[This book review appeared in the Summer 2010 issue of The Journal of Social, Political and Economic Studies, pp. 255-265.] 

 

Book Review 

Freefall: America, Free Markets, and the Sinking of the World Economy

Joseph E. Stiglitz

W. W. Norton & Company, 2010 

          Joseph Stiglitz’s Freefall is another excellent discussion of the global economic crisis, authored by a man who ranks high among the commentators.  Stiglitz was the chief economist at the World Bank during the East Asian economic crisis in 1997-1998, and then chaired the United Nations commission that sought reforms for the global financial and monetary system.  He was a member of President Clinton’s Council of Economic Advisors.  This is his fifth book.  There seem to be a great many Nobel Prize winners in Economics (whose collective wisdom doesn’t seem to have saved the world from its financial travails), but it would surely be amiss not to mention that Stiglitz is among them.  This book testifies to his distinction in that select group.

          Because Freefall can hardly examine the crisis without covering much of the same ground as the other books we have reviewed, we will avoid repeating that analysis here.  We prefer to focus on those aspects of Stiglitz’s discussion that address unresolved issues or that most bring his own learning to bear:

          .  His view of the plight in which today’s “capitalism” finds itself.

          .  What he says (and yet doesn’t say) about the whirlpool of global finance.

          .  His critique of the response that the U.S. Federal Reserve and government have made to the crisis, including what he thinks should have been done.

          .  In connection with this critique, his reflections on the performance both of the George W. Bush and Barack Obama administrations’ actions through the end of 2009.

          .  What reforms Stiglitz considers needed.          

His view of today’s “capitalism.”  Although Stiglitz affirms “that markets lie at the heart of every successful economy” and is by no means anti-capitalist, he shares the view that has come to be held by a great many thoughtful commentators that today’s “capitalism” bears little resemblance to the competitive “private enterprise” that supporters of a market economy have long championed.  He speaks of an “ersatz capitalism” that features a “corporate welfare state” driven by “blatant greed” and an ideology, sponsored by special interests, that has made a fetish of “self-regulating markets.”  “The current crisis has uncovered fundamental flaws in the capitalist system, or at least the peculiar version of capitalism that emerged in the latter part of the twentieth century in the United States.” 

          This realization is an intellectual earthquake.  It should profoundly redirect the thinking of America’s free-market enthusiasts, who will do their philosophy a great disservice if they insist on blind loyalty to the current system.  We saw the same theme in our review of John Bogle’s The Battle for the Soul of Capitalism,[1] where we wrote that “in common with many others today, Bogle sees that the market system has become untracked – has ‘lost its soul’ – and needs much devoted attention (especially from capitalism’s supporters…).”   It is worth noting that Bogle saw the problem as societal, not just economic.  “Our society is moving in the wrong direction,” with “absurdities and inequities that we’ve come to accept” in a “wealth-oriented, things-fixated society” within which “the lure of money has overwhelmed the prestige of reputation.”

          This suggests that even though national and international financial reforms are essential, they cannot appropriately be understood as a “quick fix” that will be sufficient to put things right.  There needs to be deep concern for the systemic health of the society. 

What Stiglitz says (and doesn’t say) about the multi-trillion dollar ocean of global finance.   In our review of David Smick’s The World is Curved: Hidden Dangers to the Global Economy, [2] we found that “the risks Smick describes are so many and so palpable that any objective observer would be justified in considering them intolerable.”  Smick points out that “the size of financial markets, relative to governments, has become so monstrously huge” that “the global economy is becoming increasingly beyond the positive control of governments.”  It comprises “a raging ocean of capital” amounting to “hundreds of trillions of dollars.”  (We recall that John Lippert on Bloomberg.com reported an incredible $683 trillion market in derivatives.[3])  Smick speaks of “the seemingly endless ability of the global financial markets to create leverage and risk.”  Moreover, “the global financial system… is vulnerable to a psychological herd effect that could wreak havoc with the industrialized world economies.” 

          In light of all this, we found it incongruous that Smick considered that raging ocean indispensable, holding the catastrophic risks worth taking.  Why did he think so?  Because it is a “system that allocates so successfully for the industrial world.”  In effect, he is saying that “successfully” is compatible with “catastrophic.”  It is akin to reassuring a population living on the side of an active volcano that “sure there’s imminent risk, but don’t forget what a lovely spot you live in.”

