.
4. Restore confidence through regulatory reform. Underlying the problems are banks' bad decisions and regulatory failures. These must be addressed if confidence in our financial system is to be restored. Corporate-governance structures that lead to flawed incentive structures designed to generously reward ceos should be changed and so should many of the incentive systems themselves. It is not just the level of compensation; it is also the form — nontransparent stock options that provide incentives for bad accounting to bloat up reported returns.
5. Create an effective multilateral agency. As the global economy becomes more interconnected, we need better global oversight. It is unimaginable that America's financial market could function effectively if we had to rely on 50 separate state regulators. But we are trying to do essentially that at the global level.
The recent crisis provides an example of the dangers: as some foreign governments provided blanket guarantees for their deposits, money started to move to what looked like safe havens. Other countries had to respond. A few European governments have been far more thoughtful than the U.S. in figuring out what needs to be done. Even before the crisis turned global, French President Nicolas Sarkozy, in his address to the U.N. last month, called for a world summit to lay the foundations for more state regulation to replace the current laissez-faire approach. We may be at a new "Bretton Woods moment." As the world emerged from the Great Depression and World War II, it realized there was need for a new global economic order. It lasted more than 60 years. That it was not well adapted for the new world of globalization has been clear for a long time. Now, as the world emerges from the Cold War and the Great Financial Crisis, it will need to construct a new global economic order for the 21st century, and that will include a new global regulatory agency.
This crisis may have taught us that unfettered markets are risky. It should also have taught us that unilateralism can't work in a world of economic interdependence.
Going Forward
The next U.S. President will have a very hard time of it. Even the most well-thought-out plans may not work as intended. But I am confident that a comprehensive program along the lines I have suggested — stemming foreclosures, recapitalizing banks, stimulating the economy, protecting the unemployed, shoring up state finances, providing guarantees where needed and appropriate, reforming regulations and regulatory structures and replacing regulators and those with responsibility to protect the economy with those focused more on rescuing the economy than on rescuing Wall Street — will not only restore confidence but in due time also enable America to live up to its full potential. Halfway approaches, on the other hand, by continually bringing disappointment, are sure to fail.
In a country where money is respected, Wall Street's leaders used to have our respect. They had our trust. They were believed to be a font of wisdom, at least on economic matters. Times have changed. Gone is the respect and trust. Too bad, because financial markets are necessary for a well-functioning economy. But most Americans believe that Wall Streeters are more likely to put their interests ahead of those of the rest of the country, dressing it up in as fancy language as necessary. If the next President is seen to have his policies unduly shaped by Wall Street and those policies don't do the trick, his honeymoon will be short. That will be bad news for him, for the country and for the world.
Nobel laureate (2001) Stiglitz is University Professor at Columbia University. He was chief economist of the World Bank and chairman of President Clinton's Council of Economic Advisers
Sumber: Time, 17 Oct 08
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