Stiglitz on the Credit Crisis

It was a pleasure today to see Prof Joseph Stiglitz deliver the University of Manchester’s Foundation Day Lecture, titled ‘The Financial Crisis – Lessons for Economic Theory and Policy’. So, what does the Nobel prize winning economist think of the current financial climate?

In sum: Things look bleak, no doubt about it. And the US response is misdirected. Ultimately, the behaviour of lenders that has created the current mess, and the overriding response to it, are based on ideological beliefs not genuine knowledge. This may be, joked the Professor Stiglitz, because business schools’ graduate students ‘ran off to Wall Street to make a load of money, before hearing the end of the lecture’.

The most important lecture was probably the one on ‘securitization’ – that is, using the financial system to offset risks. This has clear relevance to the current crisis since the latter is founded in the creation of ‘toxic’ loans, which have invisibly circulated throughout the global financial system with three results:

  1. Credit contraction has occured because, since the toxic products are hard to find, lenders can’t be sure what their own balance sheets total. Neither can they fathom what other banks and businesses balances are, so they’re unwilling to lend any money.
  2. The loans themselves will continue to go bad. They were based on entirely unsustainable expectations of the US housing market and so more repossessions will occur, and those who currently own the loans will continue to find holes opening up in their balance sheets.
  3. Together they will continue to produce a shrinking of the economy.

Professor Stiglitz argued that the US plan to pour $700 billion into Wall Street tried to deal with a fourth problem – confidence. But, as he rightly pointed out, confidence will only reappear if the solution is right. But the US money has been made available with little government oversite, and no garuntee for the taxpayer if thing get worse. And since the money is not going to help anyone repay their mortgages problem 2, at least, looks set to continue. One interpretation of the US decision is, to closely paraphrase Stiglitz’s words, that ‘they were seeking a non-transparent way to shift wealth from the taxpayer to the bankers’.

So is the UK situation any better? Well, an equity injection does seem to be a valuable instrument in order to deal with credit contraction, so long as government money is garunteed. That’s pretty much what was announced this morning, since preference shares offer some potential profit for the treasury in an upswing, but protection in a downswing. So far, so good. But what’s missing is any way to deal with the negative effects of falling house prices, and therefore the continuing losses to mortgate lenders. Stiglitz outlined a number of proposals for doing so, which all rested on the idea that it is necessary to assist lower income people make their repayments, whether that’s through tax credits or cheap government loans. This is especially important in the US, of course, since that’s where all the toxic debt originates.

So that’s the policy story – what about the lessons for economic theory? The overriding lesson of the current crisis is that micro-economic inefficiencies can lead to macro-economic crisis. And those inefficiencies may be created in a number of ways, importantly including problems with incentives, innovation and information.

The financial sector has, over the last decade, been taking around 30% of the profits of the whole economy in both the US and the UK. This should suggest that its been exceedingly productive in its particular area, including tasks like finding new ways to mobilise savings, managing and ultimately reducing risks of investment, and finding ways to properly allocate the capital that is available. But they’ve failed on all counts. Individual savings have been insubstantial as consumers have used easy credit for over-consumption. Risks have been created and multiplied rather than managed. Also, the bursting of US housing market bubble is evidence of a massive misallocation of resources: too many houses have been built, they’ve been too big, and they’ve been built in the wrong areas. This is not to say the financial system hasn’t been innovating. Its found innovative ways of avoiding regulation, of reducing taxation and of inflating share prices through misleading profit reporting. Such innovations are of no benefit to the 3 million Americans who have lost thier homes due to the current crisis, or to the 2 million also expected to do so. And the financial sector’s innovative activity has been irrelevant to the real lives of everyday folk because corporate incentive schemes incentivise increasing share price, rather than increasing productivity in their core business. As executives are offered share options worth millions of dollars (which, not incidentally, reduce the value of shares that other investors hold) their interest is clearly in seeing the share price increase.

Share price increases have been bought through the manipulation of relevant information, as risks are hidden on the balance sheet, or exported overseas. But not only that, the toxic lending was justified in the first place by misinformation and inappropriate incentives. It should have been obvious to mortgage lenders that they were creating bad loans. People on low and middle incomes in the US have seen their incomes falling steadily for the last 8 years. (Which is also to say that what economic growth the US has seen in that time has been to the benifit of those at the top, and only those at the top.) At the same time as incomes falling, house prices were increasing and lenders were offering as much as 105% of the asset value as a mortgage on the basis of expected increasing prices. But how could the bubble possibly be sustained without rising incomes? That is simply unanswerable, as the lenders must have realised. However, securitization offers an intriguing  possibility: if one is to sell these loans as assets to other companies without those companies knowing just how high the risk of payment defaults is, then the loans are a good way of producing profit. That is: the only way it was rational to mortgage lenders to create portfolios of very high risk loans is on the belief that ‘there’s a fool born every minute, and globalization has given American banks access to millions more fools.’ And many of those fools, it seems, work in European financial centres. Securitization, then, incentvisied the banks to create bad loans, and they did so through misinforming their lenders.

UPDATE: Audio of the lecture is now available online at Manchester University.