mercoledì 8 ottobre 2008

Nobel Laureate Stiglitz lectures on the Financial Crisis / Summary

Université de Genève, October 6th 2008
According to Mr Stiglitz, today’s key problems are three: liquidity shortage, financial structure and the macroeconomic context.
Finance has historically three functions: mobilize savings, allocate capital and manage risk. Thus, increasing productivity in the real economy. As theory says, private rewards (wages) are set in conformity with the social returns. Today’s mess suggests ironically that the return we get from bankers is not exactly as great as their wages.
But coming to the original functions of finance, let’s make an overall assessment.
What about savings? US households’ savings have fallen to zero. If the Ricardian equivalence is correct, hard times are looming ahead. And public debt, which is already rising, is not including all the unfunded liabilities that the US will face in the future, such as terror-war veterans’ subsidies.
Financial institutions did not manage, but created risk. Innovation had the shape of mainly circumventing legislation. Think of all the subprime packaging, splitting and unpackaging of risk. Moreover, they resisted “good” innovation. Wall Street, he recalls, was opposed to inflation-indexed bonds the Clinton administration had proposed back in the ‘90s. Same with GDP-based bonds for Argentina’s default, which would have allowed the country to pay less interest when in recession and more when growing.
Also, capital allocation was far from good. Too much capital was devoted to the housing market, which ended in failure. And we cannot forget the role Western banks played as regards the financial crisis in Asia and South America.
Mr Stiglitz defines finance as “modern alchemy”. It is an opaque world with “no information”, rather than “asymmetric information”. It turns out that banks don’t even know their own balance sheets, let alone their counterpart’s.
The reason why the crisis spreads to the real sector has to do with the mechanism of “leverage”. The higher the leverage, the higher the expected return. Banks raise their assets by lending, but deposits are sticky. Firms borrow hoping they get a return from investment. They expect to repay when investment yields its fruits. But this is an amplifying circle, which brings us further from stability.
Banks lent too many mortgages because they were expecting prices to go up and up. They expected people to be able to pay back thanks to ever-rising prices. Unluckily, economics also tell us that no such free meal exists. The mechanism was intrinsically unstable: real wages have stagnated since 2000 (dot bubble bust) in the US. With housing prices rising and stable incomes, it was maybe surprising that the game could go on for so long.
Then, securitization played a role in this crisis. Risks were correlated across banks, which makes it difficult for portfolio diversification to hold as a defense against reversals. Add to this, a range of dubious predicting models, some of them excluding past variables before World War II (and the Great Depression..?). Others, like Merton and Scholes’s, two Nobel laureates whose derivative model for hedge funds famously lost 4.6 bn $ in 1998.
But the main problem with securitization is that it brings a new source of asymmetric information. The risk originator does not bear the risk anymore, so we get a “hot potato” with risk going around from hand to hand. In this respect, rating agencies are among those to blame. Furthermore, this new development of risk management was not followed by a wave of new strict legislation, unlike insurance companies.
But let’s come to the core issue: why did people want to buy houses for so long? We need to go back to 2001, when the dot bubble went bust and the war on terror began. Financing the war required a huge fiscal stimulus, but this was mainly flowing from the US to abroad (ie, contracts to reconstruct Iraq, keep the army going, etc) with few spillovers for the US domestic economy. Nevertheless, the domestic economy needed to recover, and the FED poured a huge amount of liquidity into the economy. Ex post, this was shortsighted. Also, this echoes the South American debt crises of the ‘70’s. There, expansionary policies to boost consumption relied on heavy indebtment but all ended in implosion. “Borrow borrow borrow…boom”.
When he speaks about the rescue plans, Mr Stiglitz is gloomy. He compares them to “curing a hemorrhage with blood transfusions only”. The Paulson plan does not address the mortgage-side problems, it only provides for the buyout of bank bonds. But what will happen when house prices will fall under the threshold level and people will be forced out of their homes by mortgage contract? On the other hand, even if the plan succeeds, recession will be inevitable.
In the meanwhile, the US exported their downturn to Europe, not necessarily through financial linkages but also simply because the dollar was weak for a long time, thus depressing European exports. Mr Stiglitz calls for European governments to stand united, as decision-making fragmentation is a major problem in times of panic. Europe should grant for deposit insurance and suspend the Stability Pact in order to stimulate the economy.
In conclusion, Mr Stiglitz leaves the audience with a glimmer of hope. At the question “do we have the knowledge to avoid a Great Depression”, the answer was yes.

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