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The only surprise about the economic crisis of was that it came as a surprise to so many. For a few observers, it was a textbook case that was not only predictable but also predicted. A deregulated market awash in liquidity and low interest rates, a global real estate bubble, and skyrocketing subprime lending were a toxic combination.
Add in the U. What was different about this crisis from the multitude that had preceded it during the past quarter century was that this crisis bore a "Made in the USA" label.
And while previous crises had been contained, this "Made in the USA" crisis spread quickly around the world. We liked to think of our country as one of the engines of global economic growth, an exporter of sound economic policies--not recessions. The last time the United States had exported a major crisis was during the Great Depression of the s. The basic outlines of the story are well known and often told. The United States had a housing bubble. When that bubble broke and housing prices fell from their stratospheric levels, more and more homeowners found themselves "underwater.
As they lost their homes, many also lost their life savings and their dreams for a future--a college education for their children, a retirement in comfort. Americans had, in a sense, been living in a dream. The richest country in the world was living beyond its means, and the strength of the U. The global economy needed ever-increasing consumption to grow; but how could this continue when the incomes of many Americans had been stagnating for so long? Americans came up with an ingenious solution: borrow and consume as if their incomes were growing.
And borrow they did. Average savings rates fell to zero--and with many rich Americans saving substantial amounts, that meant poor Americans had a large negative savings rate.
In other words, they were going deeply into debt. Both they and their lenders could feel good about what was happening: they were able to continue their consumption binge, not having to face up to the reality of stagnating and declining incomes, and lenders could enjoy record profits based on ever-mounting fees. Low interest rates and lax regulations fed the housing bubble. As housing prices soared, homeowners could take money out of their houses.
But all of this borrowing was predicated on the risky assumption that housing prices would continue to go up, or at least not fall. The economy was out of kilter: two-thirds to three-quarters of the economy of GDP was housing related: constructing new houses or buying contents to fill them, or borrowing against old houses to finance consumption.
It was unsustainable--and it wasn't sustained. The breaking of the bubble at first affected the worst mortgages the subprime mortgages, lent to low-income individuals , but soon affected all residential real estate. When the bubble popped, the effects were amplified because banks had created complex products resting on top of the mortgages. Worse still, they had engaged in multibillion-dollar bets with each other and with others around the world.
This complexity, combined with the rapidity with which the situation was deteriorating and the banks' high leverage they, like households, had financed their investments by heavy borrowing , meant that the banks didn't know whether what they owed to their depositors and bondholders exceeded the value of their assets.
And they realized accordingly that they couldn't know the position of any other bank. The trust and confidence that underlie the banking system evaporated. Banks refused to lend to each other--or demanded high interest rates to compensate for bearing the risk.
Global credit markets began to melt down. At that point, America and the world were faced with both a financial crisis and an economic crisis. The economic crisis had several components: There was an unfolding residential real estate crisis, followed not long after by problems in commercial real estate.
Demand fell, as households saw the value of their houses and, if they owned shares, the value of those as well collapse and as their ability--and willingness--to borrow diminished. There was an inventory cycle--as credit markets froze and demand fell, companies reduced their inventories as quickly as possible.
And there was the collapse of American manufacturing. There were also deeper questions: What would replace the unbridled consumption of Americans that had sustained the economy in the years before the bubble broke? How were America and Europe going to manage their restructuring, for instance, the transition toward a service-sector economy that had been difficult enough during the boom?
Restructuring was inevitable--globalization and the pace of technology demanded it--but it would not be easy. While the challenges going forward are clear, the question remains: How did it all happen? This is not the way market economies are supposed to work. Something went wrong--badly wrong. There is no natural point to cut into the seamless web of history. For purposes of brevity, I begin with the bursting of the tech or dot-com bubble in the spring of a bubble that Alan Greenspan, chairman of the Federal Reserve at that time, had allowed to develop and that had sustained strong growth in the late s.
Tech stock prices fell 78 percent between March and October It was hoped that these losses would not affect the broader economy, but they did. Much of investment had been in the high-tech sector, and with the bursting of the tech stock bubble this came to a halt. In March , America went into a recession. The administration of President George W.
Bush used the short recession following the collapse of the tech bubble as an excuse to push its agenda of tax cuts for the rich, which the president claimed were a cure-all for any economic disease. The tax cuts were, however, not designed to stimulate the economy and did so only to a limited extent.
That put the burden of restoring the economy to full employment on monetary policy. Accordingly, Greenspan lowered interest rates, flooding the market with liquidity. With so much excess capacity in the economy, not surprisingly, the lower interest rates did not lead to more investment in plant and equipment. They worked--but only by replacing the tech bubble with a housing bubble, which supported a consumption and real estate boom.
The burden on monetary policy was increased when oil prices started to soar after the invasion of Iraq in The United States spent hundreds of billions of dollars importing oil--money that otherwise would have gone to support the U. Greenspan felt he could keep interest rates low because there was little inflationary pressure, and without the housing bubble that the low interest rates sustained and the consumption boom that the housing bubble supported, the American economy would have been weak.
In all these go-go years of cheap money, Wall Street did not come up with a good mortgage product. A good mortgage product would have low transaction costs and low interest rates and would have helped people manage the risk of homeownership, including protection in the event their house loses value or borrowers lose their job. Homeowners also want monthly payments that are predictable, that don't shoot up without warning, and that don't have hidden costs.
