Stiglitz: On the Fallen Standing of the US High Finance

This article from Project Syndicate (hat tip Mark Thoma) is a report from Davos by Nobel Prize winner Joesph Stiglitz on the considerable skepticism abroad toward US financial and business practice, particularly our faith in deregulation. It is a telling indicator of how rapidly the world is changing, yet many in the US are still in denial.

From Stiglitz:

Not surprisingly, the atmosphere at this year’s World Economic Forum was grim. Those who think that globalisation, technology, and the market economy will solve the world’s problems seemed subdued. Most chastened of all were the bankers.
Against the backdrop of the sub-prime crisis, the disasters at many financial institutions, and the weakening of the stock market, these “masters of the universe” seemed less omniscient than they did a short while ago.

And it was not just the bankers who were in the Davos doghouse this year, but also their regulators – the central bankers.

Anyone who goes to international conferences is used to hearing Americans lecture everyone else about transparency. There was still some of that at Davos. I heard the usual suspects – including a former treasury secretary who had been particularly vociferous in such admonishments during the East Asia crisis -– bang on about the need for transparency at sovereign wealth funds (though not at American or European hedge funds).

But this time, developing countries could not resist commenting on the hypocrisy of it all. There was even a touch of schadenfreude in the air about the problems the United States is having right now –- though it was moderated, of course, by worries about the downturn’s impact on their own economies.

Had America really told others to bring in American banks to teach them about how to run their business? Had America really boasted about its superior risk management systems, going so far as to develop a new regulatory system (called Basle II)? Basle II is dead –- at least until memories of the current disaster fade.

Bankers – and the rating agencies – believed in financial alchemy. They thought that financial innovations could somehow turn bad mortgages into good securities, meriting AAA ratings. But one lesson of modern finance theory is that, in well functioning financial markets, repackaging risks should not make much difference.

If we know the price of cream and the price of skim milk, we can figure out the price of milk with 1% cream, 2% cream, or 4% cream. There might be some money in repackaging, but not the billions that banks made by slicing and dicing sub-prime mortgages into packages whose value was much greater than their contents.

It seemed too good to be true -– and it was.

Worse, banks failed to understand the first principle of risk management: diversification only works when risks are not correlated, and macro-shocks (such as those that affect housing prices or borrowers’ ability to repay) affect the probability of default for all mortgages.

I argued at Davos that central bankers also got it wrong by misjudging the threat of a downturn and failing to provide sufficient regulation. They waited too long to take action. Because it normally takes a year or more for the full effects of monetary policy to be felt, central banks need to act preemptively, not reactively.

Worse, the US Federal Reserve and its previous chairman, Alan Greenspan, may have helped create the problem, encouraging households to take on risky variable-rate mortgages by reassuring those who worried about a housing bubble that there was at most a little “froth” in the market.

Normally, a Davos audience would rally to the support of the central bankers. This time, a vote at the end of the session supported my view by a margin of three to one.
Even the plea of one of central banker that “no one could have predicted the problems” moved few in the audience -– perhaps because several people sitting there had, like me, explicitly warned about the impending problem in previous years.

The only thing we got wrong was how bad banks’ lending practices were, how non-transparent banks really were, and how inadequate their risk management systems were.

It was interesting to see the different cultural attitudes to the crisis on display. In Japan, the CEO of a major bank would have apologised to his employees and his country, and would have refused his pension and bonus so that those who suffered as a result of corporate failures could share the money. He would have resigned.

In America, the only questions are whether a board will force a CEO to leave and, if so, how big his severance package will be. When I asked one CEO whether there was any discussion of returning their bonuses, the response was not just no, but an aggressive defence of the bonus system.

This is the third US crisis in the past 20 years, after the Savings & Loan crisis of 1989 and the Enron/WorldCom crisis in 2002.

Deregulation has not worked. Unfettered markets may produce big bonuses for CEOs, but they do not lead, as if by an invisible hand, to societal well-being. Until we achieve a better balance between markets and government, the world will continue to pay a high price.

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  1. jm

    In Japan, the CEO of a major bank would have apologised to his employees and his country, and would have refused his pension and bonus …

    Some very credible people assert that those apologies and retirements by Japanese top management are just PR moves. And though I’ve seen many of these over the decades*, I can’t recall any of them declining their pensions. I suspect they are very well cared for in retirement.

    One of the most fundamental concepts in Japanese culture is that of “honne to tatemae” — true intent versus facade.

    Many years ago an American journalist visiting Japan related to me that he had been entertained at the home of a certain company president and had been impressed by how humbly he lived. As I knew his actual residence was a penthouse consisting of the entire top floor of a fairly large condo building in one of the most expensive areas of Tokyo, I was more than a little puzzled. Later I learned that in fact the prez had borrowed his brother-in-law’s home for the occasion.