          This has caused us to hope that a major economist will not only perceive the brinksmanship, as Smick does, but will prescribe how the world can remove itself from the edge.  What is needed is to assess just how valuable the global financial market really is, to weigh whether its worth truly justifies the extreme dangers.  If it does not, then there is a need to address in detail how the world can tame the beast.  A premise that seems obvious to this reviewer, but that is not apparent to most commentators who adhere to the globalist wisdom, is that there is almost no amount of “resource allocation” that will justify world catastrophe.  According to Smick, a global “herd effect,” even among individually small investors such as the “Japanese housewives” of whom he speaks, can sweep the global economy in its path.  If so, it would seem that a drastic downsizing, accompanied by checks on rapid speculative swings, would be imperative, far outweighing the value (which Stiglitz questions) of free-wheeling global finance.

          Stiglitz speaks to part of this.  Unlike Smick, he thinks unconventionally enough to see relatively little value in the global financial market.  His discussion mixes his awareness of the dangers with his assessment of the system’s countervailing value:  speaking of the “short-term money” that “flows freely” under “capital market liberalization,” he observes that “one can’t build factories and schools with such hot money; but such hot money can wreak havoc on an economy.”  Hot money’s coming “into a country overnight to flow out equally rapidly” was “a key factor contributing to the East Asian crisis of 1997-1998.”  This shows his awareness of the dangers, and Stiglitz proceeds to the next step, saying that “I had been particularly critical of capital market liberalization because while the costs – the huge risks – were clear, there were no apparent benefits” (emphasis added).  He analyzes the various justifications cited for the rise of the multi-trillion dollar derivatives market – and finds none of them persuasive. He says “it is hard to point to any clear link between ‘financial-sector innovations’ and increased productivity” (again, emphasis added).   We see his opinion of “securitization” when he says that “as far back as 1992, I worried that the securitization of mortgages would end in disaster.”   All of this contradicts those who argue that the global financial market is connected at the hip to worldwide economic dynamism.

          But having led us to this point, Stiglitz shrinks from drawing the conclusion his premises would seem to make imperative.  Despite it all, he says, “we cannot function without… our financial markets,” and “securitization will not go away.  It is part of the reality of a modern economy.”  Derivatives, he says, shouldn’t be banned; only regulated, with “full transparency.”  Oddly, he comments at one point, in contradiction to this, that “the outsized financial sector had to be downsized,” but this seems only a blip on his intellectual horizon, since he doesn’t pursue it and he offers no suggestions about downsizing.

          This leaves room for a thinker who will be radical enough to buck the conventional wisdom’s continuing loyalty to the relatively recent burgeoning of international capital flows.  (When we say “relatively recently,” we recall that William Greider wrote in One World, Ready of Not: The Manic Logic of Global Capitalism [1997]) that “finance capital – the trading of stocks, bonds, currencies and more exotic forms of financial paper – has accelerated its movements around the world at an astonishing pace.”)

His critique of – and thoughts about alternatives to -- the responses to the crisis. 

          The “bailouts.”  In the United States, both the right and the left have excoriated the bailouts, although the rhetoric hasn’t given the public much theoretical insight as to why.  (In May 2010, the Republican state convention in Utah repudiated incumbent U.S. Senator Bob Bennett, keeping him off the primary ballot, for the reported reason that he voted for TARP, the bailout bill.)  On the right, there is a commonly held school of thought that economic collapses are best addressed by doing nothing, allowing things to collapse so that they can rapidly hit bottom, wash out the “malinvestments,” and get on with the process of engendering new growth. 

          Stiglitz doesn’t belong to this “do nothing” school, but he is nevertheless bitingly critical of the bailouts.  Thus, he lends an authoritative voice to the cries of anguish. (Readers of these reviews will recall that the early books described the crisis and its causes, but that a second wave of books was to be expected that would assess the responses to the crisis.)  Stiglitz’s book is one of these, and here are some of the points he makes:

          .  There was no coherent plan.  The need for action was apparent at least thirteen months before the panicky steps were taken in September 2008.  Even then, “the Treasury and the Federal Reserve veered like drunk drivers from one course to another, saving some banks while letting others go down.”  Neither candidate in the impending presidential election “wanted to risk delving into the deeper causes of the crisis.”  The banks themselves were the drivers of the policy: “The banks’ influence dominated almost every decision the U.S. Treasury made.”