The U. Instead, Wall Street firms, focused on maximizing their returns, came up with mortgages that had high transaction costs and variable interest rates with payments that could suddenly spike, but with no protection against the risk of a loss in home value or the risk of job loss.
Had the designers of these mortgages focused on the ends--what we actually wanted from our mortgage market--rather than on how to maximize their revenues, then they might have devised products that would have permanently increased homeownership. They could have "done well by doing good. The failings in the mortgage market were symptomatic of the broader failings throughout the financial system, including and especially the banks.
There are two core functions of the banking system. The first is providing an efficient payments mechanism, in which the bank facilitates transactions, transferring its depositors' money to those from whom they buy goods and services. The second core function is assessing and managing risk and making loans. This is related to the first core function, because if a bank makes poor credit assessments, if it gambles recklessly, or if it puts too much money into risky ventures that default, it can no longer make good on its promises to return depositors' money.
If a bank does its job well, it provides money to start new businesses and expand old businesses, the economy grows, jobs are created, and at the same time, it earns a high return--enough to pay back the depositors with interest and to generate competitive returns to those who have invested their money in the bank. The lure of easy profits from transaction costs distracted many big banks from their core functions.
The banking system in the United States and many other countries did not focus on lending to small and medium-sized businesses, which are the basis of job creation in any economy, but instead concentrated on promoting securitization, especially in the mortgage market.
It was this involvement in mortgage securitization that proved lethal. In the Middle Ages, alchemists attempted to transform base metals into gold.
Modern alchemy entailed the transformation of risky subprime mortgages into AAA-rated products safe enough to be held by pension funds. And the rating agencies blessed what the banks had done. Finally, the banks got directly involved in gambling--including not just acting as middlemen for the risky assets that they were creating, but actually holding the assets. They, and their regulators, might have thought that they had passed the unsavory risks they had created on to others, but when the day of reckoning came--when the markets collapsed--it turned out that they too were caught off guard.
As the depth of the crisis became better understood--by April it was already the longest recession since the Great Depression--it was natural to look for the culprits, and there was plenty of blame to go around. Knowing who, or at least what, is to blame is essential if we are to reduce the likelihood of another recurrence and if we are to correct the obviously dysfunctional aspects of today's financial markets.
We have to be wary of too facile explanations: too many begin with the excessive greed of the bankers. That may be true, but it doesn't provide much of a basis for reform. Bankers acted greedily because they had incentives and opportunities to do so, and that is what has to be changed.
Besides, the basis of capitalism is the pursuit of profit: should we blame the bankers for doing perhaps a little bit better what everyone in the market economy is supposed to be doing? In the long list of culprits, it is natural to begin at the bottom, with the mortgage originators. Mortgage companies had pushed exotic mortgages on to millions of people, many of whom did not know what they were getting into.
But the mortgage companies could not have done their mischief without being aided and abetted by the banks and rating agencies. The banks bought the mortgages and repackaged them, selling them on to unwary investors. They had created new products which, while touted as instruments for managing risk, were so dangerous that they threatened to bring down the U.
The rating agencies, which should have checked the growth of these toxic instruments, instead gave them a seal of approval, which encouraged others--including pension funds looking for safe places to put money that workers had set aside for their retirement--in the United States and overseas, to buy them. In short, America's financial markets had failed to perform their essential societal functions of managing risk, allocating capital, and mobilizing savings while keeping transaction costs low.
Instead, they had created risk, misallocated capital, and encouraged excessive indebtedness while imposing high transaction costs. At their peak in , the bloated financial markets absorbed 41 percent of profits in the corporate sector. One of the reasons why the financial system did such a poor job at managing risk is that the market mispriced and misjudged risk. The "market" badly misjudged the risk of defaults of subprime mortgages, and made an even worse mistake trusting the rating agencies and the investment banks when they repackaged the subprime mortgages, giving a AAA rating to the new products.
The banks and the banks' investors also badly misjudged the risk associated with high bank leverage.
Freefall: Free Markets and the Sinking of the Global Economy by Joseph Stiglitz
Stiglitz , first published in by W. While focusing on the roots of the financial crisis of and the subsequent global economic slowdown , which he claims to find mainly in fiscal policy as conducted during the Bush presidency and decisions made by the Federal Reserve , Stiglitz also talks about the failure to cope with the recession during the months succeeding the Wall Street Crash of Finally, he sketches various schemes as to the possible future of the American economy , vigorously proposing a profound policy shift. In compliance with Stiglitz's general attitude towards economic policy , Freefall contains "proposals to tame the banking sector and to foster a more humanistic style of capitalism in the United States and abroad.
What Happened to Regulatory Reform?
Joseph E. But Mr. Stiglitz laments that the president failed to make good on such soaring rhetoric. He argues that Mr.
Freefall: America, Free Markets, and the Sinking of the World Economy
N o one can say they weren't warned. It was a full-on attack from a Washington insider and it hurt, especially when Stiglitz said many of those responsible for forcing countries such as Thailand and Indonesia into deeper, longer recessions were "third-rate graduates from first-rate universities". He concluded his essay in the New Republic by warning the IMF and the US Treasury that unless they began a dialogue with their critics "things will continue to go very, very wrong". Now they have. The Asian crisis of was merely the warm-up act for the events of the past two and a half years. Problems that first surfaced on the periphery of the global economy gradually worked their way to its core — the United States.