    It’s never a good idea to take anything in Japan at face value.

    * I’m fluent in Japanese and much of my career has been in Japan-related positions.

  2. marco

    Very interesting.

    But, nonetheless, US mega bonuses, golden parachutes and similia are true examples of (LEGAL) BANK ROBBERIES…

    So asking them to be returned is a no-brain !

  3. Anonymous

    The main points seems to be a recognition that American dominance in financial matters is coming to an end and a belief that regulation solves or prevents many economic bubbles from occuring.
    America has proven that it is not a trustworthy financial enity, better to invest your money with the local mob.
    Gov’t regulations look great on paper but they do require someone to enforce them which means money and strong support from the political establishment, both are lacking in the US and will probably be that way for sometime.

  4. Anonymous

    Stiglitz is a fine economist but like all humans is prone to cognitive biases. While I agree that we have had three major market corrections over the past twenty years, it has also been a time of unprecedented economic growth across the globe. The standard of living across the globe has improved materially. Stiglitz is simply wrong in asserting that we have a major problem. He is correct that we need to better understand the dynamics we are experiencing. To summarize it is a common cognitive bias to focus on the losses and not the entire economic situation.

  5. Anonymous

    “They thought that financial innovations could somehow turn bad mortgages into good securities, meriting AAA ratings.”

    Global collusion and financial engineering gurus fused together packages of localized loan pools into globalized loan pools in hopes that the default rates would be insignificant and thus any impairment or dilution would be diluted to zero risk.

    The result of what these gurus engineered is a global systemic financial failure resulting in denial on their part, no accountability on their part and defaults on a global scale never before seen. These gurus will return to Davos with new derivatives and be held in high regard, versus being placed into global prison cells!

  6. Anonymous

    The issue with respect to bonuses for senior Wall Street executives is that they were all based on the last several years of earnings, which were largely generated by structured financial products. Now that we know that these profit numbers were nothing more than fabrications (no one knows for sure when execs realized this), shareholders deserve to get the bonuses back. The problem is that boards never structure employment agreements with a claw back. The argument for excessive executive pay was twofold (1) the firms were generating outstanding returns, and (2) companies would loose top talent. Well, looking back, the excess returns have been vaporized and most shareholders would likely agree that loosing this “talent” wouldn’t have necessarily been a bad thing as newcomers could have hardly done worse.

  7. Anonymous

    “The standard of living across the globe has improved materially.”

    Well in the USA what has improved materially is the lot of the top 1%. For example, wages of men in their 30’s have declined 12% since the ’70’s. For most, family income has stagnated rather than declined only because women have gone to work.

    Argue for predatory deregulated American style capitalism if you like, but you aren’t entitled to your own facts.

  8. eh

    cognitive biases

    Those definitely exist, especially among traders (bulls, bears) — it is based on more than fundamental analysis, and recognizing and controlling it is a major problem for many of them.

    Still I don’t think it is ‘cognitive bias’ to point out the varied failings of modern ‘financial engineering’ and the regulatory milieu around it, since by this point they are more than obvious. Nor is it ‘cognitive bias’ to suggest that what appears to be prosperity here in the US is actually, to a significant degree, über-consumption financed by debt and debt driven asset inflation:

    Mr. Rosenberg, calculates the debt-service-to-income-ratio — interest and principal payments siphoned from after-tax earnings — has now soared to a near-record of 14.3%. That means 14.3¢ of every after-tax dollar of income earned goes to debt service.

    The aggregate household debt-to-income ratio soared to 138% in the third quarter of 2007 from 101% at the end of 2001, an increase equal to all of the last 40 years combined.

    “We have taken out so much debt as a society to finance a consumption boom and asset boom…that total interest payments are a bigger drag today than they were 25 years ago when the prime and conventional mortgage rate were both north of 16%,” Mr. Rosenberg said in a research note. “This is rather unbelievable.”

  9. s

    Cognitive bias? What? The wealth creation over the past decade plus has been on the back of a system that has grown more corrupt by the year. It is a parasytic system that is rotten to the core and feeding off the real economy, empowered by the bankrupt foreign economic policy that has essentially given away our competitive advantages and gutted out industrial base. Who said American’s aren’t generous?

  10. Tom

    “If we know the price of cream and the price of skim milk, we can figure out the price of milk with 1% cream, 2% cream, or 4% cream.”

    That’s a bit of misdirection – the point with securitisation is that you should get all the cream if you buy the AAA’s, so you buy, say, 70% of the milk but get 100% of the cream. 4% cream in a carton becomes 5.7% of the tranche, which (following his own logic) we can all value… Still, if the milk goes sour…

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