          .  “The AIG bailout was particularly foolish [since] little of it went to systemically significant institutions.”  The money was largely directed, instead, to Goldman Sachs and foreign banks, with the consequence that “we were, in effect, giving foreign aid to other rich countries.”  In all, the bailouts were conducted “unconscionably,” with runaway generosity toward an institution such as Goldman Sachs.

          .  Bailing out banks produces almost no “multiplier” to amplify the level of economic activity. 

          .  Abuses abounded.  The banks paid “huge bonuses for record losses”; “dividends continued unabated, and shareholders and bondholders were protected.”  The result was “one of the largest redistributions of wealth in such a short period of time in history.”

          .  The theory was wrong.  The bailouts were “trickle-down economics” premised on the idea that “by helping the banks enough, homeowners and the rest of the economy might get some respite.”  This trickle-down didn’t work, despite a total of $12 trillion in U.S. bailouts and guarantees.  The large American banks “didn’t even pretend to resume lending,” even though “they knew that the intent of the money was to recapitalize the banks to enable them to lend.”

          .  There was little transparency.  “Hundreds of billions of dollars were in hidden giveaways.” 

          This leads to the question of what Stiglitz thinks should have been done:

          .  First of all, the crisis could have been prevented: “If the Fed thought it didn’t have authority to regulate the investment banks, if they were systemically important, it should have gone to Congress and asked for this authority.”  Instead, it “bought into the deregulatory philosophy.”  The Fed thought it couldn’t tell whether a bubble was occurring, but Stiglitz says that, to assure sound markets, it “could have pushed for higher down payments on homes or higher margin requirements for stock trading.”  

          .  Instead of “throwing money at the banks,” the government should have helped homeowners, the unemployed, and used fiscal policy to stimulate the economy.  It was the underlying economy and “flood of mortgages going into foreclosure” that had to be addressed.

          .  As to the troubled financial institutions, the U.S. government should have followed the traditional path of forcing their financial reorganization through the use of conservatorships, with possible short-term government ownership.  (Readers may wish to note Richard Posner’s disagreement with this in his The Crisis of Capitalist Democracy (2010), at p. 314.  He sees it as a proposal from “left-leaning economists.”  Even a temporary government take-over, he argues, would be fraught with complications and would have “a baleful effect on business morale.”)

          .  Stiglitz continues: “Instead of trying to save the existing banks, which had thoroughly demonstrated their incompetence, the government could have given the $700 billion [in the bailout program] to the few healthy and well-managed banks or even to establish a set of new banks.”  The result of the bailouts, with the financial mergers that it spawned, has been more, not less, concentration in the financial industry.  It would have been much better to restructure the financial system.

          The stimulus.  Stiglitz says the stimulus plan, adopted in February 2009 a few days after Obama took office, suffered from a lack of vision and that “it helped – but only to prevent things from becoming worse.”  The spending was largely misdirected, producing too small a multiplier.  Too much, he says, went to “mega-payments to America’s companies in the form of subsidies and tax preferences,” when it should have gone to “poor Americans or to high-return investments in infrastructure and technology.” (Much of the stimulus was allocated to environmental “green” spending, but it is unclear to this reviewer whether Stiglitz thinks this was the best sort of technological spending under the circumstances.)

          Stiglitz adds that the stimulus wasn’t large enough to serve its purpose, and “too much went to tax cuts” (although he thinks an investment tax credit would have been helpful).  Considerably more should have gone to “help states and localities and those that were falling through the holes in the safety nets.”  (The stimulus was largely nullified during the first year by being offset by the reductions in state budgets forced by the states’ loss of revenues from the declining economy.)  And he is critical of the timing: the spending was ostensibly to recharge a failing economy, but was spread over several months and even years (he mentions a two-year span, somewhat oddly overlooking that portions of it are actually spread over ten years).  

Stiglitz’s critique of the performance of the two presidential administrations. 

          It may be surprising that Stiglitz, who by reputation is on the left, takes a dim view of both administrations’ actions.  Among the other things we will mention, he says they each “turned to the Fed” because “they were trying to circumvent democratic processes, knowing that many of the actions had little public support.”

          About the George W. Bush administration:  In late September 2008, the bailout (“TARP”) bill was defeated by 23 votes in the U.S. House of Representatives. This set the Bush administration into action to buy congressmen’s votes: “It asked, in effect, each of the opposing congressmen how much they needed in gifts to their districts and constituents to change their vote.  Thirty-two Democrats and twenty-six Republicans who voted no on the original bill switched sides,” so that the new version, which “contained $150 billion in special tax provisions for their constituents,” was enacted in early October.  This was combined with strategies, long on-going but ultimately not entirely successful, to keep the public from a full realization of the crisis until after the November elections.  The bailout of AIG took place under the Bush administration, and we have seen Stiglitz’s criticisms of its lack of transparency and its subsidizing, in effect, Goldman Sachs and foreign banks.

          About the Obama administration:  Rather than a sharp change in personnel or policy, the new administration “only slightly rearranged the deck chairs on the Titanic.” It did not, according to Stiglitz, push for efficacious alternatives that were readily at hand.  “Muddling through” was the order of the day, and Stiglitz speaks of “Obama’s gamble of continuing the course on bank bailouts,” with “seemingly limitless support for the banks.”  What was needed was a new vision of “what kind of financial markets and economy we wanted to emerge,” but Obama didn’t offer one.

          The bailout continued on what Stiglitz considers its unconscionable course.  “Some of the giveaways to the banks were as bad as any under President Bush.”  Rather than the dangers from the potential failure of gigantic financial institutions being addressed, “the financial system that is emerging is less competitive, with too-big-to-fail banks presenting an even greater problem.”  The product is an “ersatz capitalism, the privatizing of gains and the socializing of losses.”  The continuing privilege extended to the rich was apparent in the Obama administration’s surprising double standard: Stiglitz points out that “contracts for AIG executives were sacrosanct, but wage contracts for workers in the firms receiving help had to be renegotiated.”

          The many criticisms we have seen that Stiglitz makes of the “stimulus package” apply, of course, to the Obama administration, under which it was passed.  It would have been preferable, he argues, to “pick up the mortgage payments” of the unemployed, who had “lost their homes soon after they lost their jobs – all through no fault of their own.”  The mortgage payments by the borrower could then be resumed after the borrower had found a job.  There was a program for the renegotiation of mortgages, but it was implemented at a snail’s pace: “Only 20 percent of the 3.2 million eligible troubled loans had been modified by the end of October 2009, even on a trial basis.” 

          The “cash for clunkers” program, which paid people to trade in their vehicles for ostensibly fuel-saving newer ones, was a poor form of stimulus, since it primarily moved forward the time of people’s purchase of cars, leaving a decreased demand for cars once the program ended.  

The reforms that Stiglitz thinks are needed

          Our earlier reviews of books on the financial crisis have told what other authors are suggesting for reforms.  Stiglitz’s recommendations should be considered in comparison with, and perhaps addition to, theirs:  

          Re “stimulus”:  He called for “a much larger stimulus” and says that “a well-designed stimulus program should reflect seven principles”: fairness; speed; an effective multiplier effect; dealing with short-term exigencies created by the crisis, but also addressing the country’s long-term problems; focusing on investment; and targeting areas of job loss.  Among other things, he favors direct government lending to homeowners at low rates during the crisis.

          Re global stability: Internationally, there needs to be “a globally coordinated stimulus” and “a globally coordinated regulatory regime.”  As part of this, he favors creation of a “new global reserve currency.”

          Re bankruptcy law: Stiglitz wants a more “people-friendly” bankruptcy act than the one that was enacted in 2005.  This would involve providing a “homeowners’ Chapter 11.”  (As we have known it, Chap. 11 is the alternative to a business’s liquidation, allowing for a plan of reorganization, with perhaps a restructuring of debt.)

          Re taxation: He argues that current tax policy toward home ownership, which provides for the tax deductibility of mortgage interest and property taxes, favors wealthy homeowners.  He would prefer a progressive, cashable tax credit, “with a higher rate for the poor than the rich.”  More generally, Stiglitz would like to see a large redistribution of income through progressive taxation.

          Re executive compensation: Companies, he says, moved to stock options as a way of paying executives “because it is a way for companies to give high pay without shareholders knowing the full cost,” which comes in the form of “dilution of the ownership claims of [those] other shareholders.”  A “simple reform” would take care of this: “basing pay on long-term performance, and making sure that bankers share in the losses and not just the gains.”  He calls for more transparency in compensation, and for giving stockholders “more say in determining compensation,” pointing out that companies even lobbied against “laws that would simply require shareholders to have a nonbinding vote on executive compensation.”

          Re “mark-to-market” accounting: Stiglitz strongly favors “mark-to-market” accounting, so that banks list assets at their current market value rather than at the earlier nominal value.  He is critical of the March 2009 accounting change that permitted banks not to mark down troubled mortgages.  His support of “mark-to-market” is qualified, however, by his saying that it depends on what regulators are doing with regard to lending against the value of banks’ capital.

          Re “off-balance-sheet magic tricks”:  He considers this sort of accounting “cooking the books to hide from investors what is going on,” and would abolish it, requiring everything to be shown on a firm’s balance sheet.

          Re off-shore tax and regulation havens: He is sharply critical of “the secrecy havens like the Cayman Islands,” which are “deliberately created ‘loopholes’ in the global regulatory system….”      

          Re the “too-big-to-fail” financial institutions: Stiglitz says the huge size of financial institutions can’t be justified on the ground that they produce economies of scale, for which he sees no evidence.  He would cause them to “spin off… their commingled activities – insurance companies, investment banking, anything that is not absolutely essential to the core function of commercial banking.”  Size, though, isn’t the only problem: regulators need to prevent the intertwining of activities from different firms whenever their joint activities would result in a “too-intertwined-to-be resolved situation.”  He calls for preventing financial institutions’ becoming so large or intertwined in the first place.  In the absence of such prevention, he would give “the Fed and Treasury clearer authority to ‘resolve’ financial institutions whose failure might put the economy at risk.”  The bailout process, he says, has immensely increased the problem of “moral hazard” (institutions’ willingness to take imprudent risks because they feel sure government will ride to the rescue).

          Re financial regulation: An important reform, Stiglitz argues, would be for regulators to be appointed “from among those who might be hurt by a failure of regulation, not from those who would benefit.”  Such people can be found among “financial experts in unions, nongovernmental organizations, and universities.”  By no means should regulators be lulled to sleep by the recent vogue that markets always work, needing little regulation, and are humane.

          Re political reform: Stiglitz points to the abuses brought about by moneyed political influence, saying about banks in particular that they have “grown too politically powerful to be constrained.”  This causes him to call broadly for “reforms in campaign contributions and electoral processes.”  [That’s a big subject, of course, and deserves a lot more attention than he is able to give it in this book.  It would seem vital, in fact, to accomplishing truly meaningful reform.] 

          Re the crisis in monetary theory: “Monetarism” (by which Stiglitz means Milton Friedman’s proposal that the money supply be increased by a fixed annual rate) was in vogue in the 1970s and ‘80s, but failed and was replaced since the late 1990s by “inflation targeting.”  Stiglitz says this focus on inflation is itself unsound, being based on four fallacies.  What he does see favorably is that “today, most central bankers realize that they must pay attention to financial markets and asset price bubbles as well as commodity inflation.” As our series of reviews has shown, several commentators agree that the current crisis shows how imperative it is for regulators to pay continuing attention to the systemic soundness of the financial system.

          Re the mortgage market: Abuses, he says, such as “liar loans” (where the loan applicant is not called upon to disclose his income), 100 percent loans (i.e., those having no down payment), and variable-rate loans should be abolished, as they are “in many countries.”

          Re stabilizers: Stiglitz favors building in automatic counter-cyclical stabilizers, such as triggered increases in unemployment benefits.

          Re credit card companies: Pointing out that “the banks essentially own the two major credit/debit card systems, Visa and MasterCard,” he calls for more “effective enforcement of competition regulations.”  Under the existing system, it has “just been easier to hand out credit cards to anyone who breathed than to do the hard work of credit assessment and to judge who was creditworthy and who was not.”  This lends itself, of course, to the extension of bad credit, with many consumers getting into debt beyond their means.  Moreover, the United States should move toward “an efficient electronic payment mechanism,” which Stiglitz sees as essentially a debit-card system in which “funds would be instantaneously transferred from the cardholder’s account to the merchant’s.”

          But, overall, he is pessimistic about whether enough will actually be done: We would like to think that Stiglitz, who was so active in seeking reforms after the East Asian crisis more than a decade ago, foresees adequate corrective action this time.  But he doesn’t.  “Something will be done – but it almost surely will be less than what is needed… to prevent another crisis.”  These are fateful words. 

 

                                                                                                 Dwight D. Murphey

           

 



[1]   See The Journal of Social, Political and Economic Studies, Winter 2009, pp. 517-522.

[2]   See The Journal of Social, Political and Economic Studies, Summer 2009, pp. 260-267.

[3]   John Lippert on Bloomberg.com, January 3, 2009.